Edited version of your written advice

Authorisation Number: 1051384622249

Date of advice: 13 June 2018

Ruling

Subject: Income tax – assessable income – income v capital

Question

Will the gain on the sale of the Property be assessable to the Fund under section 102-5 of the Income Tax Assessment Act 1997 (ITAA 1997), rather than section 6-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

Relevant facts and circumstances

The facts relied upon to make this private ruling are based on the following documents:

● Private Ruling Application, including attachments;

● Fund Trust Deed;

● Fund Information Memorandum dated;

● Correspondence sent by Trustee of Fund to investors; and

● The Fund’s responses to a request for further information.

The Fund

The Fund is a wholesale unregistered managed investment scheme that was established for the purpose of acquiring a single property.

The Fund does not, and did not, hold any other property.

The Trustee of the Fund holds an Australian Financial Services Licence to operate wholesale managed investment schemes.

By the trust deed (“the Deed”), the Fund was established with the Trustee acting as the trustee and investment manager for the Fund.

In order to construct the commercial premises at the Property, the Fund entered into a Development and Asset Management Agreement (“the Development Agreement”) with ABC. ABC is a group specialising in developing commercial premises.

To finance the acquisition of the Property and construction of the commercial premises, units in the Fund were offered to investors by way of an Information Memorandum (“the IM”). The IM contained all the relevant information with respect to the Property and the investment for investors.

Unit Holders

The Fund raised a sum of capital, comprising of a number of Class A units of $1 each and a number of Class B units of $1 each. No other units or classes of units have been issued by the Fund.

The Class A units were offered to sophisticated wholesale investors. A number of investors subscribed for Class A units.

The Class B units were offered and issued to an entity in the ABC group.

Terms of the Fund

Under a clause of the Deed, the Trustee is given the power to deal with the trust assets in any way.

Under a clause of the Deed, the Trustee has the power at any time to convene a meeting of Unit Holders.

Under a clause of the Deed, a resolution will be passed if Unit Holders holding 75% voting interest vote in favour of the resolution.

The Trustee stated in the IM its intention to call a meeting of Unit Holders on the fifth anniversary of the Fund to allow investors to wind up the Fund. If Unit Holders holding 75% of the voting interests in the Fund vote in favour of winding up the Fund, the Trustee will explore options for the disposal of the Property between the date of the Unit Holder meeting and the seventh anniversary of the Trust. If the vote is not successful, the Trustee would continue to hold the Property and would have provided the option for another vote on the next fifth anniversary.

The IM included a number of statements regarding the intentions of the Trustee to hold the Property as a medium to long term investment.

Property construction and financing

The Property was acquired when the Fund entered into a contract for the acquisition of the Property for a purchase price. The Property was acquired with a development approval in place to construct the commercial premises as well as a possible extension of the commercial premises (known as Stage 2 of the development).

Construction of the commercial premises commenced and was completed.

Finance was obtained through a bank under a Development Facility agreement. This agreement then converted to a term facility for two years for funding upon practical completion of the centre.

Prior to the settlement of the Property, the Trustee secured a long term tenant for the commercial premises with the tenant signing a twenty year lease. Post settlement, the Trustee then secured ten year leases with other tenants. Together, these leases comprised approximately 60% of all the rental income of the Fund.

The bank term facility was due to be refinanced.

The Fund was also looking to borrow an additional amount to fund Stage 2 of the development.

The bank offered unfavourable refinancing terms being a decrease in the loan to value ratio (LVR) and an increase in Line Fees on the facility.

This was the final offer provided by the bank and better terms could not be obtained from them.

From this point forward of the ruling, references to “the Property” includes the original land and the commercial premises built on that land.

Events leading to Sale of Property

Sometime after the completion of the commercial premises, the Trustee became concerned with four main aspects relating to the Property and the Fund:

● Liquidity and distribution risk;

● Refinancing risk;

● Extension funding risk; and

● Market risk.

Feedback from investors

Taking into account the four concerns outlined above, the Trustee believed it was necessary to seek feedback from investors. The Trustee emailed all Class A investors to outline its concerns and seek feedback.

After emailing the investors, the Trustee spoke with all investors individually (as outlined in the email). The outcome was that at least 75% of investors of both classes resolved to terminate the Fund and thus sell the Property. The Trustee resolved to sell the Property. The Trustee commenced discussions with an agent to sell the Property.

Sale of the Property

The Property was sold under a contract of sale. Settlement for the sale of the Property occurred.

The Fund therefore stands to make a gain on the disposal of the Property.

Other retail property investments of the Trustee

The Trustee is currently the trustee of two property funds and two debt funds. The two property funds are Fund B and Fund C.

