Edited version of private advice

Authorisation Number: 1051687054478

Date of advice: 29 May 2020

Subject: Income tax - capital gains tax - capital v revenue classification - asset sale

Question 1

Will the proceeds or net profit from a proposed sale of the property (the Property) be considered ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the proceeds from the proposed sale of the Property be assessable on capital account and dealt with exclusively under the Capital Gains Tax (CGT) provisions of Part 3-1 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period(s)

1 July xx to 30 June xx

The scheme commences on

1 July xx

Relevant facts and circumstances

A private company resident in Australia acts as trustee (the Trustee) for a Unit Trust (the Trust).

The Trust is a single purpose investment vehicle established to hold one asset. It does not own any other properties and has not been involved in the development and sale of any properties.

There are four principals associated with the Trust (the Principals).

The Principals have a history of carrying on the business operations and providing management services through a related company, D Pty Ltd (D), a private company. The Principals of the Trust are also directors of D.

Prior to acquiring the Property over 10 years previously the Principals had been actively involved in the business management activities and have operated the management business on the Property for over 20 years.

The Principals do not have any history of developing property with the intention to sell for a profit.

Property history

The Property is a multi-purpose commercial property originally constructed over 100 years previously.

The Trust acquired the Property with the intention of conducting an enterprise as well as leasing the retail shops to commercial tenants. The intention of the Trustee was to hold the Property as a long-term investment to derive rental income. This intention has not changed throughout the period of ownership.

For in excess of 10 years prior to the Trust's acquisition of the Property, D was the Head Lessee of the Property and remained the Head Lessee of the Property post-acquisition by the Trust to the present date.

The Trustee has been returning net rental income derived from the enterprise and retail shop tenancies in its annual income tax returns since acquisition of the Property.

The Trust primarily commenced refurbishments and renovations to the Property after owning it for several years. The Property had not been substantially renovated for some decades previously and the renovations were necessary with the aim of attracting better quality tenants and customers to the Property and therefore higher rents.

The refurbishment was undertaken in stages so the enterprise could remain operational.

Apart from substantial renovations mentioned, no other development activity such as demolition, re-construction of buildings, subdivision or acquisition of adjacent land has been undertaken by the Trust during its period of ownership of the Property.

D continued at all times to manage the enterprise operations and leasing of the retail shops where tenants generally enter into leases for a period of several years with options to renew.

The Trust is intending to sell the Property.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 Part 3-3

Reasons for decision

Question 1

Summary

The proceeds or net profit from a proposed sale of the Property will not be considered ordinary income under section 6-5 of the ITAA 1997

Detailed reasoning

There are three means by which proceeds from the sale of the Property owned by the Trust can be treated for taxation purposes depending on the circumstances:

·   the underlying property constitutes trading stock for the purposes of section 70-10 of the ITAA 1997 on the basis the taxpayer is carrying on a business of property development. Gross proceeds constitute ordinary income under section 6-5 of the ITAA 1997

·   the net profit from sale of the property is ordinary income under section 6-5 of the ITAA 1997 on the basis that, although there is not a business of property development, a taxpayer is nevertheless involved in a profit making undertaking

·   as statutory income under the CGT provisions (sections 10-5 and 102-5 of the ITAA 1997) on the basis that a capital gain has been realised from the disposal of a CGT asset under CGT event A1.

Ordinary business income - trading stock

The Trust was established to acquire and hold the Property as a long-term investment. It was acquired to conduct a passive leasing enterprise earning rental income.

The Commissioner's has released Taxpayer Alert TA 2014/1 - Trusts mischaracterising property development receipts as capital gains (TA 2014/1). The alert describes arrangements where property developers use trusts to return the proceeds as capital gains instead of income on revenue account.

The Trust's circumstances are distinguishable from the arrangements contemplated in TA 2014/1. The main differences are:

·   the Principals do not have a history of developing property with the intention to sell for a profit

·   the Trust's intention in acquiring the Property was one of long-term investment deriving rental income. This intention has not changed throughout the period of ownership

·   activity has not been undertaken at odds with the stated purpose of treating the property as a capital asset. No development activity has been undertaken by the Trust on the Property during its period of ownership apart from substantial refurbishments undertaken that focused on improving the long-term rental yield of the Property

As the Trust is not carrying on a business of acquiring property for the purpose of profit making by developing and selling properties, the Property would not constitute 'trading stock' under section 70-10 of the ITAA 1997. The proceeds received by the Trust from a sale of the Property, on this set of circumstances will not be derived in the course of carrying on a business of property development.

Isolated business transaction or a profit making undertaking

Taxation Ruling TR 92/3 - Income tax: whether profits on isolated transactions are income (TR 92/3) provides guidance in determining whether profits from isolated transactions are income and therefore assessable. In the Ruling the term 'isolated transactions' refers to:

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

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

The Ruling sets out the view of the Commissioner as to the application of the decision of the Full Court of the High Court of Australia in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium). Profits arising from an isolated business or commercial transaction will be assessable income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business.

The principles in Myer Emporium are not conclusive statutory tests. They are general principles to be considered in deciding whether a profit is income.

Whether a profit from an isolated transaction is income according to ordinary concepts depends on the circumstances of the case. It is generally income when both of the following elements are present:

(a) the intention or purpose of the 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 or in carrying out a business operation or commercial transaction.

