Edited version of private advice

Authorisation Number: 1051798121686

Date of advice: 12 February 2021

Ruling

Subject: Capital gains tax - subdivision

Question 1

Will the sale of the house, to be built on the proposed subdivided rear lot be a mere realisation of a capital gains tax asset?

Answer

No.

Question 2

Will the profit from the sale of the house, to be built on the proposed subdivided rear lot be assessable under section 6-5 of the Income Tax Assessment Act 1997 as a profit-making undertaking?

Answer

Yes.

Relevant facts

The existing land, at xxxx (the property), contains a house. The property was purchased by entity A in xxxx as a holiday home for the family. The property was extended in xxxx.

The value of the property has increased significantly since purchase and extension. For family finance reasons, it is proposed that the property be subdivided. To control what is built on the land, a house will be constructed at the rear. The new house will eventually be sold to extract the increased value/equity of the land. The sale proceeds will supplement the family's financial resources.

The contract price of the property in xxxx was $xxxx. Capital improvements up to xxxx were $xxxx. The total cost to that date was $xxxx. Other minor capital and annual holding costs have been incurred since. After taking into account holding costs, the cost base as at xxxx was $xxxx.

On inspection by a Registered Valuer on xxxx, he considered the current value at $xxxx and indicated that 'the highest and best use would be a subdivision into x lots'. One lot will be with the existing house and a separate vacant lot at the rear. The total value of the lots was estimated at $xxxx. The front lot being worth $xxxx for approximately xxxx square metres (sq m) with the existing home and $xxxx for xxxx sq m at the rear including a xxxx metre driveway on the eastern side.

The property has increased in value. To supplement diminishing retirement funds, it is desired to crystallise some of that gain by:

a. subdividing the land into x lots. and

b. controlling what is constructed on the rear lot.

The principal purpose is to extract some of the equity to supplement the family's cash resources, retain the holiday house and the surrounding amenity while controlling what is constructed.

Background

Entity A for many years derived minimal amounts of interest income from small bank deposits.

Entity A acquired properties since xxxx. Some properties were used for rental. Some properties were subdivided.

Entity A investigated the feasibility of acquiring property for development purposes. During the years xxxx to xxxx, entity A acquired a number of properties with the express purpose of development of residential home units and subdivision of the land. Those activities amounted to carrying on a business of property development.

While conducting the development business, but entirely separate from the development activities, entity A purchased the property in xxxx as a family holiday home. The property replaced an on-site caravan that had been owned by the family and used for many years.

From xxxx, both the property and the family's main residence were used as security for financing entity A's property development activities.

All construction activities were contracted to entity B from xxxx to xxxx and one project in xxxx to xxxx.

During the period of xxxx to xxxx, there were no development activities undertaken. The property development business activity ceased due to the Trust entering into another business. Following the sale of that business, a final property development opportunity arose. Entity A's final property development sale occurred on xxxx. This resulted in losses due to the downturn in the real estate market at the time of completion.

All development business activities ceased in xxxx. No other development activities have been undertaken since then. Entity C was actively involved with each of the development properties throughout xxxx to xxxx. However, entity C's involvement was to a much limited extent in xxxx and xxxx.

Upon the introduction of GST, on xxxx, entity A was registered for GST purposes in relation to the property development business.

The only other activities by entity A since xxxx have been to assist a related entity with a property and holiday rental of the property from xxxx to xxxx.

As development business activities ceased in xxxx and none contemplated, the GST registration of entity A was cancelled from xxxx.

Entity A did not claim any GST credits in connection with the renovation and extension of the property, as it was entirely separate from the development activities.

The property has been used exclusively by the family as a holiday home to the present date, except for the period commencing xxxx, when it commenced to be used jointly, both as a holiday home and as a holiday rental. All rental activity ceased in xxxx.

The rationale for renting the property commencing in xxxx was the increasing holding and maintenance costs of the property, (for example, rates, land tax, power and gas and maintenance) and the diminishing personal superannuation.

On xxxx, a real estate agent and land valuer, was approached to inspect the property and provide a report.

In light of the value of the property, the diminishing superannuation of relevant parties and the loans to entity A, the family considered their position and decided to realise the unrealised gains so as to improve the family's cash position by subdividing the property.

Purchase of the property was enabled by sale of the rental investment properties financed by personal loans to entity A from entity C and entity D since xxxx. While the valuable property could be sold to repay those loans and release the increased equity within it, the family's desire to retain the home as their holiday location, both now, and for their children and grand-children into the future, far outweighs the option to sell it.

