Edited version of your written advice

Authorisation Number: 1051234103811

Date of advice: 15 November 2017

Ruling

Subject: Property Subdivision – Am I in business?

Question 1

Is the subdivision and sale of the property the mere realisation of a capital asset and only taxable under the capital gains tax provisions?

Answer

No

Question 2

Will the profit from the sale of the proposed subdivided blocks located at the property be treated as ordinary income under section 6 -5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

1 July 2016 to 30 June 2017

1 July 2017 to 30 June 2018

The scheme commences on:

1 July 2014

Relevant facts and circumstances

Pre-development

The taxpayers purchased a block of land at an address in State A (the property) in 199X as tenants in common, with Taxpayers One and Two holding a two thirds interest and Taxpayer Three holding the remaining third.

The property had two dwellings on it at the time of purchase. A homestead style house and a two bedroom cottage.

Taxpayer One and Taxpayer Two moved into the homestead and lived in it as their main residence from 199X until 200W. From 200X to 200Y they rented out the homestead.

In late 201Y the homestead was removed from the property as part of the subdivision.

Taxpayer Three and their family moved into the cottage in 199X and occupied it as their main residence until 201V.

The cottage remains on the property.

In 201V a new house (the new house) was constructed on the property by Taxpayer Three. They moved into it in 201V and occupied it as their main residence from that time. The new house is built on one of the now subdivided lots.

Before 201X, including prior to 200Z several developers made unsolicited offers to purchase the property.

In discussions with the Taxpayers, the developers advised they anticipated demands from:

● the local government authority (the Council) requiring:

● a large part of the lot to be dedicated to parkland;

● the construction of a retaining wall adjacent to council parklands;

● the construction of an water detention system;

● a reduced number of lots due to reasons; and

● the potential construction of a sewerage pumping station.

● a State Government department relating to:

● the amount of land that may have been required to be dedicated as environmental reserves; and

● extensive landscaping requirements;

● a State Government department relating to:

● areas being allocated to future roadworks leading to extensive holding costs for an indefinite period after a subdivision;

● the construction of acoustic barriers;

● acoustic controls that could be placed on individual dwellings built on the Lots; and

● limited access from main roads for construction.

● a State Government department relating to the use of an existing road reserve across the property and;

In addition, the developers expressed uncertainty as to:

● the level of bulk ground works required due to unknown ground conditions; and

● the unknown level of density of development that the Council would approve.

All of the offers from developers factored in these commercial risks. This meant that any offers:

● were highly conditional;

● required the Taxpayers to commit the Land to the project for long periods of time without the certainty that any development would go ahead; and

● were lower than what the Taxpayers were willing to accept.

The Development Application (DA)

Around 200Z, the Taxpayers decided to investigate the issues raised by the offers that had been made by engaging a firm (the Consultant) that specialises in town planning, surveying and project management within the Council and experienced on neighbouring properties. The Consultant advised that the only way to clarify these issues was to lodge a development application (DA) to obtain responses from council and other government entities.

The Consultant provided advice to the Taxpayers on what other consultants would be needed to prepare the DA. The Consultant also briefed and obtained proposals from other specialist consultants and liaised with consultants and local and state Government departments.

In early 200Z, the Taxpayers lodged the DA, prepared by the Consultant, with the Council and received approval for a subdivision of the land. The conditions for this initial DA included a large no build zone.

The Taxpayers disputed the no build zone. This dispute was eventually resolved in their favour in the Relevant Court in 201X resulting in a modified DA being granted in 201X.

The DA involved setting a large portion of the land aside to create a large public park and environmental easement connecting with existing parks, as well as working within existing parkland.

The modified DA allowed for the subdivision of the property into a number of lots including a large residual lot.

In 201X, a State A Government department purchased part of the property for reasons.

In 201X and 201Y there were a number of discussions with developers to purchase the land.

However, the feedback from these developers was that there remained significant commercial risk as construction costs remained difficult to estimate due to:

● the large bulk civil component;

● the uncertain cost of the remediation and treatment of acid sulphate soils; and

● uncertain ground conditions which meant thousands of cubic metres of soil may have to have been removed from site and replaced with material imported from quarries some distance away;

● uncertainty about the access to telecommunications services. A service provider could not provide necessary connections and the land was not in an area scheduled to be serviced.

● The Taxpayers did not accept any of these offers.

