Edited version of private advice

Authorisation Number: 1051610158130

Date of advice: 20 November 2019

Ruling

Subject: Subdivision- change of intent - capital versus revenue

Question

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

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2019

Year ending 30 June 2020

Year ending 30 June 2021

Year ending 30 June 2022

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.

You and your spouse purchased vacant land over 2 hectares in size, zoned rural.

The following year you and your spouse built a dwelling on the land and this was completed in within 12 months, it has been used as you main residence to this current day.

You have lived there for over 2 decades, raised your children, and at no stage were there a business conducted from the property.

Several years, you both became aware of the proposal of new planning scheme that affected your property.

You engaged the local town planner regarding potential use under the current town plan and zoning. This followed with making recommended town plan submissions in respect of your property.

You both received an email attaching the council's master plan from the town planner.

You forwarded an email to the local engineer regarding possible opportunities and design for the property under the master plan.

Based on the information you received from council for best possible use of the subdivision and therefore realisable value, you sought approval to divide the property into XX lots.

This financial year you received approval from your regional council to subdivide your property and operational works approval for the creation of the lots.

Based on the advice from the town planner and engineer, you formed the opinion that the value of the property would be increased if operational works approval was in place and thereby making the property an attractive investment for others. The council has approved the operational works for the lots.

You engaged a civil engineer in order to realise the maximum possible price of the subdivision. They will call tenders, award contracts and supervise all work to be carried out, in regard to creation and sale of the lots. This would leave you with no involvement in any of the construction work conducted in the subdivision.

You and your spouse's professions are not related to property development and you both have had no previous experience with property development. With retirement age looming your sole wish is to the sell the property for maximum value to provide for your retirement.

This financial year, you received a decision notice for approval for; development permit for operational work (road work, drainage work, landscaping, stormwater, earthworks, electrical and telecommunication).

The DA development application submitted by the civil engineer on your consent, for a development permit to reconfigure of the land plus drainage reserves and pump station lot for subdivision purposes, level of the assessment impact which requires public notification, the subdivision will not be in stages. You have provided the preliminary pricing schedule for the residential subdivision from re/max property sales.

The estimated gross proceeds of the sales of the X lots are over a million dollars as per estimate from a property professional, this estimate is before sale costs such as commission, advertising. etc.

You do not have a business plan for the development and there is no development agreement. The developer will be paid as you are billed for the expenses.

You will be borrowing funds to pay for the construction expenses.

The developer will not be receiving a percentage of each of the lots sold, they have a set fee.

The construction expenditure comes to a total over a million dollars. After expenses are paid all profit is distributed directly to you.

Once you provide the developer with approval for the commencement of the subdivision, the developer will proceed and be responsible for the subdivision. You will not have an active role in the construction process.

At this stage no professionals have been engaged for the construction of the subdivision.

You have provided the map of the subdivision that include the new roads to be constructed and, town utilities such as water, sewerage, electricity, phone and internet services will be required.

You have provided the estimated value of the land before the development started.

The projected net proceeds estimated to be received are over a million dollars. If the lots do not sell you will receive no profits.

You have provided the preliminary estimates of costs of construction dated this financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 15-15

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 112-25

Detailed reasoning

As a general principle, profits from property sales will either be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

Where the profit has been made as a result of a taxpayer carrying on a business of property development or as a result of a taxpayer entering into an isolated business transaction, the profit will be assessable as ordinary income. However, where the profit is a mere realisation of a capital asset, the profit will be assessable under the CGT provisions of the ITAA 1997.

The change of intention

We note at this time that although someone may buy a property originally as their main residence where them and their family will live, the intention can change.

This was found in the decisions in Scottish Australian Mining Co Pty Ltd v. FCT (1950) 81 CLR 188 and Whitfords Beach Pty Ltd (1982) 150 CLR 355 that a taxpayer, who had originally acquired property for farming operations purposes, could subsequently embark on a profit making scheme. This means that a taxpayer can embark on a profit making scheme after property was acquired for a different purpose.

