Edited version of your written advice

Authorisation Number: 1051425914555

Date of advice: 20 September 2018

Ruling

Subject: Property – subdivision – isolated transaction - mere realisation.

Question 1

Will the subdivision and development of the Property be an isolated commercial transaction such that the profits derived from the subsequent disposals are assessed as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the profits from the sale of Lot 2 and Lot 3 be treated as statutory income under the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997?

Answer

Yes. However, section 118-20 of the ITAA 1997 will apply to reduce the capital gain to the extent that the profit from the sale of the subdivided lots is otherwise included as assessable income under section 6-5 of the ITAA 1997.

This ruling applies for the following periods:

Income year ended 30 June 20xx

Income year ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

On XXXX you and your partner (hereafter referred to jointly as ‘you’) acquired the property located at XXXX (the Property) as joint tenants, for the amount of $X.

The Property was zoned ‘Residential C’.

You occupied the dwelling with your children as your main residence until XXXX.

The Property was not used to produce income during the period that you resided in it.

On XXXX you purchased a property at XXXX (Investment property).

You rented out the Investment property from XXXX to XXXX.

In XXXX, you engaged an architect to provide advice regarding the potential to demolish the dwelling on the Property, subdivide the land and build four townhouses.

You had not attempted to sell the Property prior to development.

You had not completed any other property development activities prior to this.

On XXXX planning permits were submitted to council.

In XXXX, a planning permit was approved.

In XXXX you obtained quotes from a builder and applied for finance for the project.

On XXXX the council valuation indicated a site value of $X and a capital improved value of $X.

You signed a building contract with a builder on XXXX, with a contract price of $X to build the four townhouses.

You payed a deposit for the building contract from your own savings.

You were unable to obtain finance from a bank as you did not want to enter into a financial arrangement which required pre sales contracts for the townhouses. Without this stipulation the bank would not approve the loan.

Provisional subdivision plans were then submitted for the Property to be divided into four lots, with a townhouse to be constructed on each new lot.

On XXXX authority to demolish the dwelling was granted. You did not receive any proceeds from the demolition.

The builder did not begin demolition or construction works until finance for the project was approved, due to their insurer’s requirement that finance was confirmed before the contract could proceed.

In XXXX your family member, offered finance of a loan of $X to enable you to undertake the build and repay $X off the loan on the Investment property.

A loan agreement (the loan agreement) was drawn up on XXXX. The loan agreement provided terms for repayment of the loan and stated that you would repay these funds from the sale of part or all of the units in this development.

On XXXX you made the decision to sell Lot 2 and Lot 3 of the Property.

You moved into the Investment property for the duration of the build.

On XXXX demolition began.

On XXXX construction began.

Your role included co-ordinating between the architect, builder and council, facilitating payments of associated costs to the relevant authorities and applying for relevant applications and permits.

The builder was responsible for all demolition and construction work in relation to the project.

The builder incurred all costs associated with the demolition and construction, in return for the contract price.

On XXXX, you engaged the services of a real estate agent to pre sell two of the townhouses being Lot 2 and Lot 3 of the Property. This was in order to pay expenses and reduce debt.

You entered into an ‘off the plan’ contract for the sale of the Lot 2 on XXXX for the amount of $X.

You entered into an ‘off the plan’ contract for the sale of Lot 3 on XXXX, also for the amount of $X.

You have made a profit on the sale of Lot 2 and Lot 3.

On XXXX the construction was completed and certificates of occupancy were granted.

Subdivision was registered in XXXX.

You have retained ownership of the remaining two townhouses being Lot 1 and Lot 4.

You have decided to remain living in the Investment property because the location and proximity to transport suit you better. The yard is also more suited to your pet, a large dog.

You will rent Lot 1 and Lot 4 out to provide an income stream for your retirement. You do not intend on selling them.

The Investment property requires major renovations. You intend to complete these within the next five years at which point you will move into one of the two townhouses that you have retained ownership of. You have not decided which one.

You are employed as a teacher and your partner works as a personal care attendant.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Reasons for decision

Legislative references referred to herein are from the ITAA 1997.

Detailed reasoning

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

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

2.As ordinary income under section 6-5, on revenue account, as a result of an isolated commercial transaction entered into by a non-business taxpayer, or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose; or

3.As statutory income under the capital gains tax (CGT) legislation, sections 10-5 and 102-5, on the basis that a mere realisation of a capital asset has occurred.

Whether the proceeds are treated as income or capital depends on the situation and circumstances of each particular case.

Carrying on a business of property development

Section 995 of the ITAA 1997 states the term ‘business’ includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

To determine whether an activity, or series of activities, amounts to a business, the activity needs to be considered against the indicators of a business established by case law.

In the High Court of Australia case of Hope v. Bathurst City Council (1980) 144 CLR 1; (1980) 29 ALR 577; (1980) 80 ATC 4386; [1980] HCA 16, a business was described in the following ways:

It is the words “carrying on'' which imply the repetition of acts and activities which possess something of a permanent character.

…activities engaged in for the purpose of profit on a continuous and repetitive basis.