Fund B was established and acquired existing commercial premises. There is no intention to dispose of this property in the foreseeable future.

Fund C was established recently and has only been operation for a number of months.

Capital treatment for managed investment trust

The Fund does not satisfy the definition of a managed investment trust within the meaning of section 275‐10 of the ITAA 1997 as it has not satisfied the widely held test contained in subparagraph 275‐10(3)(e)(iii) of the ITAA 1997. Accordingly, the Fund does not qualify for a capital account election under Subdivision 275B of the ITAA 1997 in the year in which the disposal of the Property occurred.

Ruling limited to tax treatment of disposal for Trustee

As requested by the applicant, this private ruling only addresses the taxation consequences of the disposal of the Property for the Trustee of the Fund. In particular, it does not address the tax consequences of any distributions from the Fund to any particular beneficiary or unit holder of the Fund.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Subsection 70-80(1

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 118-24

Income Tax Assessment Act 1997 Subdivision 275-B

Income Tax Assessment Act 1997 Section 275-10

Income Tax Assessment Act 1997 Subparagraph 275-10(3)(e)(iii)

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

In general, the proceeds or profits from a disposal of property could be assessed in a number of ways:

(i) As gross proceeds from the disposal of trading stock which is included as ordinary income under section 6-5;

(ii) As gains from carrying on a business of investment;

(iii) As profits from an ‘isolated transaction’ which is ordinary income and included in your assessable income under section 6-5; or

(iv) As a ‘mere realisation’ of a capital asset under which capital gains may be included as statutory income (which is part of assessable income) under subsection 6-10(1), 6-10(2) and subsection 102-5(1).

Gains from the disposal of trading stock

Subsection 6-5(1) provides that your assessable income includes amounts that are income according to ordinary concepts, which is called ‘ordinary income’.

An example is the disposal of trading stock where the gross proceeds would be ordinary income under section 6-5, pursuant to subsection 70-80(1).

According to Taxation Determination TD 92/124: income tax: property development: in what circumstances is land treated as ‘trading stock’?, land is treated as trading stock if it is held for the purpose of resale and a business activity which involves dealing in land has commenced. As stated in paragraph 2 of TD 92/124, the 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. Further, under paragraph 3 of TD 92/124, it is not necessary that the acquisition of land be repetitive. A single acquisition of land for the purpose of development and sale by a business commenced for that purpose would lead to the land being treated as trading stock.

Based on the facts, the Property is not the trading stock of the Fund. The Fund is not carrying on a business of developing commercial premises for sale and does not have a history of developing commercial premises for sale. The Property was originally acquired for the purpose of constructing commercial premises for medium to long term use to derive rental returns rather than for the purpose of development and sale.

Therefore, the gross proceeds from the disposal of the Property are not included in assessable income under section 6-5 under the trading stock provisions.

Gains from carrying on a business of investment

If the disposal of the Property is in a normal operation in the course of carrying on a business of investment, any gain will be ordinary income and any loss deductible (London Australia Investment Co Ltd v Federal Commissioner of Taxation (1977) 138 CLR 106; 77 ATC 4398; (1977) 7 ATR 757).

The Commissioner’s view on whether a taxpayer is carrying on a business is set out in Taxation Ruling TR 97/11: income tax: am I carrying on a business of primary production? Paragraph 13 of TR 97/11 identifies the indicators that are considered relevant in determining whether a taxpayer is carrying on a business:

● 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 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.

Having regard to the indicators outlined above, the Commissioner does not consider the Fund to be carrying on a business of investment. Of relevance is the fact that the Property was acquired with the intention of being held as a long term investment and the Property is the sole real estate asset of the Fund (as such there is no repetition and regularity of disposal of Property). Therefore, the gains on the sale of the Property are not ordinary business income and not included as assessable income of the Fund under section 6-5.

Profits from isolated transactions – ordinary income – section 6-5

As explained in Taxation Ruling TR 92/3: income tax: whether profits on isolated transactions are income, under certain circumstances, profits from an ‘isolated transaction’ can be ordinary income. An ‘isolated transaction’ is referred to in the ruling as those transactions outside the ordinary course of business of a taxpayer carrying on a business as well as those transactions entered into by non-business taxpayers. TR 92/3 essentially sets out the Commissioner’s views as to the application of the High Court decision in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer).

Paragraph 16 of TR 92/3 states that for a taxpayer that is not carrying on a business, a profit is ordinary income if:

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

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

Profit-making intention

Paragraph 7 of TR 92/3 makes it clear 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 discerned from an objective consideration of the facts and circumstances of the case.

