Edited version of your written advice

Authorisation Number: 1012978871348

Date of advice: 24 March 2016

Ruling

Subject: Property development: Ordinary income or capital gains

Question 1

Will any gain made from the sale of Blocks 9 & 10 be a gain made from the mere realisation of a capital asset and a capital gain pursuant to subsection 104-10(4) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will section 118-20 or section 118-25 of the ITAA 1997 apply to disregard the capital gain made from the sale of Blocks 9 & 10?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2015

The scheme commences on:

The scheme has commenced

Relevant facts and circumstances

The Group is in the business of commercial leasing. It has a portfolio of commercial buildings which it has held over the past 30 years. It also undertakes residential developments, with an external joint venture partner who specialises in residential developments. Commercial properties are solely owned by the group without an external party.

They are also the directors of Coy A Pty Limited, which is the trustee for two separate trusts. These trusts have not had any other business dealings apart from the transaction which is the subject of this ruling.

On dd/mm/yyyy, the taxpayers purchased a block. This purchase followed the sale of their business, the profits of which they chose to invest in long term commercial and retail property.

One of the taxpayer's death saw the block sold to Coy A Pty Limited on trust for an investments group and a development group on dd/mm/yyyy, in the following proportions:

• Investments X%

• Developments Y%.

The Group set up the above structure so that investments would own the residential units to be constructed and sold, and developments would own the commercial and retail spaces to be retained long term.

On the block, there were a number of historic buildings and trees which were entered on a register by council. This meant any development on the block required the approval from an authority.

The authority required that any development on the site be multi-use and include residential, hotel, commercial, retail and art spaces.

It was proposed to refurbish the existing buildings and to construct a new building (Building A) to include commercial and hotel spaces.

The proposed development of Building A was not able to go ahead as planned as it was not possible to get Government tenant for a commercial site where there is a hotel above it.

The new plans for Building A were to build an eight level mixed use residential and office building. It would incorporate a 2 level basement carpark with XXX car spaces, XX residential units and 475 square metres of office storage for use by Buildings E, P and H. It would incorporate XX residential units and X,XXX square metres of commercial office and retail space.

On the dd/mm/yyyy, funding was sought for the development and was approved on the dd/mm/yyyy.

The block was subdivided into Blocks 2 and Blocks 3 on dd/mm/yyyy. All buildings were on block 2.

Construction of Building A commenced on dd/mm/yyyy.

An offer was made on dd/mm/yyyy on Building A but was declined as the taxpayer had no intention of selling.

A valuation was provided for Building A on dd/mm/yyyy. The purpose of this valuation was to be relied upon as security for first mortgage advance purposes.

Block 2 was subdivided into Blocks 4 and 5 where Block 4 includes the existing buildings and Building A.

Building A was recorded in the financial statements from construction to the sale date as a capital asset.

A unit plan was established which would cover Block 4 and all the existing buildings on the block.

All XX residential units in Building A were sold by the investments group and treated as income for income tax purposes.

In mm/yyyy, an event destroyed most of an existing building (P). A dispute over the insurance proceeds caused a delay in receiving the insurance proceeds.

There was uncertainty over the required capital to rebuild the building due to its particular status.

Building A (including the residential units) P and H buildings were all on the one unit plan. In yyyy the unit plan was cancelled, after the event and a dispute with the residential building owners over insurance and rebuilding issues. The subdivision of Block 4 resulted in Block 8, 9, 10 and 11. Building A was on Block 9 and 10.

Dd/mm/yyyy, approval was granted for the construction of a commercial and residential tower on Blocks 5 and 6. This is known as Location B and includes hotel, residential, commercial, retail and cinema spaces.

The land at Location B is owned in partnership in the following proportions:

• Investments X%

• Developments Y%.

The partnership engaged Residential Pty Limited to develop the residential component. This entity took on all the development risk. The landowners took on no development risk and received the market value of the land.

During the construction of Location B in mm/yyyy, the independent builder, Independent Pty Limited went into voluntary liquidation. Consequently, a new builder had to be brought in which resulted in additional construction costs in excess of $XX million.

No further bank financing was available for the construction and therefore, the remaining costs were required to be paid via equity funding or the development could not be completed.

Negativity of the development resulted in substantial market risk around the residential sales and uncertainty of the revenue of the development.

Dd/mm/yyyy, a valuation was done on the Building A for bank financing purposes. This value amounted to $X.

In mm/yyyy the valuers approached the taxpayer with a submission to handle sale.

The taxpayer indicated that if they received an offer above $X million, they would consider the sale.

An offer for sale from Buyer Property Limited was received on dd/mm/yyyy to Developments.

