Edited version of private advice

Authorisation Number: 1051609087555

Date of advice: 19 November 2019

Ruling

Subject: Property development - the sale of real property

Question 1

Will the profit or gain derived from the sale of the Property be ordinary income for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No - sale of the Property is a mere realisation of an asset that is subject to capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997.

Question 2

What is included in the capital proceeds pursuant to Division 116 of the ITAA 1997 on the happening of CGT event A1 in relation to the Property disposal?

Answer

The market value of the Property at the date the option to purchase the Property is exercised.

Question 3

Do the costs of obtaining the development approval form part of the cost base of the Property for the purposes of section 110-25 of the ITAA 1997?

Answer

No - to the extent that this expenditure is recouped, or the Purchaser reimburses the expense, and it has not been included in assessable income by the Trustee it will not form part of the Property's cost base or reduced cost base in calculating any capital gain or capital loss under subsections 110-45(3) and 110-55(6) of the ITAA 1997.

Question 4

Is the Trustee entitled to utilise the CGT discount under Division 115 of the ITAA 1997 in connection with the sale of the property?

Answer

Yes

Question 5

Will the Commissioner seek to make a determination that Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) applies to include an amount in the assessable income of the Trustee due to the disposal of the real property to the Purchaser?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

May 20XX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The Trust is an Australian resident trust for income tax purposes.

In accordance with the deed governing the Trust, the Trustee may invest in property.

The Trust has been operated exclusively as a long term property investor since it was settled - holding real property from which rental income is derived.

The Trustee is the registered proprietor of property (the Property).

In 20XX - the Trustee was approached by a real estate agent who advocated for the Property to be sold based on its development potential.

The real estate agent took steps and incurred costs in relation to working on a sales campaign advertising the Property.

The real estate agent engaged architects to assist in presenting the property to achieve the 'enterprising form of sale', which entailed a design and plans for 300 plus apartments. Some sites were to be retained by the Trust.

The real estate agent was unable to attain a sale of the property.

Subsequently:

a)     a special purpose company was established (Purchaser).

b)     the Trustee granted the Purchaser a call option to purchase the Property. Pursuant to the terms of the Call Option Agreement the Purchaser paid an option fee for the exclusive option to purchase the Property.

The Call Option Agreement which details the obligations of the parties have been provided.

The Trustee lodged development application for the Property with the relevant authority.

The Trustee was subsequently granted development approval to develop the Property.

The Trustee's reasons for providing the call option:

·        The Trust is a long-term passive investor whose aim is to derive rental income.

·        The Trust has assets other than the Property that it does not wish to put at risk via any activity such as property development.

·        The Purchaser does not have to commit to the purchase price until it is satisfied that the development of the property is viable.

·        The Purchaser does not wish to pay stamp duty on any contract of sale until it is satisfied the development of the property is viable.

·        The reason the Call Option Deed has a strike price for the purchase of the Property at 90% of the then market value is because:

a)     The Purchaser is obligated to pay all development expenses, outgoings and costs (whether directly or by reimbursement ) and for taking on that risk it receives two benefits:

1)     the discount of 10% from this market value at the time of the CGT Event A1 happening; and

2)     the ability to secure a substantial development site with significant income prospects going forward.

b)     the Trustee is able to:

1)     determine the market value for its Property, at the time of the disposal happening, which ensures any guess work of the value in 20XX was not need; and

2)     permit the Purchaser to take the commercial risk of development application costs and outgoings whilst otherwise retaining the Property, with the benefit of the development approvals (if any) secured until such time as the option is exercised (if ever).

The cost of those benefits is the commercial reduction of 10% of the market value at the time of disposal.

The Call Option Agreement was therefore a mechanism by which both parties could secure their commercial interests (having the exercise price calculation by the market value at the time of exercise with a commercial discount of 10%) and provide certainty as to their future conduct on and from the date of entry into that Deed.

The Purchaser has reimbursed the Trustee for all expenses referrable to obtaining approval for the development of the Property.

The call option will be exercised in the income year ended 30 June 2020 and the Trustee will dispose of the Property to Purchaser.