In light of the general redevelopment of the surrounding area, many formal and informal approaches have been received to sell for subdivision. Demolition and construction of up to x units was one option for the property, particularly in light of the numerous surrounding double storey constructions of that size in recent years.

Entity A has been actively involved in objections and appeals against double storey multi-unit developments in the area. The purpose of these objections and appeals was to protect the amenity of the area.

One approach from a building company was for a joint venture development and subdivision, however that was rejected outright. Subdivision into x lots and immediate sale of the rear lot is one option, however the family's overwhelming desire is to -

a. at a minimum, retain the front lot and existing house; and

b. control what is constructed on the rear lot to ensure that no double storey or overbearing development proceeds on the lot.

Since purchase in xxxx, there has never been any intention or purpose to develop the property. The intention and purpose always has been to retain it, but in the financial circumstances now evident, consideration was given to a subdivision to, at a minimum, subdivide the land and retain the existing house on a reduced lot.

Following consideration of the valuation, and general enquiries with town planners and with Council about the feasible options, preliminary discussions with a house construction company commenced in late xxxx with a view to having a house designed to fit on a subdivided lot. The local builder had never been used previously but had been recommended by friends. Subject to being able to fit a suitable house on the rear lot and based on all the verbal advice, it was initially proposed to subdivide first and then build later under a building permit. Following that first meeting it was decided to use their services and on xxxx,

a. a document was signed requesting entity E to commence the process by getting Soil Tests undertaken and having Property Services Information Reports prepared; and

b. A "Formal Quotation and Fee Proposal Acceptance Form" was signed.

That was the start of the process, and it was hoped to subdivide first and proceed to build on the rear lot after subdivision.

It was confirmed in an initial discussion with a Council Officer in xxxx that a subdivision permit could be obtained ahead of construction under a building permit at a later time.

A further confirmation of valuation was obtained in xxxx with indications of recent sales in the area.

Enquiries as to sources of finance indicated that following the Commission of Inquiry into banks, our own bank would not lend without adequate income to support repayments. However, two alternative sources indicated that a bridging loan (for construction) would be available solely on the basis that the property was firstly subdivided, following which the front lot with the existing house would be used as security for any loan.

This would require entering into an agreement with Council. The agreement will provide that all development will be in accordance with the endorsed plans forming part of the Planning Permit.

However, after signing of the agreement by entity A in xxxx, and approval of the sewer and storm water and driveway designs, Council advised in xxxx that the driveway and storm water would have to be constructed before subdivision approval. The consequence of that would be that damage would be caused to the driveway by trucks entering the property, with extra costs, while house construction was undertaken.

Accordingly, to avoid potential damage to a newly constructed driveway, an alternative source of finance has been obtained at extra cost so that subdivision will not occur until construction is near complete and all permit conditions have been satisfied.

With that information, key decisions were then made at the end of xxxx to instruct consultants to prepare an application to obtain a Planning Permit for subdivision.

While Council had advised verbally on xxxx that subdivision could proceed prior to building a house, after the subdivision permit application was lodged on xxxx, Council advised on xxxx that the preliminary assessment highlighted some concerns which indicate that the application might not have officer support.

Accordingly the designers, planners and surveyors proceeded with revised plans.

The Planning Permit was granted on xxxx, with many conditions relating to matters which are to be undertaken by contractors and or/sub-contractors.

An extensive amount of planning and compliance is required simply to get to the subdivision stage before construction can commence.

Apart from one meeting and emails with a Council Planner to clarify certain requirements to obtain permit, and discussions with representatives of the designer/building company and engineer, the only involvement of entity A has been, and will be, the authorisation of the contractors to undertake the work.

Entity A have not and will not be performing any of the work themselves.

Plan of Subdivision will be lodged by entity F.

Entity A expects the house on the proposed lot to be built by xxxx. Entity A expects to sell it in the second half of xxxx.

Approximate costs for construction are $xxxx, plus interest expenses of between $xxxx to $xxxx. However, some costs such as driveway, drainage, sewerage, permit, NBN and fencing need to be apportioned with the front block.

Lot 2 with the house should sell for approximately $xxxx.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 112-25

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Division 115

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Generally, an amount received in relation to subdividing land would be assessable either as:

•         ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) as business income,

•         ordinary income under section 6-5 of the ITAA 1997 as an isolated commercial transaction with a view to a profit, or

•         statutory income under the capital gains tax (CGT) provisions contained in Part 3-1 of the ITAA 1997 as a mere realisation of a capital asset.

