Edited version of private advice

Authorisation Number: 1051521706108

Date of advice: 28 May 2019

Ruling

Subject: Property subdivision - revenue or capital - CGT event K4

Question 1

Is the gain derived on sale of the subdivided lots (the Land) assessable as a capital gain under the capital gains tax provisions contained in Parts 3-1 to 3-3 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Are the proceeds from sale of the subdivided lots assessable income under section 6-5 of the ITAA 1997?

Answer

Yes

Question 3

In relation to the subdivided lots, did CGT event K4 happen?

Answer

Yes

Question 4

Can the Trust elect that the Land was transferred to trading stock on 31 July 2015 at its market value, in accordance with paragraph 70-30(1)(a) of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Year of income ended 30 June 2016

Year of income ended 30 June 2017

Year of income ended 30 June 2018

Year of income ended 30 June 2019

Year of income ended 30 June 2020

The scheme commences on:

1 July 2015

Relevant facts and circumstances

A parcel of land was purchased by the taxpayer entity for investment purposes. At the time of purchase it was leased to another unrelated entity which operated a business on the parcel of land.

Within a year of purchase, the unrelated entity went into voluntary liquidation, and the taxpayer entity located another organisation to continue the lease on the entire land.

Within a couple years, the current lessee renegotiated the rent payable to a minimal amount, in part due to high costs of maintaining all the land in a condition fit for the business being conducted. The lessee also ceased using a portion (approximately 20%) of the entire land that had been purchased for the business.

The taxpayer entity investigated alternative uses for this surplus land, but any uses that would be allowed under the then zoning requirements were not financially viable options.

The taxpayer entity also undertook extensive community consultation, along with lobbying of relevant government departments and government ministers for rezoning of the surplus land to allow a particular business to be operated on the surplus land. If successful this would have provided additional lease income to the taxpayer entity.

After a number of years, the surplus land was rezoned to urban use and the entire land subdivided so that the surplus land had its own title.

At this time, the taxpayer entity made several attempts to find a property developer to purchase the surplus land. A potential buyer was identified, price agreed and contract drafted, however the sale did not proceed. After this a further attempt was made to find a buyer, but although there were a couple interested buyers, a suitable price could not be agreed.

After a suitable buyer could not be located for the surplus land, the taxpayer entity made the decision to undertake a residential subdivision on the surplus land. To this end an unrelated third party was engaged to undertake all subdivision works, and the subdivided lots were sold at auction in two stages.

Relevant legislative provisions

Income Tax Assessment Act 1936

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 70-30

Income Tax Assessment Act 1997 Section 104-220

Income Tax Assessment Act 1997 Section 118-20

Reasons for decision

Summary

The proceeds from the sale of the surplus land will be assessable income under section 6-5 of the ITAA 1997 and therefore the capital gain derived from the sale will be reduced to nil under section 118-20.

CGT event K4 happened on 31 July 2015, and the taxpayer entity can elect to transfer the Land to trading stock at market value.

Detailed reasoning

Whether or not a profit from the sale of property is assessable income under section 6-5 of the ITAA 1997, or a capital receipt to which the capital gains tax provisions will apply depends on the particular facts. This issue has been considered on a number of occasions, and the courts have established the following propositions:

·        There is a distinction between whether the disposal of property is a mere realisation of a capital asset as opposed to an act done in the course of carrying on, or carrying out, of a business (Californian Copper Syndicate (Limited and Reduced) v. Harris ((1904) 5 TC 159); Commissioner of Taxation v. Whitfords Beach Pty Ltd (1982) 150 CLR 355; 82 ATC 4031; 12 ATR 692)(Whitfords Beach)).

·        If the sale occurs as part of a business operation, carried out in the course of a profit-making business, the sale will be income in nature (London Australia Investment Company Limited v Commissioner of Taxation ((1977) 138 CLR 106))

·        The profit will not be income according to ordinary concepts if the property is not sold as part of business operations (Whitfords Beach).

·        An isolated venture or one-off transaction can generate a profit on income account if the acquisition of the property generating the profit was part of business operations or a commercial transaction (Commissioner of Taxation v. The Myer Emporium Limited ((1987) 163 CLR 199) (Myer)).

·        If the transaction which occurs is not part of ordinary business activities then any profit from the sale of property can still be on revenue account provided the acquisition of the property was part of a commercial transaction and at the time of acquisition there was an intention or purpose of making a relevant profit (Westfield Limited v. Commissioner of Taxation ((1991) 28 FCR 333)).

The taxpayer entity was established for the specific purpose of purchasing the land for investment. Although the original tenant went into liquidation shortly after the purchase, the taxpayer entity located another tenant to continue to run the business. Once the lessee ceased operating the business on a portion of the land, the taxpayer entity pursued other income producing options for that surplus land before pursuing the subdivision option. This included commissioning a report on options that would be available under the then current zoning conditions. It also included lobbying of relevant government ministers to have the Land re-zoned to allow a particular business to be operated by a related entity on the surplus land. It is noted that the total area of the surplus land that has been incorporated into the subdivision is only approximately 20% of the total land purchased, the remaining land continues to be owned by the taxpayer entity and leased to an unrelated entity. Taking all these factors into account, it is accepted that the entire land was purchased for long-term investment purposes and therefore was purchased by the taxpayer entity on capital account.

In relation to the sale of the subdivided blocks, the following is noted:

·        When the business ceased on a portion of the land, attempts were made to find an alternative income producing use for the surplus land. Additionally, attempts were made to sell the surplus land englobo. Following a tender process, a potential buyer was found and price agreed, however the purchaser withdrew before the sale was finalised.