There is a single individual that is the controlling mind of both the Trust and the Purchaser.

Reasons for decision

Question 1

Summary

The sale of the Property is a 'mere realisation' of a capital asset.

Detailed reasoning

Taxation treatment of property sales

There are three ways profits from a land sub-division can be treated for taxation purposes:

1.     As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock.

2.     As ordinary income under section 6-5 of the ITAA 1997, 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.

3.     As statutory income under the capital gains tax (CGT) regime, (sections 10-5 and 102-5 of the ITAA 1997), on the basis that a mere realisation of a capital asset has occurred.

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

Carrying on a business of property development

Section 995-1 of the ITA 1997 states the term 'business' includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

The Commissioner's view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11).

Although TR 97/11 deals with the issues of determining whether a taxpayer is carrying on a business of primary production, the same principles can be applied to the question of whether a taxpayer is in the business of property development.

Paragraph 13 of TR 97/11, 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.

Isolated business transactions

Profits arising from an isolated transaction as a result of entering into a profit-making undertaking or scheme will be ordinary income under section 6-5 of the ITAA 1997, on revenue account, (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693(Myer Emporium)). This is distinguished from a 'mere realisation' which is not ordinary income.

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) sets out the Commissioner's view on the application of the decision in Myer Emporium and provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 of the ITAA 1997 as ordinary income.

Paragraph 1 of TR 92/3 provides that the term isolated transactions refers to:

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.

Paragraph 6 of TR 92/3 provides that a profit from an isolated transaction is generally income when both of the following elements are present:

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.

In general, whether a profit from an isolated transaction is income according to ordinary concepts depends very much on the individual circumstances of the case.

Paragraph 13 of TR 92/3 lists the following factors which are relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction include:

·        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.

In determining whether activities relating to isolated transactions are a profit making undertaking or are the 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

Where the sale is a 'mere realisation' the sale is on capital account to which the CGT rules will generally apply. These proceeds are not ordinary income.

A sale that is more than a 'mere realisation' will be on revenue account and proceeds will generally be assessable as either income from the carrying on of a business or income from a profit making undertaking or scheme.

The expression 'mere realisation' is used to distinguish a mere realisation from a business operation or a commercial transaction carrying out a profit-making scheme.

Profits made on the realisation of capital assets can still be ordinary income if the activities go beyond a mere realisation and instead become a separate business operation or commercial transaction even though the taxpayer did not have a purpose of profit-making at the time of acquiring the asset.

In McClelland v FC of T [1970] HCA 39, for example, the Privy Council held that the question to be answered was whether the facts revealed a mere realisation of capital, albeit in an enterprising way, or whether they justify a finding that the taxpayer went beyond this and engaged in a trade of dealing in the asset, albeit on one occasion only.

Lord Justice Clark, in distinguishing between proceeds that is mere realisation of capital and ordinary income, stated in California Copper Syndicate v Harris (1904) 5 TC 159 at pp 165-166 that:

...What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being - is the sum of the gain that has been made a mere enhancement of values by realising a security, or is it a gain made in an operation of business in carrying out a scheme of profit-making?

In FC of T v Whitfords Beach Pty Ltd 82 ATC 4031, Gibbs CJ similarly said (at p.4034) that:

When the owner of an investment chooses to realize it, and obtains a greater price for it than he paid to acquire it, the enhanced price will not be income within ordinary usages and concepts, unless, to use the words of the Lord Justice Clerk in California Copper...'what is done in not merely a realisation or charge of investment, but an act done in what is truly the carrying on, or carrying out, of a business'.

It is accepted that the Trustee's primary intention was to hold the Property with the possibility at some point making a capital gain as property prices rose over time. The Property has been used for over 15 years to derive rental income.

To realise the best possible return for the property the Trustee entered into an agreement with a related purchaser which provided that entity with the option to purchase the property should development approval be granted by the relevant authorities. The Trustee incurred expenditure to apply for and be granted those approvals, which have been refunded by the Purchaser. The Purchaser is to exercise the option to purchase the property on the basis that development approval has been granted.