On dd/mm/yyyy, the exchange of contracts for the sale of Blocks 9 and 10 occurred between Developments and Buyer Property Limited.

The property was sold for $X on dd/mm/yyyy and was sold as a GST-Free supply of going concern.

Developments retained ownership of the P and H buildings. It also still holds its interest in the commercial, retail and cinema spaces at Location B and another building on the site.

In mm/yyyy, the Group reinvested $X of the remaining funds into the purchase of a new commercial building. This building is being held as a long term capital asset.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 70-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 118-25

Reasons for decision

Question 1

Will any gain made from the sale of Blocks 9 & 10 be a capital gain pursuant to subsection 104-10(4) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The gain made from the sale of Blocks 9 & 10 is not assessable income, as upon entering the transaction, you did not have the requisite profit-making intention. Rather, you intended to hold the asset as a long term capital investment. As such the gain will be a capital gain pursuant to subsection 104-10(4) of the ITAA 1997.

Detailed reasoning

Section 6-5 of the ITAA 1997 states your ordinary income according to ordinary concepts is assessable income. Taxation legislation provides no specific guidance on what is meant by ordinary income. However, case law on the topic has identified the following relevant criteria:

• the characteristics of periodicity, recurrence or regularity;

• associated with business activities or services rendered, as distinct from the mere sale of property; and

• solicited, as distinct from a windfall.

Section 6-10 of the ITAA 1997 provides that your assessable income also includes some amounts which are not ordinary income called statutory income.

With regard to the sale of property, it is necessary to determine whether the profit received by the vendor on the sale of the property is considered to be assessable income, either

i. ordinary income from a business activity or as part of a profit making undertaking or scheme, or

ii. statutory income and assessable via the capital gains provision, contained in Parts 3-1 and 3-3 of the ITAA 1997.

In your situation, the sale of Blocks 9 & 10 was an isolated transaction and does not have the characteristics of periodicity or regularity. However, a profit from an isolated transaction may still be considered to be assessable income under section 6-5 of the ITAA 1997. The Commissioner's view on such transactions is detailed in Taxation Ruling TR 92/3 (TR 92/3).

Paragraph 35 of TR 92/3 states that a profit from an isolated transaction is generally income when both of the following elements are present:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

(b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

For a transaction to be considered to be of a business or commercial nature, it is usually necessary that a taxpayer has the purpose of profit-making at the time of acquiring the property.

Further, in the case of FC of T v. The Myer Emporium Ltd (1987)163 CLR 213; 87 ATC 4369; 18 ATR 699-700 (Myer), the Full High Court stated that, with regard to the nature of profits from isolated transactions:

'It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realisation. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.'

Paragraph 37 states that if a transaction satisfies both the elements in paragraph 35, it is generally not a mere realisation of an investment. A mere realisation of an investment would not be income, even if a taxpayer goes about the realisation in an enterprising way.

The elements in Myer and summarised in paragraph 35 will be discussed below with regard to your case.

Intention or purpose of the taxpayer when entering into the transaction

The intention of the taxpayer when entering into the transaction, as discussed in Myer, is not subjective, but rather an objective appraisal of the taxpayer's intention as evidenced by the facts and circumstances of the case.

Paragraph 39 of TR 92/3 states that if, a taxpayer is a company its purposes of those who control it are its purposes. Example 8 details a situation where a property developer purchases properties through a number of single-use entities. In this situation, similar to yours, the intentions of the controller of the group must be examined.

The directors and shareholders of the nominee company as well as the trustee companies also the board of the Group. Therefore the controlling minds can be said to be that of the Group.

The Group is in the business of commercial leasing. It has a portfolio of commercial buildings which it has held over the past 30 years.

When it has undertaken residential developments, it is with an external joint venture partner who specialises in residential developments. Commercial properties are solely owned by the group without an external party.

Further, as detailed in the facts set out above, you have submitted that:

• The land was subject to a Conservation Management Plan, which required a multi-use site encompassing commercial, residential, hotel and retail spaces.

• Developments always intended to own all the commercial sites in the group. The land was split so that Investments owned the residential units. All other commercial buildings on the development site are still held by the Group.

• You used long term debt finance with regard to the asset.

• Upon completion of the construction, the construction finance was converted into a X year hedged debt facility until mm/yyyy, which was extended to mm/yyyy in mm/yyyy.

• Building A's underground carpark was shared with the P and the H buildings. If the intent was to later sell Building A, the carpark would not have been shared.

• Building A (including residential units) P and H buildings were all on the one unit plan. The separation of the unit plan only occurred after the P building event in yyyy, which resulted in a dispute with the residential unit owners over insurance and rebuilding issues.

