Edited version of your written advice

Authorisation Number: 1051445649024

Date of advice: 18 December 2018

Ruling

Subject: Land subdivision

Question 1

Will the proceeds from the sale of the subdivided lots be subject to capital gains tax (CGT) under Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the profits from the sale of the subdivided lots be assessable as ordinary income under section 6-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20xx

Year ending 30 June 20xx

Year ending 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

You own a property totalling a number of hectares (the land).

You acquired the land for market value a number of years ago. At the time of acquisition, the land was zoned as farming or rural/residential.

You built a house on the land but you did not move in. You rented out the dwelling after construction was finished and is currently returning weekly rental income.

The land was subsequently rezoned and was earmarked for future residential development.

You had no involvement in the rezoning process.

An entity approached you about subdividing and developing the land into residential lots for sale on your behalf for a fee. You considered the proposal but decided not to pursue negotiations.

A developer expressed similar interest in developing the land for a fee (the developer). The developer contacted you through a local real estate agent.

Various property developers also approached you.

You advanced your discussions with the developer and agreed in principle as to the key terms and conditions of the land subdivision project. The land development agreement has not been executed.

You did not obtain any advice from professionals prior to entering into the subdivision arrangement. You also did not apply for planning permission from the relevant authorities.

You will remain the legal and beneficial owner of the land during the course of the development.

The developer proposed that the land will be subdivided into a number of residential lots. You will retain a small number of lots.

You have provided details of the land’s current un-subdivided value and details which provide that total proceeds of the subdivided lots will be significantly higher than the land’s unimproved value.

You have provided details of your expected net proceeds.

The land subdivision activities will occur over a number of years and stages.

The developer’s overall activities include:

● land development feasibility study

● demolition and removal of any buildings and other structures on the land;

● liaising with responsible authorities;

● carrying out of construction works;

● supervision and engagement of contractors; and

● preparation of any marketing plan, brochures, signage, shop displays, advertising and web site.

You did not place the land on the market for sale and did not receive any offers to purchase the property.

You have no previous direct or indirect experience in property development.

You are not registered for GST.

Draft Development Agreement

The developer will complete the development works and enter into contracts related to the works.

The developer will provide you with a feasibility study for the development and be involved in preparing sale contracts of the subdivided lots.

You will provide the developer and relevant entities access to the land and authorise the developer to act on your behalf.

The Developer shall be solely responsible for the financing and payment of all Development Costs but your land may be used as security.

You will pay a retainer fee to the Developer in equal monthly instalments plus GST in advance commencing on the date of the Agreement

Sale proceeds will be used to pay development costs, as well as a percentage to the developer, before you receive the balance.

On termination by either party, you will be liable for the development fee and all reasonable costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 70-10

Income Tax Assessment Act 1997 Section 70-30

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Subsection 104-10(1)

Income Tax Assessment Act 1997 Subsection 104-10(2)

Income Tax Assessment Act 1997 Subsection 104-10(3)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 118-25

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Reasons for decision

Summary

On balance, you are carrying on a business, and the proceeds on the sale of subdivided lots are on revenue. Alternatively, you have entered into a profit making undertaking or scheme, and the proceeds are on revenue. This means that you have derived ordinary income which is assessable under section 6-5 of 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 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; or

2. As ordinary income under section 6-5 of the ITAA, on revenue account, as a result of an isolated business 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 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 indicators must be considered in combination and as a whole.

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, subdivided lots 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

When the business starts, the subdivided land becomes 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 of the ITAA.

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 have become a separate business operation or commercial transaction, or an isolated profit making venture.

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.

In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations.

Capital gains tax 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.

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 of the ITAA 1997.

Any capital gain you make will be reduced under 118-20 of the ITAA 1997 to the extent that the profit from the sale of the properties is otherwise included as assessable income including under section 6-5 of the ITAA 1997.

Application to your situation

Carrying on a business

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

We acknowledge that you acquired the property for private residential purposes then held this as an investment property after construction of the house. You submitted that the development works go no further than what is necessary to prepare the land to be sold as smaller parcels. Although you contend that there will be no additional structures or amenities added to the land beyond what the council requires, this must be considered in the context of the level of activity required for the development and not simply based on the fact that the parties carried out what council required them to do. While you contend that your role will be passive, ultimately you, as the legal owner, are baring the financial risk and maintain control through the developer.

The land has been acquired near the urban fringe of a city and was earmarked for future residential development. There have been no attempts to dispose of the land in its entirety prior to being contacted by property developers. Furthermore, you have received interest from a number of developers to develop the land for fee prior to your discussions with the developer. It is arguable that you held the property for the purpose of development and resale.

The proposed development agreement shows that the development will be carried out in a planned, organised and business-like manner; thereby indicating a significant commercial purpose. The development works will be completed in a business-like manner and the developer and will provide a feasibility report for the development. Additionally, the plans of subdivision are coherent and include significant improvements including potential roads. We note that the land will be developed over a number of stages over a number of years. While you have granted development rights to the developer, you maintain a degree of control. As confirmed by the proposed agreement, you remain the legal owner of the land throughout the development process; and you will enter into contracts of sale with purchasers of subdivided land lots. You submitted that the development’s timing has been determined by the developer. We consider that where the developer can control the timing of works and sales, the release of stages of land and the development of that land, this may indicate that you are baring the risks associated with carrying on a development business or a profit-making undertaking yourself.

It is noted that you will enter a land development arrangement baring substantial financial risk, an indication of a profit-making activity. If the completion of the development and sales go beyond the projected timeframe, you will still be required to pay the monthly retainer fee to the developer until completion date. In the event that the developer breaches the agreement and you choose to terminate the contract and continue with the development; you are liable to pay the developer the balance of the development fee owing, less any sum required to complete the development. Likewise, in the event that you breach the agreement, you are liable to pay the development fee plus all other reasonable amounts incurred by the developer in continuing the development or selling the land in its uncompleted state.

The financial risk involved in the development rests directly with you as legal owner and availability for the land to be used as security for the development costs incurred by the developer. While you stand to profit from the overall development, in the event the development fails, you will be subject to losses or resulting liabilities. Ultimately, you will bear significant profit and loss risk in relation the development of your land.

You will incur significant expenses in relation to the development compared to the property’s market value. The development fee is estimated to be several millions more than the market value of the undeveloped land. You expect to receive several millions from the sale of the subdivided lots. This is substantially higher than the expected market value of when you acquired the land and indicates that by undertaking the development and incurring significant expenses to develop the land, there is an intention to make a profit, rather than the sale being a capital transaction to realise the value of the land as subdivided lots. Additionally, depending on future movements in land values, the total amount you will receive is uncertain and dependent on market forces, and a degree of risk remains. Based on the figures provided, the objective intention is that the development will be undertaken for the purpose of producing a profit.

As you are carrying on a business of property development subdivision, land will be treated as trading stock under section 70-10 of the ITAA 1997. When the land becomes trading stock, you are 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. You can elect to use the value at cost or market value of the land. If you elect for the transfer of the land to trading stock to occur at market value, CGT event K4 occurs at the time of the transfer.

Isolated transactions

Alternatively, the proceeds from the sale of the land will be those from an isolated transaction. Based on the facts, it can be concluded that the development and subsequent sale of the subdivided lots, occurs with the intention of profit as a 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 you are not carrying on a business the subdivided lots would not be treated as trading stock.

Conclusion

In this case, you are considered to be carrying on a business of property development and any profit from the sale of the subdivided lots will be assessable as ordinary income under section 6-5 of the ITAA 1997. 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.