The Taxpayers engaged a consulting engineer to obtain quotes from contractors to better quantify these construction costs. A consulting engineer sought prices and quotes which were submitted in late 201Y.

These quotes better clarified the costs but scope for significant variations remained. These included:

● uncertain costs of remediation and the treatment of the acid sulfate soils;

● access costs; and

● working with uncertain ground conditions.

Developers remained unwilling to pay prices the Taxpayers wanted because of these uncertainties.

The Development

In mid 201Y, an independent market valuation was obtained valuing the entire property at an amount.

In mid 201Y, the Taxpayers formed a company (the Company) to carry out the subdivision. The company is owned by two discretionary trusts: 1/3 by a trust controlled by Taxpayer Three and 2/3 by a trust controlled by Taxpayers One and Two.

Taxpayer One and Taxpayer Three are the directors of the Company.

In late 201Y, the Taxpayers committed to not selling the Land as a whole to a developer and the Company was appointed to carry out the subdivision. A development agreement was entered into with the Company.

Under the development agreement, the Company:

● engaged sub-contractors to carry out the development work, which included:

● roadworks and culvert installation;

● concrete works;

● electrical reticulation;

● surveys;

● geotechnical works;

● communications installation;

● engineering works;

● asphalting; and

● earthworks to raise the level of a number of the blocks; and

● marketed the sub-divided lots by:

● engaging an unrelated party with experience in neighbouring developments to assist with early marketing; and.

● marketing the lots through a local real estate agent.

There was no written agreement however it was agreed that the Company would:

● be reimbursed for the costs of the development; and

● receive a development fee equalling 10% of these costs .The development fee paid to the Company for these services was the reimbursement of its costs plus a 10% margin.

Initial funding for the development was obtained by Taxpayer One drawing down on an existing loan agreement with a bank and provided a loan to the Company. This money was subsequently repaid to Taxpayer One with interest.

The Company then obtained a loan to cover the remaining cost of the development from a bank.

In order to grant the loan, the bank required the pre-sale of a number of lots of the subdivision.

The Taxpayers agreed to provide the land as security for this loan.

The subdivision was completed around mid 201Z. Most lots have been sold and the applicants have retained several lots including a large residual lot.

Several lots will continue to be held by the Taxpayers.

There were projected expenses and revenue. To date, actual revenue from sales has been around X % of projections.

The Taxpayers have lodged a new subdivision application to divide a lot and the large residual lot into an additional number of lots.

If the DA is approved, the Taxpayers may engage the Company to manage the subdivision or sell the block as a whole along with the DA approval.

If the DA is not approved, the Taxpayers may sell the blocks or may decide to keep the blocks for their own use.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 subsection 70-10

Income Tax Assessment Act 1997 section 70-30

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 104-10(5)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 112-25

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

Reasons for decision

Question 1 & 2

Summary

The Taxpayers are considered to be carrying on a business of property development and any profit from the sale will be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). The land will be treated as trading stock under section 70-10 of the ITAA 1997.

Alternatively, any profit from the sale of the subdivided blocks will still be accounted for on revenue account as an isolated commercial transaction. Any profit from the sale will be assessable as ordinary income under section 6-5 of the ITAA 1997 as an isolated transaction.

Detailed reasoning

There are three ways profits from property sales can be treated for taxation purposes:

1. As ordinary income under section 6-5 of the ITAA, on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock;

2. As ordinary income under section 6-5 of the ITAA, on revenue account, as a result of entering into a profit-making undertaking or scheme;

3. As statutory income under the capital gains tax legislation.

Under section 6-5 of the ITAA 1997, your assessable income includes the ordinary income you derived directly or indirectly from all sources, during the income year.

Carrying on a business

Subsection 995-1(1) of the ITAA 1997 defines ‘business’ as ‘including any profession, trade, employment, vocation or calling, but not occupation as an employee’.

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? provides the Commissioner’s view of the factors used to determine if you are in business for tax purposes. In the Commissioner’s view, the factors that are considered important in determining the question of business activity are:

● whether the activity has a significant commercial purpose or character

● whether the taxpayer has more than just an intention to engage in business

● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

● whether there is regularity and repetition of the activity

● whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

● the size, scale and permanency of the activity, and

● whether the activity is better described as a hobby, a form of recreation or sporting activity.

No one factor is decisive. The indicator must be considered in combination and as a whole. Whether a ‘business’ is carried on depends on the large or general impression.