In consideration of all of the above, and given the length of time the land has been held for rental income, and that the Trustee has not, other than to realise the asset, undertaken development work, the Commissioner considers that the Trustee has not undertaken a business operation or commercial transaction.

The sale of the Property is the mere realisation of an asset: it is the disposal of a CGT asset that is subject to capital gains tax. Upon the execution of the sale contract CGT event A1 will happen in relation to the Property.

Question 2

Summary

The capital proceeds that the Trustee receives upon the disposal of the Property is modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997 and the capital proceeds of market value less 10% is substituted with the market value of the Property when the purchase option is exercised.

Detailed reasoning

Sale of the Property - CGT Event A1

The CGT provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997. Broadly, the provisions include in assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own.

Section 102-5 of the ITAA 1997 provides that your assessable income includes an amount that is a net capital gain.

Pursuant to section 102-20 of the ITAA 1997, you can only make a capital gain or loss when a CGT event happens. The gain or loss is made at the time of the CGT event and can only be made in respect of a CGT asset.

Note 1 of section 108-5 of the ITAA 1997 lists land and buildings as an example of a CGT asset.

CGT event A1, under section 104-10 of the ITAA 1997, happens if you dispose of a CGT asset (subsection 104-10(1) of the ITAA 1997). You dispose of a CGT asset if your ownership interest in a CGT asset changes to another entity (subsection 104-10(2) of the ITAA 1997). CGT event A1 occurs when you enter into a contract to dispose of the CGT asset (subsection 104-10(3) of the ITAA 1997).

Under subsection 104-10(5) of the ITAA 1997, any capital gain or capital loss you make is disregarded if you acquired the CGT asset prior to 20 September 1985.

Therefore, at the time of entering into the contract for the disposal of the Property, at the time the call option is exercised there is a contract to dispose of the Property to the Purchaser, CGT event A1 will occur as per section 104-10 of the ITAA 1997.

Capital proceeds - 'Reimbursed expenses'

Subsection 116-20(1) of the ITAA 1997 states:

The capital proceeds from a * CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the * market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1 of the ITAA 1997).

In this case, the amount received is described in the Call Option Agreement as 90% of the 'market value' (see discussion below on the application of market value substitution rule). The amounts received as refunds to the Trustee by the Purchaser pursuant to the Call Option Agreement, including for seeking and receiving development approval, are amounts received that are not capital proceeds in relation to the happening of CGT event A1, but reimbursements (see discussion below on reimbursements).

The option agreement - CGT Event D2

CGT event D2 happens if you grant an option to someone, or renew or extend an option that you had granted (section 104-40 of the ITAA 1997).

The amount of your capital gain or loss from CGT event D2 is the difference between what you receive for granting the right and any expenditure you incur on it. The CGT discount does not apply to CGT event D2.

In this case the Trustee granted the option and received an option fee in the income year prior to the year the option is exercised. Therefore, the granting of the option by the Trustee meant that CGT event D2 happened and the date of the event is when the option was granted in the prior income year.

However, in this case, the option will be exercised and the Property will be disposed of to the Purchaser in the in the income year ending 30 June 2020.

Taxation Determination TD/16 Capital Gains: What is the date of acquisition (or date of disposal) of an asset acquired (or disposed of) on the exercise of an option? confirms that the date of disposal of an asset under an option is the date of the transaction entered into as a result of the exercise of the option. Accordingly, the date of disposal of the property is the date that the option is exercised. The subsequent disposal of the land resulting from exercising the option will be a CGT event A1 under section 104-10 of the ITAA 1997.

In addition, section 116-65 of the ITAA 1997 provides that where you dispose of a CGT asset because another entity exercises an option you granted in relation to the asset, the capital proceeds from the disposal include any payment you received for granting the option. This means that the capital proceeds from the A1 event include any payment you received for granting the option. Therefore, the original CGT event D2 is disregarded under subsection 104-40(5) of the ITAA 1997.

Where an option is given in one income year and exercised in another income year, an amendment to the taxpayer's income tax assessment for the income year in which the option was granted will be necessary.

