Edited version of private advice

Authorisation Number: 1051905159438

Date of advice: 30 September 2021

Ruling

Subject: Capital allowances - depreciation

Question

Is the Trustee for the Trust carrying on a business of holding and leasing commercial properties for the purpose of subsection 328-110(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

Relevant facts and circumstances

The Group

The Trust is part of a family group (Group) that carries on extensive property development and leasing operations.

The Group holds a substantial portfolio of properties through numerous trusts and companies. The Group's projects include the development of residential properties for sale and rent as well as the development of commercial properties for rent. The Group retains many of the commercial properties that it constructs. Its current rental portfolio comprises more than XXX properties.

The Trust

The Trust was established as ABC Trust. The trustee of the Trust is XYZ Pty Ltd (Trustee). The directors of the Trustee are A, B, C and D. The same individuals are also managing directors of the Group.

The trust deed of the Trust was varied to change the name of the Trust to XYZ Trust.

A clause of the trust deed allows the Trustee to carry on a business. Another clause allows the Trustee to deal with real property including to purchase, construct, develop, sell and lease such property.

Over the years, the Trust has accumulated a significant portfolio of properties. The Trust held X commercial properties as at 30 June 20XX.

The Trust's focus is to build and rent properties. Its activities comprise acquiring sites for redevelopment or land with buildings that require significant upgrades and improvement. The Trust develops/upgrades the properties with the aim of leasing the properties to derive rental income once the works are completed.

The Trustee intends to develop the remaining properties (i.e. those not already under construction or recently constructed) as the existing leases expire in further 'build to rent' projects.

The financial statements of the Trust show land, buildings and depreciable assets with a value in excess of $X million as at 30 June 20XX. For the year ended 30 June 20XX, the Trust derived rental income of $X.

Trustee

The strategic high level decisions of the Trust are made by the directors of the Trustee which include:

•         identifying suitable sites to acquire

•         negotiating the acquisition of suitable sites

•         seeking finance and negotiating with financiers

•         identifying suitable tenants and entering into pre-lease negotiations with tenants

•         overseeing the progress of construction and development works and maintaining relationships with external contractors

•         maintaining and building relationships with tenants which are typically well-known and large organisations, and

•         resolving complaints and disputes with tenants, including recovering outstanding rent.

The directors of the Trustee meet regularly to discuss the strategy and direction of the Trust. They also continually monitor the financial performance of the Trust.

Service Pty Ltd

The Trustee engages Service Pty Ltd (Service) to manage the day-to-day operations of the Trust. Service acts as the service entity for the Group. It employs the employees to conduct the Group's operations.

The Group has:

•         an Asset and Funds Management Team

•         a Development Management Team, and

•         a Property Management Team.

The managers of each team report to the directors of the Trustee. The Trust has not entered into written agreements with Service to formalise its engagement with Service for these services as both entities are ultimately controlled by the Group.

Asset and Funds Management Team

The Asset and Funds Management Team undertake feasibility analyses to determine how the returns on a property can be maximised. It also monitors the financial performance of a property on an ongoing basis.

Examples of asset and funds management services provided by Service to the Trust include:

•         management and administration of the Trust's portfolio

•         preparing business plans

•         arranging valuations of the properties

•         arranging and reviewing debt facilities

•         undertaking market research and making recommendations for acquisitions and capital expenditure, and

•         preparation and maintenance of financial records, including bookkeeping, bank reconciliations, rental collection records, financial statements and business activity statements.

Development Management Team

The Development Management Team manages the development and construction process from commencement to completion. It engages external consultants such as planners, architects, engineers and builders.

The services provided by the team include:

•         preparation of feasibility studies, concept plans and designs

•         preparation of plans and budgets for infrastructure and development works

•         day-to-day management of infrastructure and development works during the construction phase

•         briefing, liaising with and managing various consultants such as architects

•         preparing and submitting planning permit applications and managing the application process

•         monitoring of defects after the completion of works, and

•         marketing properties for rent and managing rental enquiries with interested parties.

The Development Management Team is required to seek approval from the Trustee for:

•         plans and budgets prior to commencing work, and

•         variations to the approved budget and scope of works.

The Development Management Team is also required to report to the Trustee on matters including the progress of infrastructure works.

Property Management Team

The Property Management Team attends to tenant requests for repairs and maintenance, property inspections and the collection of rent. The team is also responsible for administrative matters such as the payment of invoices and maintenance of financial and other records. It utilises the advice of lawyers, accountants and valuers as required.

The services provided by the team include:

•         maintaining leasing and tenancy records

•         arranging for lease documentation to be prepared

•         collection of rent

•         attending to property inspections

•         attending to tenants' complaints

•         ensuring leased properties are maintained in good condition, and

•         arranging for repairs and maintenance.