Ordinary income

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Carrying on a business of property development

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

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? outlines some factors that indicate whether or not a business of primary production is being carried on. These factors equally apply to other types of businesses. The question of whether a business is being carried on is a question of fact and degree. In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators should be considered in conjunction with the other factors.

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.

Although the Trust has previously carried on a business of property development, based on the information provided and above factors, we do not consider that any proceeds from the current activities and sale of the subdivided lot would be derived in the course of carrying on a business.

Profits from an isolated transaction

Profits arising from an isolated commercial transaction will be ordinary income if the 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 a taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693).

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are ordinary income and therefore assessable under section 6-5 of the ITAA 1997.

The term isolated transaction refers to:

•         those transactions outside the ordinary course of business of a taxpayer carrying on a business; and

•         those transactions entered into by non-business taxpayers.

If a taxpayer not carrying on a business makes a profit from an isolated transaction or operation, that profit is assessable ordinary income if both of the following elements are present:

•         the intention or purposes of the taxpayer in entering into the transaction or operation was to make a profit or gain; and

•         the transaction or operation was entered into and the profit was made in carrying out a business operation or commercial transaction.

Profit-making does not need to be the sole or dominant purpose for entering into the transaction. A profit-making purpose must exist at the time the transaction or operation was entered into. Whether an isolated transaction is business or commercial in character will depend on the circumstances of each case.

In this situation, the property has been held for several years. Entity A has decided to subdivide the property, construct a house and sell the subdivided lot.

Although entity A is not currently in the business of property development, to decide if any profit made is ordinary income, we need to consider if the transactions are made in a commercial manner.

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

1. the nature of the entity undertaking the operation or transaction;
2. the nature and scale of other activities undertaken by the taxpayer;
3. the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;
4. the nature, scale and complexity of the operation or transaction;
5. the manner in which the operation or transaction was entered into or carried out;
6. the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;
7. if the transaction involves the acquisition and disposal of property, the nature of that property; and
8. the timing of the transaction and the various steps in the transaction.

In contrast, paragraph 36 of TR 92/3 notes that the courts have often said that a profit on the mere realisation of an investment is not ordinary income, even if the taxpayer goes about the realisation in an enterprising way. However, if a transaction satisfies the elements set out above it is generally not a mere realisation of an investment.

Paragraphs 41 and 42 of TR 92/3 outline that where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction, the activity of the taxpayer constitutes the carrying on of a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity is income even though the taxpayer did not have the purpose of profit-making at the time of acquiring the asset.

In addition to the above factors, for the purposes of determining whether the activities undertaken in relation to real property and development equate to a profit-making undertaking or scheme, Miscellaneous Taxation Ruling MT 2006/1 aligns itself with TR 92/3 and provides a list of factors which, if present may be an indication that a business or profit-making undertaking or scheme is being carried on.

The factors listed in paragraph 265 of MT 2006/1 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.

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.

Numerous cases have considered the assessability of profits or proceeds from the sale of land including the following cases:

Whitfords Beach Pty Ltd v Federal Commissioner of Taxation (1983) 14 ATR 247 where the taxpayer acquired 1.584 acres of land for non- commercial purposes. Thirteen years later, the original shareholders sold out and the company and the new ownership adopted an entirely new set of articles. It then embarked on a long and complex course of activity which involved the land being rezoned and developed as a residential subdivision. Vacant lots were sold over a period of many years for a substantial profit. The High Court held that the adoption of a new set of articles resulted in a change in the intended usage of the land. This resulted in the taxpayer's activities going beyond the realisation of a capital asset, with the activities constituting the carrying on of an actual business of subdividing and selling land.

Statham & Anor v. FC of T 89 ATC 4070 20 ATR 228 (Statham's case) where the property was subdivided and sold after a business of raising cattle had failed. The taxpayer relied on the local council to carry out the subdivision work and the local real estate agents handled the advertising and sale of the lots. The Full Federal Court held that what occurred was the realisation, by the most advantageous means, of the asset which the owners had on their hands when they abandoned the intention of farming the subject property.

Casimaty v FC of T 97 ATC 5135; (1997) 37 ATR 358 (Casimaty's case) where due to the growing debt and the ill health of the taxpayer, primary production land was progressively subdivided and sold off over a period of 18 years. There was no coherent plan conceived for the subdivision of the whole property. The taxpayer had acquired and had continued to hold and use the residence and conduct the business of a primary producer on the property. Therefore, there was no change of purpose of object for which the property had been held. In his judgment, Ryan J in the Federal Court held that the profits resulted from the mere realisation of a capital asset and as such the profits were not assessable as ordinary income.