In the Trustee's case, the option was granted in a prior income year to the year in which the option to purchase the property is exercised, subsection 104-40(5) of the ITAA 1997 applies so that the original CGT event D2 is disregarded, The assessment for the prior income year will need to be amended to exclude the effect of that CGT event. The amount received for the granting of the option will then be included in the capital proceeds the Trustee received in relation to CGT event A1 happening to Property in the income year the option will be exercised.

The 'market value substitution rule'

However, there are a number of modifications to the general rules. Relevantly, the 'market value substitution rule' in section 116-30 of the ITAA 1997 provides that an entity is taken to have received the market value of the relevant CGT asset in certain situations.

In particular, subsection 116-30(2) of the ITAA 1997 modifies the general rules by replacing the capital proceeds with the market value of the relevant CGT asset (worked out as at the time of the event) if:

(a) some or all of those proceeds cannot be valued; or

(b) those capital proceeds are more or less than the market value of the asset and:

(i) you and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event; or

(ii) the CGT event is CGT event C2 (about cancellation, surrender and similar endings).

Meaning of 'at arm's length'

Subsection 995-1(1) of the ITAA 1997 defines 'arm's length' as follows:

...in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

The question of whether parties that are not at arm's length have dealt at arm's length is to be determined by considering whether the outcome of their dealing is a matter of real bargaining. The principle of 'arm's length dealing' was considered in The Trustee for the Estate of the Late AW Furse No 5 Will Trust v FC of T 91 ATC 4007, Hill J stated (at p 4015):

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing, they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining.

The question is not answered solely by asking whether the parties were at arm's length to each other. The emphasis is on whether the parties dealt with each other at arm's length and as such, it is a question of fact.

Determining whether the capital proceeds from the sale will be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997.

Paragraph 116-30(2)(a) of the ITAA 1997

Paragraph 116-30(2)(a) of the ITAA 1997 is not applicable to the current circumstances as, based on the facts, the value of the capital proceeds under the sale is the market value less 10%.

Subparagraph 116-30(2)(b)(i) of the ITAA 1997

For subparagraph 116-30(2)(b)(i) of the ITAA 1997 to be satisfied:

2.     the capital proceeds that the Trustee receives under the property's sale must be either more or less than the market value of the Property, and

3.     the Trustee and the Purchaser must not have dealt with each other at arm's length in connection with the Property's sale.

In this case the Trustee will receive 'market value' for the property, but this will be discounted by 10%.

If the second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is not satisfied, then the market value substitution rule in subsection 116-30(2) of the ITAA 1997 will not apply.

Did the Trustee and Purchaser deal with each other at arm's length?

The second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997.

In determining whether the Trustee and Purchaser were dealing with each other at arm's length in connection with the Property's sale, the Commissioner is required to take into account not only the relationship or connection between the Trustee and Purchaser, but also the circumstances of the property sale with a view to determining whether or not the parties were conducting the sale in a way which one would expect of parties dealing at arm's length in such a transaction.

It is considered that that Property sale that was conducted and influenced by the controlling mind led to the market value of the transaction to be discounted by 10% - that is, dealings between unrelated parties would not have led to the 10% discount for the reimbursement of the development approval expenses.

Accordingly, in that case subparagraph 116-30(2)(b)(i) of the ITAA 1997 is satisfied. It will therefore be necessary for the purpose of this subparagraph to consider whether the capital proceeds are more or less than the market value of the Property.

Subparagraph 116-30(2)(b)(ii) of the ITAA 1997

Subparagraph 116-30(2)(b)(ii) of the ITAA 1997 is not relevant in the current circumstances as the applicable CGT event is not CGT event C2. When the option is exercised and the Property is disposed of CGT event A1 will be triggered.

The capital proceeds that the Trustee receives upon the disposal of the Property is modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997 and the capital proceeds of market value less 10% is substituted with the market value of the Property.

Question 3

Summary

The costs of obtaining the development approval will not form part of the cost base of the Property for the purposes of section 110-25 of the ITAA 1997.

Detailed reasoning

Property Cost base - costs of obtaining development approval.

A capital gain is made on the disposal of a CGT asset when the proceeds received from the sale are more than the cost base of the asset. Accordingly, to determine the extent of any assessable gain, it is necessary to determine the cost base of the asset.

