Edited version of your written advice

Authorisation Number: 1013088432216

Date of advice: 23 September 2016

Ruling

Subject: Income tax ~~ Deductions ~~ Trading stock

Question 1

Is the Taxpayer's proposed methodology for calculating the value of its trading stock using the cost method under section 70-45 of the Income Tax Assessment Act 1997 reasonable?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

The scheme commences on:

1 July 2015

Relevant facts and circumstances

1. The Trust acquired a property in 20XX.

2. The Trust applied to council to develop a moveable dwellings estate on the land. The Estate is aimed at providing an affordable alternative to retirement villages. A resident or their spouse must be at least 50 years old.

3. The Estate is governed by the Residential Tenancies Act. The estate will comprise the sale of movable dwellings to be located on blocks of land owned and licenced to residents by the Trust on long term leases. The licenses are life tenancies.

4. The dwellings are an 'unregistrable movable dwelling' which is defined in the Residential Tenancies (Caravan Parks And Movable Dwellings Registration and Standards) Regulations 2010 as a dwelling that:

a) is constructed on a chassis or in prefabricated sections; and

b) once installed, is a freestanding dwelling with solid walls and roof; and

c) is not a registrable movable dwelling.

5. Movable dwelling is defined in the Residential Tenancies Act 1997 as meaning a dwelling that is designed to be movable, but does not include a dwelling that cannot be situated at and removed from a place within 24 hours.

6. The Trust plans to build a number of dwellings in stages. Stage one will be made up of XX sites and communal facilities. Communal facilities will include a lifestyle centre with resident lounge, bar, kitchen, gym, cinema, library and craft room. There will also be a bowling green and BBQ area.

7. Residents are required to pay for their water and electricity usage. They will make their own arrangements with other suppliers such as telephone line suppliers.

8. The Trust has provided a brochure which is being using for advertising purposes and it provides information about the Estate. It explains that residents can purchase a home and lease the land on which it sits with no council rates or stamp duty to pay. Residents pay a low weekly site fee and individual power, water, sewage, phone/internet and insurance costs.

9. The bank requires the Trust to have two signed pre-sale contracts before construction will commence. It was expected that this would occur by 20xx. The Trust intends to also develop x display homes/units for display and marketing purposes and hold them for around 4 years.

10. The Trust will enter into two contracts with residents, a Home Purchase Agreement for the purchase of the home and a Site Agreement for the license of the site to the resident. These agreements have been provided with the ruling application.

11. The Trust will derive income from the following activities:

(a) Income from the sale of the movable homes; and

(b) Rent payable under the license of the sites.

12. The ruling request is seeking the Commissioner's agreement to absorption of the indirect or external costs between the cost of trading stock and the capital asset, the land.

13. The following costs will be incurred in relation to the sales of the park homes and the license of the site.

• Engineer costs;

• Architect costs;

• Planning costs;

• Construction costs (pertaining to the site as a whole) - roads, sewerage and stormwater, footpaths, telecommunications

• Construction of community centre and facilities;

• Landscaping - communal areas - footpaths, community centre/common areas and entrance structures;

• Fencing in communal areas.

These external costs exclude those costs (such as marketing fees, sales commissions and project management fees) that would be directly expensed.

14. Engineer costs are costs incurred to design the homes. These costs cannot always be separated from other engineering costs associated with infrastructure, they include all necessary costs associated with the planning, obtaining permits and building of the homes such as roads, sewer, stormwater, footpaths, telecommunications; style, type, placing, energy efficiency, landscaping, CFA Compliance, Building Code Compliance and number of homes for the project; and the supervision, inspection certification of these.

15. Engineer costs are invoiced as a fee for service, not under contract.

16. Architect costs are costs incurred to design the homes. These costs cannot always be separated from other costs associated with infrastructure. Landscaping design is for example an integral part of home design. These costs also include all necessary costs associated with planning/obtaining permits and building of the homes including roads, sewer, stormwater, footpaths, telecommunications; style, type, placing, energy efficiency, landscaping, CFA Compliance, Building Code Compliance and number of homes for the project; and the supervision, inspection certification of these items.