·        The scope and scale of the subdivision is significant and goes well beyond a mere realisation of the surplus land in an enterprising way.

·        There is a lack of nexus between the original long-term investment purpose of the land at the time of its acquisition and the subdivision and sale of the subdivided lots.

·        Although the taxpayer entity entered into a contract with an unrelated entity to undertake all the subdivision work, the taxpayer entity was still exposed to a degree of risk in relation to the subdivision development.

Had the surplus land been sold englobo prior to any development work being undertaken, it is arguable that the sale might have been a mere realisation of a capital asset. The entire land was purchased for investment purposes to provide an income stream from the leasing of the land to the business operator. Once the business ceased operating on a portion of the land it was no longer fit for purpose, and no viable alternative investment options were available.

However, it is considered that the taxpayer entity has done more than merely realise a capital asset. It has embarked on a series of activities that exposed the taxpayer entity to some degree of risk, and involved further capital outlay on the part of the taxpayer entity and therefore, the proceeds from the sale of the subdivided blocks are proceeds from carrying on a business of property subdivision and sale, and will be assessable income under section 6-5 of the ITAA 1997. Any capital gain made on the sale of the subdivided land will not be assessable under the capital gains provisions due to the operation of section 118-20 of the ITAA 1997.

CGT event K4

CGT event K4 happens when you start holding as trading stock a CGT asset that you already own and you elect to be treated as having sold the asset for its market value under paragraph

70-30(1)(a). The time of CGT event K4 is the time that you started holding the CGT asset as trading stock (subsection 104-220(2)). Therefore, it needs to be determined at what point in time the surplus land became trading stock of a property development business of taxpayer entity.

Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock'? (TD 92/124) provides that land will be treated as trading stock if it is held for the purpose of resale and a business activity which involves the dealing in land has commenced. Both the required purpose and the business activity must be present.

In Whitfords Beach the full Federal Court had to consider at what point in time land was ventured into a business of developing, subdividing, and selling land at Whitfords Beach. Bowen CJ, Morling and Fitzgerald JJ considered that this occurred when there was both a 'persistent intention to develop, subdivide and sell all of the... land and a continuous course of conduct directed to the implementation of that intention'. Additionally, in considering whether either a business has commenced or activities are merely preliminary to commencement of the business, the element of commitment is important (Softwood Pulp and Paper Limited v Federal Commissioner of Taxation 76 ATC 443; Goodman Fielder Wattie Ltd v Federal Commissioner of Taxation (1991) 101 ALR 329).

Therefore, in accordance with TD 92/124 and the decision in Whitfords Beach, in the current case, CGT event K4 will happen when there is a definite and continuous cycle of operations designed to lead to the sale of the land as the final step in a business of property development and subdivision. This cannot be a date earlier than when the business of property development commenced. That is, this will occur at the time there is a 'persistent intention to develop, subdivide and sell the land and a continuous course of conduct directed to the implementation of that intention' (Whitfords Beach).

At the time that the business operations ceased on the surplus land, the taxpayer entity pursued alternative investment options for the surplus land that would have been possible without rezoning. At the same time, the taxpayer entity lobbied government ministers to allow rezoning to permit a particular business be operated on the surplus land. If any of these options had been proceeded with, the land would continue to be held and generate investment income for the taxpayer entity. Therefore, whilst these alternative investment options were being explored, the surplus land had not been definitively committed to a business of property development, the intention being to continue to derive investment income from the use of the surplus land. Accordingly during this period, the surplus land was still held on capital account, and had not been converted to trading stock. CGT event K4 will not have happened at any time during this period.

At a point in time, the taxpayer entity undertook action to cause the Land to be rezoned as future urban area and obtained approval to subdivide the land so that the surplus land had its own title. Following this, the taxpayer entity attempted to sell the surplus land englobo. In particular, approaches were made to various specific entities. Following a tender to find a willing buyer for the Land, a potential buyer was identified, however the sale was never finalised due to the buyer withdrawing. Following this potential sale not proceeding, further approaches were made to 2 potential buyers neither of these were willing to purchase at a price acceptable to the taxpayer entity.

Whilst the taxpayer entity was actively pursuing a suitable buyer, it is considered that the surplus land had not been 'definitively committed to a business of property development'. The original land purchase was for investment purposes, and the subdivision has occurred on only approximately 20% of the total land purchased. The remaining land is continuing to generate lease income to the taxpayer entity. Thus it is considered that the land became trading stock of the taxpayer entity at the time that they committed to undertaking the subdivision, rather than selling the land englobo. This will be around July 2015, after the final approaches to sell the land englobo did not produce an acceptable offer. Therefore, CGT event K4 happened on 31 July 2015.

Trading stock election

Under section 70-30, if an item you own later becomes part of your trading stock you are treated as if you had sold that item to someone else (at arm's length) and immediately bought it back for the same amount. Under paragraph 70-30(1)(a) you can elect that this amount be either the cost of the item (as calculated under subsections (3) or (4)), or its market value just before it became trading stock. An election under subsection 70-30(2) must be made by the time that taxpayer entity lodges its income tax return for the income year ended 30 June 2016. If the election is not made by that time because the taxpayer entity did not realise until later that it started to hold the item as trading stock, the election must be made as soon as is reasonable after realising that. The Commissioner can allow further time in which to make the election.

Subsection 70-30(2) was introduced as part of the re-write of the former trading stock provisions in the Income Tax Assessment Act 1936 into the ITAA 1997. The Supplementary Explanatory Memorandum - Senate to the Tax Laws Improvement Act 1997 (Chapter 1 - Trading Stock: Changes in use) is silent on the circumstances in which the Commissioner would allow further time for an election to be made.