Section 110-25 of the ITAA 1997 provides that the cost base of a CGT asset has five elements. Subsection 110-25(5) of the ITAA 1997 provides that the fourth element of the cost base of a CGT asset is capital expenditure incurred to increase the asset's value. For expenditure to be included in the fourth element of the cost base of an asset under subsection 110-25(5) of the ITAA 1997, it must be incurred 'to' enhance the value of the asset, that is, for the purpose of enhancing the value of an asset. It is immaterial whether or not the expenditure in fact enhances the value of the asset.

However, subsections 110-45(3) and 110-55(6) of the ITAA 1997 provide that for assets acquired after 7.30pm on 13 May 1997 recouped expenditure does not form part of any element of cost base or reduced cost base (respectively), except so far as a taxpayer has included it as assessable income: section 995-1 of the ITAA 1997 provides that 'recoupment' has the meaning given by section 20-25 of the ITAA 1997.

Section 20-25 of the ITAA 1997 defines a 'recoupment' of a loss or outgoing as including '...any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described'.

The ordinary meaning of the term 'recoup' is provided in The Macquarie Dictionary [Multimedia], version 5.0.0, 01/10/01 (Macquarie Dictionary) and includes '...to obtain an equivalent for; compensate for: to recoup one's losses', '...to regain or recover' and '...to reimburse or indemnify: to recoup a person for expenses'.

In this case, the Trustee is incurring expenditure to increase the value of the asset by obtaining development approval, which is a requirement for the Purchaser to exercise its option under the Call Option Agreement. However, to the extent that this expenditure is recouped, or the Purchaser reimburses the expense, and it has not been included in assessable income by the Trustee it will not form part of the Property's cost base or reduced cost base in calculating any capital gain or capital loss under subsections 110-45(3) and 110-55(6) of the ITAA 1997.

Question 4

Summary

As the Trustee acquired the Property more than 12 months before the CGT event, the capital gain from the disposal of the Property may be reduced by 50% as outlined in Step 3 of the method statement set out in subsection 102-5(1) of the ITAA 1997.

Detailed reasoning

CGT discount

Subdivision 115-A of the ITAA 1997 provides that a discount capital gain is a capital gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997.

Under section 115-5 of the ITAA 1997 you make a discount capital gain if the following requirements are satisfied:

·        you are an individual, a trust or a complying superannuation entity

·        a capital gains tax (CGT) event happens to an asset you own

·        the CGT event happened after 11.45am (by legal time in the ACT) on 21 September 1999

·        you acquired the asset at least 12 months before the CGT event, and

·        you did not choose to use the indexation method.

Under the discount method you reduce your capital gain by the discount percentage. Section 115-100 of the ITAA 1997 provides that the discount percentage for a trust is 50%.

In this case, the Trustee owned the property for more than 12 months and its sale occurred after 21 September 1999, the Trustee is able to make a discount capital gain where the sale of the property results in a capital gain.

Question 5

Summary

Part IVA of the ITAA 1936 will not apply to the disposal and the acquisition of the Property under this arrangement.

Detailed reasoning

Part IVA

Section 177D of the ITAA 1936 provides that Part IVA will apply to a scheme where the scheme was entered into for the purpose of enabling a taxpayer to obtain a tax benefit.

Law Administration Practice Statement PS LA 2005/24 Application of General Anti-Avoidance Rules (PS LA 2005/24) deals with the application of the general anti-avoidance rules, including Part IVA of the ITAA 1936. Before the Commissioner can exercise his discretion to make a determination in respect of Part IVA under subsection 177F(1) of the ITAA 1936, three requirements must be met:

·        there must be a scheme within the meaning of section 177A of the ITAA 1936;

·        a tax benefit must arise based on whether a tax effect would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out; and

·        having regard to the matters in subsection 177D(2) of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies (dominant purpose).

The Commissioner has considered these three requirements and will not seek to make a determination that Part IVA of the ITAA 1936 applies to include in the assessable income of the Trustee the whole or a part of the amount of assessable income that is derived as a result of development of the Property by the Purchaser