The intention or purpose of the taxpayer (of making a profit or gain) is the taxpayer's intention or purpose discerned from an objective consideration of the facts. If a transaction involves the sale of property it is usually, but not always, necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

Some matters which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are not limited to but include the following:

·   the nature of the entity undertaking the transaction;

·   the nature and scale of other activities undertaken by the taxpayer;

·   the manner in which the transaction was entered into or carried out;

·   the nature of the property; and

·   the timing of the transaction or the various steps in the transaction.

TR 92/3 following paragraph 71 provides some examples of the application of the principles, remembering that whether a profit constitutes income depends on circumstances of the particular case. Consequently the following example is not determinative of the Commissioners views on cases with similar, but different, facts. Example 9 from paragraphs 93 and 94 is repeated below:

Mr Bates purchased a motel in a country town intending to carry on a business as the owner and operator of that motel. He ran the motel for 7 years earning moderate returns and then sold it at a large profit. Mr Bates had not previously purchased property other than a house in which he had lived.

The profit on the sale of the motel is not income. It cannot be inferred from the objective facts that Mr Bates acquired the motel with a purpose of making a profit (as distinct from income from the carrying on a business). Furthermore, the sale of the motel was not made in the ordinary course of carrying on a business. The motel was a structural asset of the business.

Applying principles from cases and TR 93/2 to the facts, the Commissioner considers that the proceeds from the proposed sale of the Property will not be ordinary income derived from a profit-making undertaking or scheme. Relevant to this finding is:

·   the facts do not reveal a profit-making purpose when the Trust acquired the Property, but an intention to hold it as a long-term investment deriving rental income from the enterprise and retail shop tenancies

·   there is no evidence the above intention has changed throughout the period of ownership by the Trust

·   no development activity has been undertaken by the Trust apart from renovations/refurbishments that improve long-term rental yields

·   the Principals' have been the unit holders of the Trust since its establishment, and the directors and shareholders of the Trustee have not changed throughout the Trust's ownership of the Property

·   the Principals do not have a history of developing property with an intention to sell for profit.

On this basis, the requisite profit-making purpose has not occurred during or after the Trust's acquisition of the Property, to establish that proceeds received by the Trust from the proposed sale of the Property will be considered ordinary income derived from a profit-making undertaking or scheme.

Therefore, the gross proceeds or net profit from the proposed sale of the Property will not constitute ordinary income under section 6-5 of the ITAA 1997.

Question 2

Summary

The proceeds from the proposed sale of the Property will be assessable on capital account and dealt with exclusively under the CGT provisions of Part 3-1 of the ITAA 1997.

Detailed reasoning

Capital gain

Under section 6-10 of the ITAA 1997, assessable income also includes amounts that are not ordinary income but are included as assessable income by provisions of the tax law. These amounts are called 'statutory income'. Capital gains are an example of statutory income.

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes their net capital gain (if any) for the income year. As a general rule, a taxpayer is required to include in their assessable income any capital gain they make from a CGT event that happens to a CGT asset the taxpayer acquired on or after 20 September 1985. Pursuant to section 108-5 of the ITAA 1997, a CGT asset is any kind of property, or a legal or equitable right that is not property. Accordingly, land and buildings are CGT assets.

Proceeds from the sale of property more often represent the mere realisation of capital assets, which will fall for consideration under the CGT provisions in Part 3-1 and Part 3-3 of the ITAA 1997.

In the course of its decision in Myer Emporium, the Full High Court said that profits made on a realisation or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realised subsequently in order to capture the profit arising from the expected increase in value. In a joint judgment, their Honours stated:

It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.

Paragraph 36 of TR 92/3 states:

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. The expression 'mere realisation' is used to contradistinguish a business operation or a commercial transaction carrying out a profit-making scheme. If a transaction satisfies the elements set out in paragraph 35 it is generally not a mere realisation of an investment.

As per the Commissioner's response to Question 1, the facts reveal the Trust's intention at the time of acquiring the Property was to hold the Property as an investment that would generate passive rental income/capital returns on a long-term basis.

The Trust has not carried on a business of purchasing and selling real property, as demonstrated by the Trust holding the Property (being its only asset) for many years and the Principals have not had any history of developing property with the intention of sale for a profit.

Prior to acquisition of the Property by the Trust, the Principals were the head lessees of the Property and operated an enterprise on the Property for many decades.

The Trust was not carrying on a business of purchasing, developing and selling real property. The requisite profit-making purpose has not happened at any time after the Trust's acquisition of the Property, as determined in the response to Question 1.

Without a profit-making intent, the activities of the Trust in respect of the sale of the Property would not ordinarily be regarded as revenue-based income.

Despite the potentially sizeable profit from the sale of the Property, the mere magnitude of the realisation does not convert the activities of the Trustee into a business.

Therefore, in applying the principle held in Myer Emporium, as the Property is a capital asset and not a revenue asset, and in the absence of a profit-making intent by the Trustee, it is the Commissioner's view that the sale of the Property would more accurately represent the mere realisation of a capital asset.

As a mere realisation of a capital asset, the proceeds from the sale of the Property will not be assessable as ordinary income under section 6-5 of the ITAA 1997. The proceeds from the sale of the Property will be subject to the CGT provisions provided in Part 3-1 and Part 3-3 of the ITAA 1997.