If the transaction involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However, as the High Court decision in FC of T v. Whitfords Beach Pty Ltd (1982) 150 CLR 355; [1982] HCA 8; 82 ATC 4031; 12 ATR 692 (Whitfords Beach) demonstrates, that is not always the case. For example, if a taxpayer acquires an asset with an intention of using it for personal enjoyment but later decides to venture or commit the asset either as the capital of a business or into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction, the profit is income even though the taxpayer did not have the purpose of profit-making at the time of acquisition.

As stated in paragraph 40 of TR 92/3, it is not necessary that the profit-making intention be the sole or dominant purpose for entering into the transaction.

Sometime after the completion of the commercial premises, the Trustee became concerned with four main aspects relating to the Property and the Fund:

● Liquidity and distribution risk;

● Refinancing risk;

● Extension funding risk; and

● Market risk.

The Trustee received an unfavourable offer to refinance its term facility from the bank. The offer was unfavourable on the basis of a decrease to the LVR and higher line fees. The Trustee believed that there was a significant risk that asset values would decrease in the short to medium term which could put pressure on the Fund and may result in it breaching the LVR covenant. The higher line fees under the bank offer also would have the effect of reducing the income available for distribution to investors.

In the Trustee’s opinion, the market risk for retail property had increased due to expected inflation and the increased competition from online retailers. Accordingly, the Trustee was concerned with protecting unit holders’ capital. The valuation risk would also increase the risk of the Fund breaching its banking covenants (i.e. LVR) which could place the Fund at risk.

Summary

Based on the above considerations, the Commissioner accepts that the Fund purchased the Property with an intention to hold it as a long term investment but circumstances after the completion of construction on the commercial premises led to the Trustee seeking investor feedback on the possible sale of the Property which led to its eventual sale.

The Commissioner accepts that the Fund did not enter into the transaction with the intention to profit from the sale of the Property. As a result, the profit on the disposal of the Property is not ordinary income from an isolated transaction under TR 92/3.

Business operation or commercial transaction

Even if a profit-making intention is found to exist (which is not the case), the Commissioner must also be satisfied that the profit was made in carrying out a business operation or commercial transaction in order for the profit to be assessed as ordinary income from an isolated transaction.

As stated in paragraph 49 of TR 92/3, the following factors may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction:

(a) the nature of the entity undertaking the operation or transaction;

(b) the nature and scale of other activities undertaken by the taxpayer;

(c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

(d) the nature, scale and complexity of the operation or transaction;

(e) the manner in which the operation or transaction was entered into or carried out, including use of professional agents or advisers;

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

(g) if the transaction involves the acquisition and disposal of property, the nature of that property; and

(h) the timing of the transaction or the various steps in the transaction.

It is important to note that no single indicator is determinative and must be weighed against all the other indicators.

The Commissioner considers that the isolated transaction would have amounted to a business operation or commercial transaction based on a consideration of the following factors:

● The nature of the property involved being the construction and leasing of a commercial premises, with approval to expand further;

● the extensive planning that went into the construction, development and leasing of the commercial premises as outlined in the IM, including:

● securing financing for the project;

● contracting a project builder;

● engaging a development and asset manager; and

● securing a number of tenants for the commercial premises;

● the length of time taken to build the commercial premises;

● the number of commercial contracts and agreements entered into as part of the project with builders, tenants and development managers;

● the magnitude of the cost of the project; and

● the expertise of the consultants employed, including:

● the appointment of an asset and development manager - ABC who has extensive experience in commercial developments and will be paid a substantial development management fee; and

● use of an experienced project builder.

However, as the Commissioner has determined that the Property was not acquired with an intention to profit from a sale, the fact that the profit was made in carrying out a business operation or commercial transaction does not result in a profit from an isolated transaction that is ordinary income under TR 92/3.

Mere realisation

Section 108-5 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property. The Property is a CGT asset. The Property does not include depreciating assets which are not attached to the Property and which are excluded from the CGT regime under section 118-24.

CGT event A1 under section 104-10 happens if you dispose of a CGT asset. CGT event A1 will happen upon the sale of the Property and a capital gain will be made by the Trustee pursuant to subsection 104-10(4) to the extent that the capital proceeds received on the sale exceed the cost base of the CGT asset.

The Trustee estimates there will be a capital gain. The capital gain derived by the Fund on the sale of the Property will form part of the net income of Fund in the year in which the sale happens (as determined by subsection 104-10(3)).

The net capital gain of the Fund is included in its assessable income pursuant to section 102-5.

Based on the facts, the disposal of the Property is a mere realisation of a CGT asset rather than ordinary income from the disposal of trading stock or gains from an investment business or profit from an isolated transaction. Therefore the anti-overlap provision of section 118-20 is not relevant.