Edited version of your written advice

Authorisation Number: 1051283061935

Date of advice: 15 September 2017

Ruling

Subject: Tax treatment of the subdivision of property and the active asset test

Question 1

If you undertake the development comprising the subdivision, improvement and sale of lots from the Property, are the sale proceeds ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If you transfer the Undeveloped Property to the Proposed Taxpayer (New Family Trust), will the disposal of the property be an ‘isolated transaction or profit-making undertaking or scheme’ as understood in FC of T v Myer Emporium Ltd (1987) and assessable income under section 6-1(1) of the ITAA 1997?

Answer

Yes

Question 3

If you transfer the Undeveloped Property to the New Family Trust, is the market value of the Undeveloped Property when it was committed to the profit-making undertaking or scheme used for calculation of any profit on disposal?

Answer

Yes

Question 4

Is the Undeveloped Property an ‘active asset’ within the meaning of section 152-40 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2017

Year ended 30 June 2018

Year ended 30 June 2019

Year ended 30 June 2020

The scheme commences on:

The scheme is yet to commence

Relevant facts and circumstances

You are the sole registered proprietor of a rural property.

The Property consists of a house, various other buildings such as sheds and open land used for cattle breeding and grazing.

You acquired the Property with the intention of holding it over the long term and using it for primary production purposes in connection with his farming business.

You did not acquire the Property with the intention of realising it in a short or long term profit making undertaking or scheme, as a business activity or for profitable resale.

At the time the Property was acquired, it was not within the city’s Urban Growth Zone.

Your Business

Primary production activities are conducted on the whole Property. You engage in this activity on a substantially full time basis and are not employed in any other full time capacity.

The Property and nearby properties owned by you are used for breeding beef cattle and another nearby property is used for the growing and harvesting of hay. All properties have been exempt from land tax for a number of years on the basis that they each conduct a primary production business.

All cattle are tagged in accordance with the National Livestock Identification System.

Rezoning of the Property

You have decided to sell the Rear of the Property and to extract a larger sale price. You have decided to sell the Rear of the Property in a subdivided form, as vacant lots for residential housing (the Subdivision).

The rezoning of the Rear of the Property has via an amendment to the local council planning scheme.

To sell the Rear of the Property in a subdivided form, various permits need to be obtained and various works will need to be carried out to the land. In particular, the Subdivision will involve the following:

● obtaining planning permits;

● subdivision of the property into separate lots;

● connection of essential services to each of the lots, such as electricity, water, gas, sewerage and road access; and

● sale of the lots as vacant blocks to third party purchasers.

Development works are likely to commence in the current income year on the Property.

Proposed Development

You are engaged in your business in a substantially full time capacity and wish to minimise your involvement with the Subdivision.

You have never developed the Property or engaged in a property development business, the purchase of real estate for profitable sale or a profit-making undertaking or scheme involving property.

As such, you have appointed a real estate development company to do all things necessary to undertake the Subdivision including facilitating the sale of the lots on the Property.

The development company will carry out the Subdivision and provide the Development Services.

The Development Services include:

(a) financial management of the project;

(b) planning and approval of the project, for example, planning permit and plan of the subdivision;

(c) sales and marketing functions;

(d) construction of essential services such as earthworks and roads;

(e) appointing agents to sell the lots; and

(f) general management of the Subdivision.

You will arrange for a debt facility to fund the project costs.

It is expected that the Subdivision will take up to three years.

Transfer of the Property to a Family Trust

You own the Property in your personal name and will ultimately be the seller of the subdivided lots.

In the unlikely event that defects arise during the Subdivision, you may be exposed to the risk of claims being made against you by the purchasers of the lots. You own significant other assets in your name and carry on a farming business in your name. Those assets could be exposed to any such claim.

For asset protection reasons, you are therefore considering transferring the Property out of your name prior to the Subdivision commencing. You are considering selling the Property for its current market value to a newly incorporated company. Under this alternative, the company will act as the trustee of a new discretionary family trust to be controlled by you (the New Family Trust).