Transactions were entered into on a continuous and repetitive basis for the purpose of making a profit…manifested the essential characteristics required of a business.

The Commissioner’s view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 (TR 97/11) which uses the following indicators to determine whether a taxpayer is carrying on a business:

● whether the activity has a significant commercial purpose or character;

● 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.

In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impressions gained from looking at all the indicators and whether these indicators provide the operations with a commercial flavour.

Application to your circumstances

In your situation, the Commissioner is satisfied that you are not carrying on a business of property development. Therefore, we will consider whether or not the proceeds from the sale of Lots 2 and 3 will be viewed as being received in relation to an isolated business transaction or a mere realisation as follows:

Isolated business transaction

Profits from isolated transactions will be assessable as ordinary income where the intention or purpose 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 out a business operation or commercial transaction.

Taxation Ruling TR 92/3 (TR 92/3) sets out the Commissioner’s view of the general principles and factors that have been considered in determining whether an isolated transaction is of a revenue nature.

Paragraph 1 of TR 92/3 explains that isolated transactions are:

a) those transactions outside the ordinary course of business of a taxpayer carrying on a business; and

b) those transactions entered into by non-business taxpayers.

The ruling outlines at paragraph 6 that whether a profit from an isolated transaction will be ordinary income will depend on the circumstances of the case, however a profit from an isolated transaction will be ordinary income when:

a) the intention or purpose of a 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 operation or commercial transaction.

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.

Paragraphs 41 and 42 of the ruling outline that where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset 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 operation or commercial transaction carrying out a profit-making scheme, as the case may be.

Whether a particular transaction has a business or commercial character depends very much on the circumstances of the case. Paragraph 13 of the ruling outlines the following factors which may be relevant when considering whether an isolated transaction amounts to a business operation or commercial transaction:

● 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 direction provided within TR 92/3 and in case law indicates that profits in this context are more likely to be considered ordinary income if they are made in the ordinary course of carrying on a business. Further, ordinary income may be derived from an isolated transaction which becomes commercial in nature, or as a result of profits on a transaction in which the initial intention was to make a profit on sale.

Paragraph 36 of TR 92/3 notes that the courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. However, if a transaction satisfies the elements set out above it is generally not a mere realisation of an investment.

Miscellaneous Taxation Ruling MT 2006/1 provides a list of specific factors relevant to isolated transactions and sales of real property. If several of the factors are present, it may be an indication that a business or an adventure or concern in the nature of trade is being carried on. These factors are as follows:

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

● additional land is acquired to be added to the original parcel of land;

● the parcel of land is brought into account as a business asset;

● there is a coherent plan for the subdivision of the land;

● there is a business organisation – for example a manager, office and letterhead;

● borrowed funds financed the acquisition or subdivision;

● interest on money borrowed to defray subdivisional costs was claimed as a business expense;

● there is a level of development of the land beyond that necessary to secure council approval for the subdivision; and

● buildings have been erected on the land.

In determining whether activities relating to isolated transactions are an enterprise or are the mere realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. This may require a consideration of the factors outlined above; however there may also be other relevant factors that need to be weighed up as part of the process of reaching an overall conclusion. No single factor will be determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities.

Mere realisation

CGT event A1 happens if you dispose of a CGT asset. A CGT asset is any kind of property or a legal or equitable right that is not property.

When a CGT asset (the original asset) is split into 2 or more assets (the new assets), such as when land is subdivided, the subdivision of the land into subdivided blocks is not a CGT event, according to subsection 112-25(2). Each new subdivided block retains the acquisition date that the original asset was acquired on.

The mere realisation of a capital asset has been described as “liquidating or realising the old assets” (Commissioner of Taxes v Melbourne Trust Limited [1914] AC 1001).

In the High Court of Australia case of Federal Commissioner of Taxation v NF Williams 72 ATC 4188; (1972) 127 CLR 226, at ATC 4194-4195; CLR 249, Gibbs J explained mere realisation of land as follows:

An owner of land who holds it until the price of land has risen and then subdivides and sells it is not thereby engaging in an adventure in the nature of trade, or carrying out a profit-making scheme. The situation is not altered by the fact that the landowner seeks and acts upon the advice of an expert as to the best method of subdivision and sale or by the fact that he carries out work such as grading, levelling, road-building and the provision of reticulation for water and power to enable the land to be sold to its best advantage. The proceeds resulting from the mere realization of a capital asset are not income either in accordance with ordinary concepts…even though the realization is carried out in an enterprising way so as to secure the best price…

Application to your circumstances

You purchased the Property in XXXX with the intention to reside in it as your main residence, which you did, up until XXXX.

We accept that there had been no-profit making motive when you had acquired the Property. However, the question before us is whether your intention changed when you committed this one-off undertaking in relation to the subdivision and development of the Property and sale of Lots 2 and 3.

The acts of seeking approvals and undertaking of the subdivision and construction of townhouses must in some way contribute towards a finding that the overall activity constitutes something more than a ‘mere realisation’ of a capital asset.