Service is required to obtain approval of the Trustee in relation to various matters including:

•         an annual budget for each property and material changes to the annual budget

•         renewals of leases

•         agreeing to rent reviews

•         entering into service, maintenance and repair contracts that will result in net income of the Trust to fall below the amount specified in the annual budget

•         entering into contracts for capital works that will result in the net income of the Trust to fall below the amount specified in the annual budget

•         where a tenant is in arrears:

­   drawing down on or enforcing any security or guarantees other than in accordance with the instructions of the Trustee, and

­   issuing or threatening to issue any legal proceedings against a tenant, and

•         evicting any tenant or terminating a tenancy agreement.

The Trust's profit and loss before tax for the 20XX to 20XX income years is as follows:

•         Year ended 30 June 20XX: $X

•         Year ended 30 June 20XX: -$X

•         Year ended 30 June 20XX: -$X

•         Year ended 30 June 20XX: -$X.

The Trust's losses in the 20XX income year is due to the Trust having significant depreciation expenses of $X. The losses in the 20XX and 20XX income years were largely due to the properties being under construction during that time.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 328-110

Income Tax Assessment Act 1997 Subsection 328-110(1)

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

A "small business entity" is defined in section 328-110 of the ITAA 1997. This definition requires an entity to "carry on a business" in the current year.

Section 995-1 of the ITAA 1997 defines "business" to include "any profession, trade, employment, vocation or calling, but not occupation as an employee." However, this definition does not provide any guidance for determining whether activities amount to carrying on a business.

Whether an entity is carrying on a business is a question of fact and degree and requires a consideration of a range of indicators. Guidance has been provided by the ATO on this issue in Taxation Ruling TR 97/11 Income tax: Am I carrying on a business of primary production? (TR 97/11)and Taxation Ruling TR 2019/1 Income tax: When does a company carry on a business?.

Paragraph 13 of TR 97/11 states that the courts have held that the following indicators are relevant to determining the question whether a business is being carried on:

• whether the activity has a significant commercial purpose or character; this indicator comprises many aspects of the other indicators
• 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 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.

No one indicator is decisive and the all indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the "large or general impression gained" (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a "commercial flavour" Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884).

Significant commercial purpose or character

This indicator generally covers aspects of all the other indicators and broadly requires that a taxpayer be able to show that the activity is carried on for commercial reasons and in a commercially viable manner. A taxpayer needs to be able to show that the interaction between the size and scale of the activity, the repetition and regularity and the intention and prospect of profit are sufficient to conclude that the activity has a significant commercial purpose.

Paragraph 30 of TR 97/11 states that in determining whether there is a significant commercial purpose or character of an activity, the following may be relevant:

• existence of a business plan
• advice sought by the taxpayer from experts in the industry in which the taxpayer intends to operate
• proper investigation of capital required for the activity and a plan on how this capital will be obtained
• research having been conducted into the activity. This research should demonstrate that profits can be expected
• size and scale of the activity is sufficient for a commercial venture
• compliance with regulatory requirements necessary for commercial operations, and
• existence of an intention to make a profit together with a reasonable belief that a profit will be generated.

It is noted that the Trust was established in 20XX and the trust deed empowers the Trustee to carry on a business. The size and scale of the Trust's activities is considerable. The Trust has acquired and developed a significant portfolio of properties over the years.

As at 30 June 20XX, the Trust had accumulated X commercial properties with a value in excess of $XX million per the financial statements of the Trust. It has completed the development of two of those properties and commenced deriving rental income from those properties. There are currently three projects under construction with significant capital requirements.

For the year ended 30 June 20XX, the Trust derived a significant amount of rental income of approximately $X million. The Trust also has significant tenants. It is anticipated that the quantum of rental income will increase as the Trust completes its projects.

The strategic decisions of the Trust are made by the Trustee with the assistance of the expertise provided by Service which has expertise in property investment, development and management. Service also assists with the day-to-day management of the operation of the Trust.

Therefore, it is considered that the Trust's activities have significant commercial purpose or character.

Whether the taxpayer has more than just an intention to engage in business

The intention of the taxpayer in engaging in the activity is a relevant indicator in determining whether a business is being carried on.

According to paragraph 40 of TR 97/11, this indicator is particularly related to:

• whether the activity is preparatory or preliminary to the ultimate activity
• whether there is an intention to make a profit, and
• whether the activity is better described as a hobby.

Over the years, the Trust has outlaid significant expenditure to acquire and develop its property portfolio. The Trust derives significant rental income annually from its property portfolio. A significant amount of work was required to complete the completed projects and to negotiate leases with tenants. Similarly, a significant amount of activity was required to get the other projects ready for construction.

The scale of the activities undertaken and the income derived are well beyond the scope of a hobby or an activity which is 'preparatory' or 'preliminary'. Therefore, the Trust 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

This indicator is directed at determining whether the taxpayer entered into the activity with an intention to make a significant commercial or financial gain from it. In Hope v The Council of the City of Bathurst (1980) 144 CLR 1; 80 ATC 4386; (1980) 12 ATR 231, Mason J states that business activities are usually activities that are 'engaged in for the purpose of profit on a continuous and repetitive basis'.