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-1(1)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-220

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Question 1

Summary

The nature of the project, including the scale of the undertaking and the required cost of development compared with the undeveloped value of the land, are sufficient to take the proposed transaction beyond the realms of a mere realisation of an asset. The proceeds from the proposed sale of land are considered to be ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) as income from carrying on a business of property development.

Detailed reasoning

Section 6-5 of the ITAA 1997 includes in your assessable income, where you are an Australian resident, all ordinary income which you derive during an income year. Ordinary income is defined as income according to ordinary concepts.

Ordinary income generally includes income that arises in the ordinary course of a taxpayer’s business. However, in certain circumstances proceeds not within the ordinary course of the taxpayer’s business may form part of their ordinary income.

Therefore the following needs to be considered in order to determine whether the proceeds received from the sale of the land are:

● assessable ordinary income under section 6-5 of the ITAA 1997 as income from carrying on a business of property development; or

● assessable ordinary income under section 6-5 of the ITAA 1997 as income from an isolated commercial transaction with a view to a profit.

Carrying on a business of property development

The question of whether a business is being carried on is a question of fact and degree to be determined on a case by case basis.

Subsection 995-1(1) of the ITAA 1997 defines 'business' to include 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'. This definition simply states what activities may be included in a business; it does not provide any guidance for determining whether the nature, extent, and manner of undertaking those activities amount to the carrying on of a business.

Profits made on the sale of land can be considered ordinary income under section 6-5 of the ITAA of 1997 if the activities become a separate business operation. Taxation Ruling TR 92/3, paragraph 11 states:

The transaction may take place in the course of carrying on a business even if the transaction is outside the ordinary course of the taxpayer’s business.

Paragraph 13 of Taxation Ruling TR 97/11 states that the courts have held that the following indicators are relevant to whether or not a person is carrying on a business (although TR 97/11 specifically deals with carrying on a primary production business, the principles discussed in that Ruling can apply to any business):

a) does the activity have a significant commercial purpose or character?

b) does the taxpayer have more than a mere intention to engage in business?

c) is there an intention to make a profit or a genuine belief that a profit will be made? Will the activity be profitable?

d) is there repetition and regularity in the activity? i.e., how often is the activity engaged in?

e) is the activity of the same kind and carried on in a similar way to that of the ordinary trade?

f) is the activity organised in a businesslike manner?

g) what is the size or scale of the activity?

h) is the activity better described as a hobby, a form of recreation or a sporting activity?

All the facts and circumstances in each case must be examined. No one indicator is decisive and the indicators often overlap significantly. The indicators must be considered in combination and as a whole. Whether activities amount to the carrying on of a business will depend on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) and whether the operations overall have a 'commercial flavour' (TR 97/11 paragraphs 15 and 16).

In considering the factors outlined in TR 92/3 and TR 97/11, the following facts and circumstances of your particular case are relevant:

● You have a number of properties in your portfolio;

● The land was purchased with the intention of holding it over the long term and using it for primary production purposes;

● The project costs and holding costs will be incurred by the owner;

● You will have significant borrowings that will finance the development;

● The expected costs to subdivide and improve the rear of the property are more than double the undeveloped market value of the property;

● The development is significant in scale;

● the subdivision will be developed in a businesslike manner for example there will be a project manager and significant development costs;

● The expected total proceeds from the sale are nearly triple the undeveloped market value of the property;

● It can be said that the activity has a significant commercial component and that there is an intention to make a profit. You have appointed a development company who will undertake all aspects of the property development.

The key clauses of the development agreement which outline the project rights and responsibilities, debt facility and holding costs support the conclusion that this is not a mere realisation of a capital asset, rather you will be carrying on a business of Property Development. The nature, scale and complexity of the development, the significant amounts of money involved and the financial risks borne by the Owner demonstrate the commercial nature of the transaction. By undertaking a land subdivision of this scale you have taken on a financial risk akin to a normal business undertaking.

CGT Event K4

While a taxpayer may have originally purchased a property with an intention other than property development (ie. farming activities) CGT event K4 may be triggered when that original intention changes and a Property Development commences. CGT event K4 (section 104-220 of the ITAA 1997) allows an election to be made to treat a CGT asset as trading stock, after which the property would be carried at the then current market value for trading stock purposes. The election must be made in the tax return of the year in which CGT event K4 occurs.