At the time you sought finance for the development from your relative you made the decision to sell two of the townhouses for a profit. This was to enable you to pay expenses and reduce your debt.

It has been determined that the Property was valued at approximately $X in XXXX. After subdivision, development and the sale of Lots 2 and 3, the Property you have retained ownership of (lots 1 and 4) has a value of approximately $X (based on the sale price of Lots 2 and 3).

The profit that you have made by selling Lots 2 and 3 has been used to pay off the debt you incurred to complete the subdivision and construction. How you directed the funds that you received does not change the fact that a profit was made.

You have made reference to three cases which you believe to be similar to your situation; Casimaty v FC of T 97 ATC 5135 (Casimaty); McCorkell v FC of T 98 ATC 2199 (McCorkell); Statham v FC of T (1988) 20 ATR 228 (Statham).

Whilst there are similarities between these cases and your situation, in that you adopted a relatively passive role in the subdivision, your case can be distinguished from all three because you actually developed the Property by building four townhouses upon it.

In the Federal Court of Australia case of Casimaty v Federal Commissioner of Taxation 97 ATC 5135, at 97 ATC 5152, Ryan J described a salient characteristic of the mere realisation of land as follows:

…[to not] undertake any works on, or development of, the land beyond what was necessary to secure the approval by the municipal authorities of the successive plans of subdivision and enhance the presentation of individual allotments for sale as vacant blocks.

In distinguishing mere realisation from a commercial transaction, Ryan J further said:

Had he constructed dwelling houses, internal fencing or other improvements, it would have been easier to impute to him an intention to carry on a business of land development and improvement.

You have asserted that your situation can be clearly distinguished from the case Federal Court of Australia case of Federal Commissioner of Taxation v Whitford’s Beach Pty Ltd 82 ATC 4031 (Whitford’s Beach). In this case the taxpayer’s activities amounted to more than a ‘mere realisation’ of a capital asset and constituted the carrying on a business of land development. Mason J explained:

… I do not agree with the proposition which appears to be founded on remarks in some of the judgments that sale of land which has been subdivided is necessarily no more than the realization of an asset merely because it is an enterprising way of realizing the asset to the best advantage. That may be so in the case where an area of land is merely divided into several allotments. But it is not so in a case such as the present where the planned subdivision takes place on a massive scale, involving the laying-out and construction of roads, the provision of parklands, services and other improvements. All this amounts to development and improvement of the land to such a marked degree that it is impossible to say that it is mere realization of an asset.

The concept of transforming an asset are discussed in Whitfords Beach Pty Ltd v Federal Commissioner of Taxation 79 ATC 4648. In his judgement Dean J offered the following example:

…a goldsmith who sells in his shop his patrimony of a single gold bar does not necessarily receive the proceeds of sale as income merely because he takes advantage of his shop to sell his capital asset more advantageously. On the other hand, the master goldsmith who labours to turn such a gold bar into finely wrought brooches which he displays and sells with his other gold wares, could not be said to receive the whole of the proceeds of sale of those particular brooches as capital merely because the gold from which they had been fashioned had not been acquired by him for the purposes of his business but had been received as a gift from his father.

You developed the land beyond what was necessary to secure council approval for a subdivision; buildings have been erected upon the subdivided land, in doing so, transforming it into something else. You have also borrowed money to finance the development.

Upon weighing the factors of your case we find that the subdivision of the land and construction of townhouse on Lot 2 and Lot 3 will constitute an isolated commercial transaction undertaking a profit- making scheme. Accordingly the profits from the transaction will be considered ordinary assessable income under section 6-5 of the ITAA 1997.

Capital gains tax

The basic capital gains tax (CGT) provisions are contained in Part 3-1 of the ITAA 1997. Broadly, these provisions include in your assessable income any assessable gain made when a CGT event happens to a CGT asset that you own (to the extent that they are not reduced by capital losses).

A CGT asset is any kind of property or a legal or equitable right that is not property. CGT event A1 under section 104-10 happens if you dispose of a CGT asset. You make a capital gain if your capital proceeds exceed the CGT asset’s cost base.

Section 118-20 contains anti-overlap provisions which operate to reduce capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 of the ITAA 1997, for example, as ordinary income under section 6-5.

Application to your situation

Making an overall assessment on the factors set out in TR 92/3, it is the Commissioner’s view that the sale of the Property will not be a mere realisation of a capital asset.

Accordingly, whilst CGT event A1 under section 104-10 will occur on the disposal of the Properties, the disposals will be viewed as isolated transactions, and any capital gain arising from these CGT events will be reduced to the extent any profit is also assessable under section 6-5.

Further information

When a property development activity is an isolated commercial transaction, a taxing point will only be triggered when the relevant property/ies are sold.

As discussed above, any gain from the time the property was originally acquired to the point at which the project became revenue in nature, i.e., the time your intention changed, will continue to be subject to CGT.

In your situation, it would be considered reasonable that your intention changed when you secured the finance to commence the townhouse constructions.

The amount by which the sale price of the subdivided/developed lots exceeds the market value of the land at the time of conversion together with other development costs, will be assessed as ordinary income and subject to income tax.