Stevenson v. Federal Commissioner of Taxation (1991) 29 FCR 282 91 ATC 4476 22 ATR 56 where the taxpayer had owned farming land for many years, selling a portion of the land to a third party to be used for agricultural purposes. In the early 1970's he decided to scale back his farming activities and sell most of the remaining 90 acres, other than a few acres retained for his use. He could not source a developer who would pay his sale price and in 1976 he determined that he would subdivide the land himself. He commenced subdividing the land in stages, obtaining finance and personally arranging for the construction of the necessary earthworks, storm water drains, guttered road works and other improvements to the land. Around the same time his farming income consisted of mainly agistment income. Throughout the process the taxpayer had personally dealt with councils, engineers, and statutory utilities. He advertised the development himself, did not engage the services of any particular real estate agent to assist him, dealt personally with prospective purchasers, did some of the physical work himself and fixed the sale price for the subdivided lots, being 220 lots. It was held that the taxpayer was carrying on a business of developing land.

As displayed in the above cases, a taxpayer can embark on a profit-making scheme after property was acquired for a different purpose.

In determining whether activities relating to isolated transactions are a profit-making undertaking, 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.

Application to your circumstances

In this case, entity A acquired the property in xxxx for use as a holiday home.

In the context of considering the above authorities and factors when determining whether your project would be viewed as a profit-making undertaking, the following general observations have been made:

•         there is a coherent plan for the subdivision of the property and construction of an additional house, which is more complex than to subdivide the property and sell the back block without a construction;

•         there has been a partial change in the purpose of owning the property;

•         entity A has been involved in property development business activities in prior years;

•         the subdivision and construction costs will be relatively substantial;

•         there is an intention to profit from the subdivision of the property and provide additional retirement funds for the beneficiaries;

•         the transaction has been undertaken in a commercial manner;

•         entity A will engage contractors to undertake the various activities;

•         entity A wants control of what is built on the back block;

•         NBN capabilities, electricity and gas, water, drainage connection, and sewerage facilities will be undertaken by entity A to comply with the permit to obtain subdivision; and

•         Entity A has obtained a planning permit.

A balanced view of these observations, with no one feature being determinative in isolation, reasonably leads to a conclusion the intention for holding the property has changed to include a profit-making undertaking.

Although the property was purchased as a family holiday home, the intention in relation to the property changed when it was decided to subdivide the property and build an additional house. The decision to pursue the subdivision shows a 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 back lot. Entity A is funding the construction through a loan.

It is acknowledged that the subdivision is not on the same scale as the above cases, and the front block will still be used as a holiday home, however, entity A has a coherent plan and a profit-making purpose in the activities.

It is also acknowledged that entity A wanted control over what was built on the land. However, with the construction of the house, it cannot be said that minimal development work will be undertaken as in Statham's case and Casimaty case.

Although entity A will not be doing the subdivision and construction work, entity A has undertaken the organisation and management of the activities. A number of entities will be engaged to sub-divide, construct the house and market the lot. It is viewed that your subdivision activity has the characterisations of a commercial or profit-making undertaking. The activities go beyond a mere realisation of a capital asset.

Based on the facts of this situation, the project is considered to be a profit-making commercial undertaking and the profits from the sale of the back lot is considered to be ordinary assessable income under section 6-5 of the ITAA 1997.

Capital gains tax

Under section 6-10 of the ITAA 1997, assessable income also includes statutory income. Capital gains are included as assessable income under section 102-5 of the ITAA 1997.

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens to a CGT asset. The property is a CGT asset (section 108-5 of the ITAA 1997).

CGT event A1 happens if you dispose a CGT asset.

When a CGT asset (the original asset) is split into 2 or more assets (the new assets), such as when land is subdivided, the subdivision of the land into subdivided lots is not a CGT event (subsection 112-25(2) of the ITAA 1997). Each new subdivided lot will be viewed as having been acquired on the same date that the original asset was acquired. The cost base of the original asset is apportioned between the newly created assets on a reasonable basis.

Section 118-20 of the ITAA 1997 contains anti-overlap provisions which operate to reduce any capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 as a result of the sale.

Application to your situation

Making an overall assessment on the factors set out in TR 92/3, it is the Commissioner's view that the subdivision and sale of lot 2 is more than a mere realisation of a capital asset.

As highlighted above, the disposal of the lot is an isolated transaction and any profit made on the sale is included in your assessable income under section 6-5 of the ITAA 1997.

Any capital gain made on the disposal of the lots will be reduced to the extent that the profit from the sale of the lot is included in your assessable income under section 6-5 of the ITAA 1997.