As to when such a business is taken to have commenced, Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock'? also states that a business activity is taken to have commenced when a taxpayer embarks on a “definite and continuous cycle of operations designed to lead to the sale of the land.” That is, the land will become trading stock when you are demonstrably fully committed to the business of land development. When that occurs is determined by a consideration of the facts of the case.

Trading Stock

Section 70-10 of the ITAA 1997 provides that trading stock includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business.

Taxation Determination TD 92/124 states that land will be treated as trading stock for income tax purposes if it is held for the purpose of resale and a business activity which involves dealing in land has commenced. Where such a business exists, the proceeds from the sale will be assessable under section 6-5.

Isolated transactions

Alternatively, Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income discusses profits on isolated transactions and the application of the principles outlined in the decision of the Full High Court of Australia in FCT v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693. This ruling states that profits on isolated transactions may be income.

Profit from an isolated transaction will be ordinary income where:

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

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

● Taxation Ruling TR 92/3 outlines that the relevant intention or purpose of the taxpayer, of making a profit or gain, is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer’s intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

Profits on the sale of subdivided land can therefore be income according to ordinary concepts within section 6-5 of the ITAA 1997 if the taxpayer’s subdivisional activities amount to a business operation or commercial transaction.

Paragraph 42 of Taxation Ruling TR 92/3 provides that if a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset either:

a) as the capital of a business; or

b) into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction,

the activity of the taxpayer constitutes the carrying on of a business or a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity is income although the taxpayer did not have the purpose of profit-making at the time of acquiring the asset.

At paragraphs 56 and 57, Taxation Ruling TR 92/3 explains that a profit is income where it is made in any of the following situations:

● a taxpayer acquires property with a purpose of making a profit by whichever means prove most suitable and a profit is later obtained by any means which implements the initial profit-making purpose; or

● a taxpayer acquires property contemplating a number of different methods of making a profit and uses one of those methods in making a profit; or

● a taxpayer enters into a transaction or operation with a purpose of making a profit by one particular means but actually obtains the profit by a different means.

CGT provisions

CGT event A1 in section 104-10 of the ITAA 1997, relating to the disposal of a CGT asset, will happen when you dispose of each subdivided block. You will make a capital gain if the capital proceeds from the disposal of the block are more than the cost base of the block. You will make a capital loss of those capital proceeds are less than the reduced cost base of the block.

Subsection 104-10(5) of the ITAA 1997, however, contains an exception, where any capital gain or capital loss made is disregarded if the asset was acquired before 20 September 1985.

Application to the Taxpayers situation

Taking all of the facts into consideration, and on weighing the various factors, the Taxpayers are carrying on a business of property development, or alternatively, they have entered into a profit-making scheme or undertaking.

We acknowledge that the Taxpayers purchased the land in 199X with the intention of renovating and living in the houses that were on it, and they did live in them. One was Taxpayer Three’s main residence until they built a new house on the land, while Taxpayers One and Two lived in the other, and subsequently rented the house for a time.

The Taxpayers have stated that they wanted to live on land. From 199X to 200Z the Taxpayers took no steps towards sale or subdivision of their land.

In 200Z they applied for permission to subdivide the property. The DA was actively pursued by the Taxpayers. The process leading up to the modified DA approval was quite lengthy, from 200Z to 201X and involved numerous requirements including the Taxpayers successfully pursuing their plan through a court case; indicating a high level of complexity in the development.

The Taxpayers have carried out the development themselves, by establishing the Company that is owned by trusts controlled by the Taxpayers to undertake the subdivision. The Company engaged sub-contractors to perform the work, as well as consultants, accountants and legal practitioners. While the Taxpayers engaged professionals in relation to various aspects of the development, they at all times retained ultimate control as the final decision makers with respect to the development.

The Taxpayers ultimately undertook the risk involved, including the profits, losses and overall success of the development. The development is of the same kind and carried on in a similar manner to that of property development and the project was planned, organised and carried on in a businesslike manner in order to make a profit; showing that the subdivision has a significant commercial purpose

A portion of the land was sold to a State A government department in 201X. From 201Y the Taxpayers began a subdivision of the remaining land.

The Taxpayers passed up opportunities to sell the land as a whole, either without a DA, with the original DA with the disadvantageous conditions or with the new, improved DA. The Taxpayers retained control and ownership of the land until it was sold.