17. Architect costs are invoiced as a fee for service, not under contract.

18. Planning costs include all necessary costs associated with planning and obtaining council permits and approvals including detailed home designs and other design work associated with design for style, type, placing, energy efficiency, landscaping, CFA Compliance, Building Code Compliance and number of homes for the project; and costs incurred with the layout of the property (considering number of homes, their size, road area, landscaped areas, community areas etc). These costs also include all necessary costs associated with the planning/obtaining of permits and building of the homes including roads, sewer, stormwater, footpaths, telecommunications; style, type, placing, energy efficiency, landscaping, CFA Compliance, Building Code Compliance and number of homes for the project; and the supervision, inspection certification of these.

19. Planning costs are invoiced as fee for service, not under contract.

20. Construction cost of roads, sewer, stormwater, footpaths and telecommunications are costs incurred to enable the property to include dwellings. The cost of purchasing the home would not be incurred without the infrastructure costs being incurred. Parts of these infrastructure items are also directly connected to the dwellings.

21. Construction of Community Centre costs include expenditure related to the design and construction of a Community Centre. The community centre will not be constructed without dwellings being on site.

22. Landscaping costs is expenditure related to the landscaping of communal areas.

23. Fencing of communal areas is expenditure related to design and construction of fencing for communal areas.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 subsection 70-10(1)

Income Tax Assessment Act 1997 section 70-25

Income Tax Assessment Act 1997 section 70-45

Income Tax Assessment Act 1997 subsection 70-45(1)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Subsection 8-1(1) of the ITAA 1997 states that:

You can deduct from your assessable income any loss or outgoing to the extent that

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

A deduction is not allowed under section 8-1 of the ITAA 1997 if the loss or outgoing is capital or an outgoing of a capital nature as per paragraph 8-1(2)(a) of the ITAA 1997.

This exception is modified by section 70-25 of the ITAA 1997 in regards to the costs of acquiring items of trading stock. It states:

An outgoing you incur in connection with acquiring an item of trading stock is not an outgoing of capital or of a capital nature.

Trading stock is defined in subsection 70-10(1) of the ITAA 1997 as including the following:

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

(b) livestock.

The term "business" is defined under subsection 995-1(1) as:

…. any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

The Trust has a business of developing and selling movable dwellings in the Estate and leasing of the sites within the Estate to residents.

In the present case, the land, infrastructure and communal facilities are not held for the purpose of resale and therefore are not trading stock of the Trust. The movable dwellings are the trading stock of the Trust until sold to the residents.

Costs of Trading Stock

Subsection 70-45(1) of the ITAA 1997 states:

You must elect to value each item of trading stock on hand at the end of an income year at:

(a) its cost; or

(b) its market selling value; or

(c) its replacement value.

The Trust will use the cost method of valuing its trading stock on hand.

Taxation Ruling IT 2350 Income Tax: Value of Trading Stock on hand at end of year: Cost price: Absorption Cost (IT 2350) provides guidance on the determination of the cost price of trading stock on hand in a case where the taxpayer is engaged in a business of manufacture.

IT 2350 outlines that it is the absorption cost method which is the correct means to ascertain the cost of trading stock on hand at the end of a year in a manufacturing business. That is, regard is to be had not only to the costs of materials and direct labour but also to what is referred to as "indirect" costs. In this context IT 2350 only refers to production costs and "indirect costs" are limited to production overhead costs as outlined in paragraph 8 of IT 2350. These costs are still considered to be incurred in bringing the trading stock into a saleable condition.

We agree that costs directly associated with the production of the demountable buildings would be a direct cost of bringing the trading stock into a saleable condition.

However, we do not agree that costs which relate to the land and other common areas or the site in general are attributable, in part, to the cost of the demountable building trading stock. We discuss this in more detail below.

Costs directly associated with the demountable homes trading stock

Costs incurred in the design, construction, marketing, transportation and installation (including costs of connecting services) in relation to the movable homes, all constitute direct costs of bringing the trading stock into a saleable condition. It is anticipated that invoices in respect of these costs should be able to be obtained from the service providers.

Costs associated with other fixed assets and the Estate as a whole

Residents of the Estate are subject to a Site Licence fee for use and enjoyment of the Estate facilities and surrounds. It is considered that the costs associated with paths, driveways, landscaping of the whole Estate, including the sites and the communal facilities centre with resident lounge, kitchen, gym, cinema, library, craft room, bowling green and BBQ area, all are capital costs in relation to either, the Estate itself and the facilitation of the Site Licence.