You confirmed a K4 election was not made pursuant to section 104-220 of the ITAA 1997 in respect of the property. Therefore the property must be carried at cost for trading stock purposes.

Conclusion

It is typically difficult to apply a blanket rule to sub-division cases and, as a consequence, each case needs to be decided on its own facts.

Based on the facts of the current case, the steps involved in subdividing the property amount to more than a mere realisation of a capital asset. Significant factors that are relevant which lead to this conclusion are as follows:

● there is a change of purpose for which the whole property is held;

● there is a comprehensive plan for the development of the property;

● the scale of the undertaking is substantial;

● the subdivision will be developed in a businesslike manner for example there will be a project manager and significant development costs;

● the costs of development are more than twice the undeveloped value of the land; and

● a substantial loan will be taken out to finance the development.

On balance, having regard to all of the facts, the project is an undertaking of a sufficient scale to extend beyond the realms of a mere realisation of an asset and characterise it as a business of Property Development. As a consequence, the proceeds from the sale of the land will be considered to be ordinary income and assessable under section 6-5 of the ITAA 1997.

Question 2 and Question 3 are closely related and will be answered collectively

Question 2 and 3

Summary

If the Undeveloped Property is transferred to the New Family Trust, the disposal of the property will be an ‘isolated transaction or profit-making undertaking or scheme’ as understood in FC of T v Myer Emporium Ltd (1987) and assessable income under section 6-1(1) of the ITAA 1997. The market value of the Undeveloped Property at the time it was committed to the profit-making undertaking or scheme should be used for calculation of any profit on disposal.

Detailed reasoning

You own the Property in your personal name and will ultimately be the seller of the subdivided lots.

In the unlikely event that defects arise during the Subdivision, you may be exposed to the risk of claims being made against you by the purchasers of the lots. You own significant other assets in your name and carry on a farming business in your name. Those assets could be exposed to any such claim.

For asset protection reasons, you are therefore considering transferring the Property out of your name prior to the Subdivision commencing. You are considering selling the Property for its current market value to a newly incorporated company. Under this alternative, the company will act as the trustee of a new discretionary family trust to be controlled by you (the New Family Trust).

We consider the proposed transfer of the Undeveloped Property to the New Family Trust, and the subsequent subdivision, improvement and sale of lots to be part of a single arrangement. You have advised the reason for the proposed transfer of the Undeveloped Property is for asset protection purposes should defects arise during the Subdivision and claims are made against you. Such risks would not arise if you did not proceed with the subdivision, improvement and sale of lots and rather continued to hold the Undeveloped Property and operate your farming business.

The principle has been established that profits arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693) (Myer Emporium case).

Taxation Ruling TR 92/3 discusses the application of principles outlined in the Myer Emporium case and provides guidance in determining whether profits from isolated transactions are ordinary income and therefore assessable under section 6-5.

According to Paragraph 1 of TR 92/3, the term isolated transactions refers to:

● those transactions outside the ordinary course of business of a taxpayer carrying on a business, and

● those transactions entered into by non business taxpayers.

Paragraph 8 of the ruling explains that it is not necessary that the intention or purpose of profit-making be the sole or even the dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose.

Therefore the profit making intention and commercial undertaking demonstrated by the size and scale of the future subdivision is also demonstrated by the preceding step of transferring the Undeveloped Property to the New Family Trust. Any proceeds on transfer will not amount to a “mere realisation” on capital account. Rather the taxpayer’s purpose or intention in entering into the transaction is to make a profit, by means of subdividing, improving and developing the property. The proposed transfer of the Undeveloped Property is a preceding step in the broader arrangement to facilitate the development. Transferring the Undeveloped Property to the New Family Trust has the potential to enhance profitability by isolating risks associated with the development.

The proposed transfer of the Undeveloped Property to the New Family Trust is an isolated transaction or profit-making undertaking or scheme, and any associated profit on disposal will be assessable under section 6-1(1) of the ITAA 1997.