The Taxpayers secured the loans to carry out the work via a mortgage over the land. The financial risk involved in the development rested directly with the Taxpayers as the legal owner of the land. Although the Taxpayers interposed the Company, who ultimately borrowed the funds, the asset protection of such an interposition was lessened as the land was used as security for the loan.

The assumption of the risks and the receipt of the subsequent rewards (or losses) is a strong indicator of profitmaking activity. The pre-sale of land as part of the raising capital for the development is a characteristic of business activity in the property development industry. The repayment of the loans required that the land be sold at a profit.

The use of a somewhat complex corporate structure to carry out the work, and the fact that they have – through related entities – maintained the management of the project rather than relying on a property developer, are also indicators of, respectively, businesslike organisation and profit making intent. (It should be noted that another reason for interposing entities between the Taxpayers and the development is to prevent liability on the Taxpayers behalf, but in this case the provision of guarantees over the loans limit the protections available).

The Taxpayers spent a substantial amount of funds on the subdivision. The total proceeds from the subdivision were an amount with several lots remaining unsold at the time of the ruling application. This is substantially greater than the advised market value of the property of an amount and indicates that by undertaking the development, there was an intention to make a profit, rather than the sale being a capital transaction to realise the value of the land. Based on the figures provided, the objective intention is that the development was undertaken for the purpose of producing a profit.

Spending more on subdividing than the land was valued at before the work began constitutes a fundamental transformation of the asset. To use Justice Deane’s analogy from the Federal Court Whitfords Beach 79 ATC 4648; (1979) 44 FLR 312; decision, the original capital gold bar has been transformed into separate brooches of trading stock jewellery – the land being the gold bar and the subdivided blocks with roads, services and parks the jewellery.

The Taxpayers have argued that the work undertaken in the subdivision has been the minimum that could be carried out to gain Council approval for the subdivision. The “minimum work necessary” rule of thumb is drawn from Casimaty v Federal Commissioner of Taxation 97 ACT 5153; (1992) (Casimaty). However, in this situation the minimum work required by local government to approve a subdivision has amounted to a major transformation of the land. What the Taxpayers sold was not parcels of the original land but housing sites with roads, drainage, fences, and services. Earthworks have been undertaken to raise the height of a number of the blocks, the moving of fill from the lower land, carting of fill from external sites, and the overflow of the raised fill areas into the existing parkland surrounding the site indicate a level of development beyond mere realisation.

While this is the first time the Taxpayers have engaged in a property development, even a single development can be a business. As well, every business begins with a single transaction – repetition and regularity is established over time. The Taxpayers are likely to perform a further subdivision of a remaining lot and the large residual lot into additional blocks which they will sell, again for a profit.

Having undertaken the subdivision as described, it is concluded that the Taxpayers are carrying on a business of property development and subdivision. The land will be treated as trading stock under section 70-10 of the ITAA 1997. When the land becomes trading stock, the owner is treated as having disposed of the land for either its cost or market value and acquired the land back as trading stock for the same amount. The owner can elect to use the value at cost or market value of the land. If the owner elects to use the market value, CGT event K4 will occur. CGT event K4 occurs when a taxpayer starts to hold the land as trading stock, which in this case would be considered when the Taxpayers commenced to engage others with respect to the development.

Alternatively, the Commissioner is satisfied that if the Taxpayers are not carrying on a business, the proceeds from the sale of the properties will be those from an isolated transaction. While we accept the property was originally acquired for the purpose of providing the Taxpayers with a residence, based on the facts and their involvement in the development, it can be concluded that there was a change of intention and the development was entered into with the intention of profit in carrying out the commercial transaction.

Therefore, proceeds from the sale of the subdivided blocks will constitute a profit from an isolated transaction and should be included as ordinary income under section 6-5. Following this, where the Taxpayers are not carrying on a business the land would not be treated as trading stock.

Where the land will be considered trading stock, and any capital gain or loss made at the time of sale of the subdivided lots will be disregarded under sub-section 118-25(1)(a).

Alternatively, whilst CGT event A1 will occur on the disposal of the subdivided blocks, the disposal of each lot will be viewed as an isolated transaction. Any profit from the sale will be assessable as ordinary income under section 6-5 of the ITAA 1997 as an isolated transaction. Any capital gain arising from each CGT event will be reduced to the extent any profit is also assessable under section 6-5 of the ITAA 1997