You have relied upon withdrawn Taxation Ruling TR 95/D15 Income tax: property development: valuing land held as trading stock at cost price (TD 95/D15) and the decision in Federal Commissioner of Taxation v Kurts Development Ltd (1988) 86 FCR 337 (Kurts Case) to support your view that the external costs are to be apportioned between your capital assets and trading stock.

TR 95/D15 dealt with the valuation of land where that land is trading stock on hand at the end of a year of income and the taxpayer values the land at cost price under former subsection 31(1) of the Income Tax Assessment Act 1936 (ITAA 1936). The Ruling considered the taxation treatment of expenditure incurred in converting such land into the condition in which it is intended to be sold. In particular, the Ruling considered what expenditure forms part of the cost price of trading stock on hand and the method of allocating development costs to trading stock on hand, including the situation where land is developed in stages.

Kurts Case involved a property developer who acquired underdeveloped land and converted it into subdivided lots for the purpose of resale. As part of the process of subdivision and sale, a portion of the land acquired was required to be converted into public infrastructure, namely roads, parks, sewerage, drainage, etc. Ownership of these infrastructures eventually reverted to the Crown or relevant public authority. In addition, certain external costs were incurred on neighbouring public land and infrastructure not owned by the taxpayer, but which would assist in the provision of services to the taxpayer's subdivided lots, and otherwise for works done by local authority in relation to the subdivision.

The issue in Kurts Case was whether the costs incurred in developing the public infrastructure, including the cost of land used for that purpose, and the external costs, formed part of the cost of the subdivided lots for trading stock purposes, and therefore part of the value of the taxpayer's trading stock on hand at year end, even after the infrastructure land became separately identifiable.

The Court decided in favour of Kurts Development Ltd stating that the infrastructure land was never a separate article of trading stock in its own right. One form of trading stock, the raw land acquired, is merely converted to a different form of trading stock, the subdivided lots. Therefore, all costs incurred in creating those individual lots were held to be part of the cost price.

The taxpayer has argued in the present case that the principle from Kurts case is applicable to the Estate's circumstances. That is, the sale of the movable dwellings is inextricably linked to the provision of the site on which the dwelling is located. They consider the "but for" test applied in Kurts Case should be applied to their circumstances.

We distinguish Kurts Case facts from those of the present case. In Kurts Case, the expenditure was incurred in order to create the individual lots, which were trading stock. But for the expenditure, it was held the lots would not have been created. However, the land in the present case is not trading stock and costs in relation to the land, communal facilities and other capital assets owned by the Trust should be readily identifiable and able to be allocated between the costs of those capital assets. As outlined previously, costs directly attributable to the demountable dwellings should be a direct cost of those items of trading stock. However, the costs in regard to the land, communal facilities and other capital assets are clearly, capital in nature. We do not consider the incurring of these capital costs is essential to the sale of the movable homes. They are instead incurred in the management of the Estate and the earning of rent from the Site Licence.

External Costs

Costs as outlined in the Private Ruling submission and in the response to our request for additional information indicated the following external costs will be incurred: engineer and architect costs (mostly incurred in the design of the home), planning costs, costs for the construction of the community centre, and costs for landscaping and fencing communal areas.

In relation to these costs our view is:

Engineers cost - mostly incurred in the design of the homes. Where infrastructure is involved, we suggest using another method of reasonably apportioning the costs between capital assets and trading stock. This could involve using a method based on estimates, or obtaining separate invoices from the service provider.

Architect costs -mostly in respect of the design of the homes. Where infrastructure costs are involved, we suggest using another method of reasonably apportioning the costs between the capital assets and trading stock. This could involve using a method based on estimates, or obtaining separate invoices from the service provider.

Planning Costs - As these costs are invoiced as a fee for service, it is anticipated that it would be reasonable to obtain separate invoices relating to the costs of the movable homes and the land, communal facilities and other capital assets.

Construction of Community Centre - the costs of this facility are capital and related to the estate itself and the site licence and therefore not considered to be allocable to the movable homes trading stock.

Landscaping and fencing of communal areas - these costs are capital in nature and not allocable to the movable homes trading stock.