How income from a land subdivision can be treated

With land subdivision cases there are three possible scenarios:

(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 property as trading stock. Where a taxpayer carries on a business, gross trading receipts are brought to account as assessable income and deductions are allowed for expenses.

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

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

Business factors

Whether a business of land development has commenced is determined as a result of a process of weighing all the relevant indicators. Miscellaneous Taxation Ruling MT 2006/1: The New Tax System: the meaning of entity carrying on an enterprise for the purposes of entitlement to an Australian Business Number, discusses at paragraph 265 certain factors that if several of them are present it may indicate that activities constitute a business in the context of property transactions.

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.

Mere realisation

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.

From Taxation Ruling TR 92/3 paragraph 6, it would appear that the following are the most important factors to consider when determining whether profits made as a result of an isolated business transaction are assessable income:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain

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

In determining whether an isolated transaction amounts to a business operation or commercial transaction the following factors are relevant (paragraph 13 of TR 92/3):

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;

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.

CGT 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.

Where the land is treated as trading stock, section 118-25 of the ITAA 1997 provides that a capital gain or capital loss you make at the time of CGT event is disregarded.

McCorkell's case

You have referred to McCorkell v. FC of T (1998) 98 ATC 2199 (McCorkell). In McCorkell's case, the taxpayer developed the land for residential use for several reasons that the Court found convincing;

·        his orchard was being encroached by residential development and people were complaining about the sprays used,

·        he had no family left to run the orchard, and

·        the taxpayer was advancing in years and looking to retirement.

The Court also noted that Mr McCorkell had contractual arrangements only with the surveyor and engineer who subcontracted the work on the subdivision, and with the estate agents who managed the advertising and sale of the land. The taxpayer did some minor work in constructing an advertising board, but on the whole had minimal involvement in the subdivision.

The principles from McCorkell are acknowledged. However, an absence of profit making intention when acquiring the land is one of a number of factors to be considered. The principles in McCorkell could not be applied in isolation to determine your case.

Your situation can be distinguished from McCorkell in that you are not undertaking the subdivision in a piecemeal fashion. A coherent plan is in place for the development of the land. Furthermore, it is considered that the size and scale of the development being undertaken is such that the development cannot be considered to be a mere realisation of the land.

Application to your circumstances

Taking all of the facts into consideration, and on weighing the various factors, you are considered to have entered into a profit making scheme or undertaking.

We do acknowledge the land was originally purchased to be your home. The property's initial purchase was not to derive an income or as trading stock for development purposes. You both have no prior history of property development and you have instructed this will be a one off transaction to assist your retirement fund. However, the intent in which is the land is held can change from being a capital transaction to an isolated business transaction.

You have 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 construction 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 subdivision and not simply based on the fact that you carried out what council required you to do. While you contend that your role will be passive, ultimately you, as the legal owner, will bare significant financial risk in entering into the transaction.

Your choice to subdivide the whole property, than sell the property in its entirety, engaging council, applying for subdivision permits, engagement of a developer to undertake the subdivision, and engaging the services of appropriate professionals to sell the subdivided blocks. This shows your choice to engage in exposure to the risks of the development, including the profits, losses and its general success for the purpose of maximising the potential profit made on the sale of the subdivided blocks. You will secure a large loan to carry out the work. You will retain all the rewards and carry most of the risks from the sale. The assumption of the risks and the receipt of the subsequent rewards (or losses) is a strong indicator of profitmaking activity.

What you propose doing involves substantially more than merely realising your asset to the best advantage. You will be significantly improving and transforming the property, increasing its value (according to the figures you have provided).

The scope and scale of the property development is significant, and goes well beyond a simple realisation of the land in an enterprising way. The estimated revenue from the sale of the lots is more than $1 million. Based on the figures provided, the objective intention is that the development will be undertaken for the purpose of producing a profit.

Conclusion

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 of the ITAA 1997.

In this case, the profit making transaction arose after there was a change of intention for which the property was held. In determining the net profit that will arise from the sale of the blocks of land, the sale proceeds can be reduced by an appropriate amount based on the market value of the land at the time it was ventured into the profit-making scheme.

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.