However, as indicated in paragraph 48 of TR 97/11, this does not require the taxpayer to make a profit in every year of operation. As explained in paragraph 49 of TR 97/11, the situation may arise where a taxpayer is carrying on a business and has an intention to make a profit but the objective evidence is such that a profit is unlikely to be made in the short term. This does not preclude a purpose of profit or prospect of profit and the taxpayer from carrying on a business.

Even though the Trust has made losses in the last few years, this has been driven by capital expenditure incurred to construct the buildings. Since a profit was unlikely to be achieved during the construction phase, the incurring of such losses does not preclude the Trust from having a purpose of profit, prospect of profit and carrying on a business. The Trustee expects the Trust to be profitable once further projects are completed.

Whether there is repetition and regularity of the activity

As stated by paragraph 55 of TR 97/11, this indicator requires a taxpayer to demonstrate that the activities are conducted in a manner that displays repetition and regularity.

The Trust constructs buildings for rental and enters into leases on a regular and ongoing basis. The Trust has already completed two significant projects and has commenced construction on three further projects. This demonstrates repetition and regularity of the activity.

The directors of the Trustee meet regularly to discuss the strategy and direction of the Trust. They also continually monitor the financial performance of the Trust including reviewing management accounts at board meetings. The day-to-day management of the properties are undertaken by Service on behalf of the Trust and encompass repetitious and regular activities such as arranging for repairs, attending to tenant complaints and the collection of rent.

The Trust has demonstrated repetition and regularity in the activities it engages in as part of building and managing its property portfolio.

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

A taxpayer's activity is more likely to be a business where it is carried on in a similar manner to other businesses in the industry. TR 97/11 provides at paragraph 64 that the consideration of the following factors as guidance in determining whether the taxpayer's activities have the characteristics of those engaged in similar trade:

• volume of sales (taking into account the fact that, at the commencement of a business, sales would be relatively low)
• the types of customers and marketing for the activity (that is, whether the taxpayer sell his/her product to the public at large or only to friends and family)
• the types of expenses incurred
• the level of capital investment
• previous experience. Specifically, a taxpayer with no previous knowledge or experience in the activity will be expected to have sought advice from experts in the industry, and
• comparison with similar activities carried out by a keen amateur.

The activities carried on by the Trust are consistent with what is required in a business of holding and leasing properties. These activities include, broadly, the acquisition of vacant land, the construction of buildings, leasing of building to tenants and maintenance of the properties.

The manner in which the Trust carries on its activities, with the assistance of Service, is similar to what other property developers do:

•         the Assets and Funds Management Team prepare feasibility studies

•         the Development Management Team engages external consultants and markets the properties for rent

•         the Property Management Team acts as the first point of call for tenants and is responsible for rent collection, property inspections, property maintenance and managing disputes with tenants, and

•         the properties are advertised and marketed on the Group's website and marketing brochures.

Whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit

A taxpayer's activities are more likely to amount to the carrying on of a business where they are carried out in a systematic and organised manner. This usually involves matters such as advertising for customers in a consistent and systematic manner, maintaining operations on a consistent basis, retaining and pursuing profitable activities, discontinuing unprofitable activities, and keeping appropriate business records.

The Trust engages the expertise of Service to manage the day-to-day operations. Service and the Trust are part of the Group which has extensive history and experience in property development and access to industry contacts.

Examples of the planning undertaken by the Trust in its activities include preparation of feasibility studies and budgets by the Development Management Team on behalf of the Trust.

The Trust maintains extensive accounting and financial records. It engages an external accountant to prepare annual financial statements and income tax returns. All agreements with tenants, builders and contracts are documented and prepared with the assistance of legal advisors.

The Trust's activities are carried on in a planned, organised and business-like manner.

The size, scale and permanency of the activity

The size and scale of the Trust's activities are significant. As noted already, the Trust has built a substantial property portfolio and already derives substantial rental income from the projects it has completed. The amount of rental income is expected to increase as projects are completed.

The Trust was established in 20XX. It is expected to continue its activities for many more years to come as it continues to redevelop, upgrade and lease properties.

Whether the activity is better described as a hobby, a form of recreation or a sporting activity

It is clear from the level of capital commitment by the Trust and time commitment from the directors in attending meetings etc, that the activities of the Trust go beyond the scope of a hobby or recreation.

Conclusion

The Commissioner agrees that the activities carried on by the Trust constitute a business of holding and leasing commercial properties. The Trust is more than a passive investor. The Trust, through the directors of the Trustee and the engagement of Service, actively engages in the activities of developing, constructing and leasing of properties to derive rental income.