• Building A was held as a capital asset for a total of 7 years before sale. You derived rents from the time of its completion until its sale.

• You only disposed of the asset due to high levels of risk within the group after the voluntary insolvency of the independent builder of the residential development.

• The funds from the sale of the commercial property were reinvested into a new commercial property as a long term capital asset.

These facts suggest that Blocks 9 & 10 were not bought and developed with the intention of profit-making, but rather to hold as a long-term asset for the purpose of gaining income from commercial leases.

Whether the transaction was entered into, and the profit was made, in the course of carrying on a business

Paragraph 13 of TR 92/3 includes factors to be considered when considering when a transaction is of a business or commercial nature:

• the nature of the entity undertaking the operation or transaction;

• the nature and scale of other activities undertaken by the taxpayer;

• the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

• the nature, scale and complexity of the operation or transaction;

• the manner in which the operation or transaction was entered into or carried out;

• the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

• if the transaction involves the acquisition and disposal of property, the nature of that property; and

• the timing of the transaction or the various steps in the transaction.

The taxpayers are part of the wider Group, who are in the business of owning investment properties as long term commercial assets with the purpose of deriving rents. They have also been involved in developing and selling new residential apartments in partnership with third parties who specialise in such ventures.

The nature and scale of these activities is significant, given the size and value of the Building A on Blocks 9 & 10 and of the overall development.

Developments only owned the commercial spaces of Building A, which were held as a capital asset.

Due to the nature of the entities involved and the scale of the development, it is clear that the transaction was of a business or commercial nature, and was entered into in the course of carrying on a business, although the sale of Blocks 9 & 10 may have been outside the ordinary course of your business.

In summary, although the transaction was of a commercial nature, outside of your ordinary course of business, you did not have the requisite profit-making intention when entering into the transaction. Rather, you intended to hold it for long-term lease as a capital asset. Therefore, the profit is not correctly classified as income but rather as a capital gain.

Capital gain: section 104-10 of the ITAA 1997

For the CGT provisions of the ITAA 1997 to be applicable, there needs to be a CGT event that happens to a CGT asset.

CGT asset is defined in section 108-5 of the ITAA 1997. Note 1 of section 108-5 of the ITAA 1997 makes it clear that land is a CGT asset.

Division 104 of the ITAA 1997 sets out the CGT events that can happen to a CGT asset. In this case, the CGT event that occurred when Blocks 9 & 10 were sold is CGT event A1, under section 104-10 of the ITAA 1997.

Under CGT event A1,

(1) you make a capital gain if the capital proceeds from the disposal (sale) are more than the assets cost base (as described in subdivision 110-A of the ITAA 1997;

(2) you make a capital loss if the capital proceeds are less than the assets reduced cost base (as described in subdivision 110-B of the ITAA 1997).

The profit you made on the sale of Blocks 9 & 10 will be a capital gain, and will be subject to capital gains tax under section 104-10 of the ITAA 1997.

Question 2

Will section 118-20 or section 118-25 of the ITAA 1997 apply to disregard the capital gain?

Answer

No

Summary

Subject to section 118-20 or 118-25 of the ITAA 1997, the capital gain made through the sale of Blocks 9 and 10 will not be disregarded. The blocks were at no point held as trading stock and therefore, the capital gain will not be disregarded/reduced at the time of the CGT event.

Detailed reasoning

Section 118-20 states that, an amount from a capital gain you make from a CGT event is reduced if, because of the event, a provision of the Act includes an amount in your assessable income, or exempt income.

Further, subsection 118-20(2) states that the gain is reduced to zero if it does not exceed the amount included in the assessable or exempt income.

Section 118-25 states that, a capital gain or loss made from a CGT asset is disregarded if at the time of the CGT event, the asset is:

• Your trading stock; or

• If you are a partner, trading stock of the partnership; or

• If you are absolutely entitled to the asset as against the trustee of a trust, trading stock of the trustee.

Trading stock

Section 70-10 of the ITAA 1997 defines trading stock as:

• Anything produced, manufactured or acquired that is held for the purposes of manufacture, sale or exchange in the ordinary course of a business; and

• Livestock.

Under section 70-10 of the ITAA 1997, the conditions for the blocks to be considered as trading stock are not met on the basis of the ordinary business activities of the Group. The nature of business of the Group in regards to commercial properties is to hold the property for long term rental lease and not for the purpose of manufacture, sale or exchange. Therefore, the capital gains made through the sale of Blocks 9 and 10 are not reduced under section 118-20 or 118-25.