In determining the net profit that will arise on the disposal by you of the Undeveloped Property to the New Family Trust, the market value of the Undeveloped Property at the time it was committed to the profit-making undertaking or scheme should be used for calculation of any profit on disposal. This was confirmed in FC of T v NF Williams 72 ATC 4188; (1972) 127 CLR 226

The CGT asset (Undeveloped Property) is held on capital account until the time it was committed to the profit-making undertaking or scheme.

Question 4

Is the Undeveloped Property an ‘active asset’ within the meaning of section 152-40 of the ITAA 1997?

Summary

The CGT asset (Undeveloped Property) is an ‘active asset’ pursuant to section 152-40 of the ITAA 1997.

Detailed reasoning

Under section 152-35 of the ITAA 1997, a CGT asset satisfies the active asset test if:

(a) you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period specified in subsection (2); or

(b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 ¹/₂ years during the period specified in subsection (2).

As per subsection 152-35(2) of the ITAA 1997, the period:

(a) begins when you acquired the asset; and

(b) ends at the earlier of:

(i) the CGT event; and

(ii) if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows - the cessation of the business.

The term 'active asset' is defined in subsection 152-40(1) of the ITAA 1997 as an asset you own and use (or hold ready for use) in the course of carrying on a business by you, your affiliate or another entity that is connected with you.

Carrying on business

Taxation Ruling TR 97/11 is the primary source of the Commissioner's view on whether activities undertaken amount to the 'carrying on of a business' and at paragraph 13 provides a number of relevant indicators as follows:

● whether the activity has a significant commercial purpose or character; this indicator comprises many aspects of the other indicators;

● 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 repetition and regularity of the activity;

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

● whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at 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 a sporting activity.

All the facts and circumstances in each case must be examined. No one indicator is decisive and the indicators often overlap significantly. The indicators must be considered in combination and as a whole. Whether activities amount to the carrying on of a business will depend on the 'large or general impression gained' and whether the operations overall have a 'commercial flavour' (TR 97/11 paragraphs 15 and 16).

In this case the CGT asset is the parcel of land that has been held for a number of years. During this time it was used for primary production purposes. You have provided a detailed list of the activities undertaken by you as part of the farming business. These include:

● you did not employ any employees or appoint any agents to assist you with the farming business;

● you purchased all animal feed, and fed the animals;

● you purchased all animals (via a livestock agent);

● you sold all animals (via a livestock agent);

● if any animals were sick or injured, you arranged for a veterinarian to assess the animal;

● you purchased all other necessary items (e.g. hay and fencing).

● on average, you spent between 10 to 20 hours per week attending to farming activities. This would increase when the animals were calving, or needed to be hand fed.

Although you have acknowledged farming activities were limited initially due to draught, financial statements indicate an expectation of making a profit, and the farming activities are regular and repetitive. The property has been exempt from land tax for a number of years on the basis that a primary production business is conducted.

The scale of the activities was small, however based on the indicators outlined in TR 97/11, consideration of the activities undertaken and review of the financial accounts, it is accepted you are carrying on a business of farming for at least half of the period of ownership of the property. Therefore, the CGT asset (Undeveloped Property) satisfies the active asset test in section 152-35 of the ITAA 1997.

Section 118-20 of the ITAA 1997 is an anti-overlap provision. Specifically, section 118-20(1) of the ITAA 1997 states a capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in your assessable income.

As determined in Question 1, the profit made on the sale of the subdivided lots will be assessable income under section 6-5 of the ITAA 1997. Therefore any capital gain you make from the CGT event (sale of subdivided lots) will be reduced under section 118-20 of the ITAA 1997 by any amount included in your assessable income.

Other relevant comments

For the purposes of questions 2, 3 and 4, the Commissioner offers no opinion or conclusion as to the relevant time when: 1) the purported change of intention occurred, 2) the business or profit-making undertaking or scheme commenced, and 3) the Undeveloped Property was commitment to the profit-making undertaking or scheme.

The relevant time in each of these circumstances may affect the tax consequences of these transactions and the amounts subject and not subject to tax under the capital gains tax regime, including the small business concessions.