Edited version of private advice

Authorisation Number: 1051935480568

Date of advice: 21 December 2021

Ruling

Subject: Sale of property - capital vs revenue

Question 1

Will any profits from the sale of the Property be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question

Will the proceeds from the sale of the Property be subject to capital gains tax (CGT) under Parts 3-1 and 3-3 of the ITAA 1997?

Answer

Yes, however, 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.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

DD MMM 20XX

Relevant facts and circumstances

Several years ago, you acquired a property (the Property) for a specified amount.

You funded the acquisition of the Property as follows:

-       An amount by a particular loan

-       Another amount with mortgage over a residence you resided in at the time.

You have provided the total amount to cover the acquisition in addition to legal fees and stamp duty.

You purchased the Property to be your new main residence due to it being larger than your previous residence in Location Z and moved into the house at the Property immediately after settlement for a number of months, during which time you renovated/upgraded aspects of the Property. During this time, you were single and did not have a spouse.

You subsequently met a partner and you both decided to move back to Location Z and live there and renovate that house and rented out the Property to tenants.

You moved out of the Property in late shortly after.

This relationship ended a few years later while you resided in Location Z.

You met your current spouse and purchased a property in Location Y as tenants in common.

You sold the property at Location Z to fund your share of the Location Y property. During this time the Property continued to be rented out. Around this time your self-managed superannuation fund purchased a unit in Location Z.

A few years later, you did preliminary feasibility works to develop the Property into a low-cost housing development to increase the rental return on the property. You had pre-DA Council meetings with an architect, after engaging a local town planner. You were then advised by the town planner to change the design to over 50's development as housing guidelines had changed in the area. Through the town planner you engaged various consultants to prepare reports required for DA application, in conjunction with the architect who designed the original concept plans for the Property. After spending some amount of funds on various reports and fees from both the town planner and architect, you paused this endeavour due to low working capital.

You had no involvement in this or any other zoning changes at the Property. During this period, your residence at Location Y was in need of major renovations. To fund this, the unit at Location Z was listed for sale and you planned that the proceeds would be paid to you by the self-managed superfund. This would fund the Location Y dwelling renovation as well as fund the continuing DA process for the Property.

You had a long association with a particular real estate agent (who had previously sold your partner's home) and during the listing phase of the Location Z unit by your SMSF, you were approached by the agent with an offer to enter into an arrangement with a developer to develop the Property, which you accepted.

The developer continued with the DA process and once approved undertook all work required to gain a Construction Certificate. The approved development includes a number of 'Over 55' townhouses, basement parking and lift access the relevant levels.

However, when the time came to develop the Property, the developer was not able to complete the arrangement and as such the agreement was terminated.

During that last year, you experienced ill health and have had a number of operations.

You did not want to wait for another two years for the developer to be in a position to re-commence the agreement. They either had to wait until property prices rose or they completed and sold off other projects to enable themselves to be more liquid or have better equity in this project.

At this stage the Property was empty for a period of time as the tenant had moved out with the understanding that the demolition was imminent and construction due to start. You then advised the real estate agent of the termination of the agreement and rented the Property out late last year on a lease.

Earlier this year, the real estate agent contacted you regarding the sale of the Property which you were open to. You advised of your desire to retire soon and would like to have closure on that property by that date. You have spent the last several years as a manager in manufacturing.

Subsequently the real estate agent introduced you to another entity and agreed to a development agreement to construct the existing approved units. The terms of the development agreement include that you will receive a fixed amount from the sale proceeds, and possibly a further percentage of any excess once GST, construction and finance costs, and the fixed amount are accounted for. The new developer (Developer Q) is responsible for all finance and construction costs, and is responsible for ensuring completion of the project.

Under the development agreement, you will grant a registered first mortgage over the Property in favour of the financier appointed by Developer Q to provide the construction loan of a specified amount.

The proceeds from sale of the Property will pay off the current loans on the Property, plus the balance go towards paying off your personal mortgage on the Location Y house. You plan that any surplus will go towards the required tax applicable and if possible, some residue into your SMSF.

You did not have any rental projections prepared for the Property once developed.

You (or any related entities) do not intend to be involved in any other property development of land subdivision activities.

You previously (several years ago) were a 25% shareholder in a land development company that bought a cattle farm and subdivided it into 40-acre hobby farms to on sell.

You have provided copies of both the first and subsequent development agreements.

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 15-15

Income Tax Assessment Act 1997 subsection 70-10

Income Tax Assessment Act 1997 section 70-30

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 104-10(5)

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 995-1(1)

Reasons for decision

Summary

Any profit from the sale will be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). Where you are not carrying on a business of property development, any profit from the sale of the newly created units at the Property will be accounted for on revenue account as an isolated commercial transaction.

Detailed reasoning

There are three ways profits from property sales can be treated for taxation purposes:

1. As ordinary income under section 6-5 of the ITAA, 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, on revenue account, as a result of entering into a profit-making undertaking or scheme;
3. As statutory income under the capital gains tax legislation.

Under section 6-5 of the ITAA 1997, your assessable income includes the ordinary income you derived directly or indirectly from all sources, during the income year. Additionally, section 15-15 of the ITAA 1997 includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan. However, this provision does not apply to a profit that is assessable as ordinary income under section 6-5 of the ITAA 1997, or which arises in respect of the sale of property acquired on or after 20 September 1985.

Carrying on a business

Subsection 995-1(1) of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? provides the Commissioner's view of the factors used to determine if you are in business for tax purposes. 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.

No one factor is decisive. The indicator must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

As to when such a business is taken to have commenced, Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock'? also states that a business activity is taken to have commenced when a taxpayer embarks on a "definite and continuous cycle of operations designed to lead to the sale of the land." That is, the land will become trading stock when you are demonstrably fully committed to the business of land development. When that occurs is determined by a consideration of the facts of the case.

Trading Stock

Section 70-10 of the ITAA 1997 provides that trading stock includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business.

Taxation Determination TD 92/124 states that land will be treated as trading stock for income tax purposes if it is held for the purpose of resale and a business activity which involves dealing in land has commenced. Where such a business exists, the proceeds from the sale will be assessable under section 6-5.

Isolated transactions

Alternatively, Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income discusses profits on isolated transactions and the application of the principles outlined in the decision of the Full High Court of Australia in FCT v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693. This ruling states that profits on isolated transactions may be income.

Profit from an isolated transaction will be ordinary income where:

• the intention or purpose of a taxpayer in entering into the transaction was to make a profit or gain and
• the transaction was entered into, and the profit was made, in the course of carrying on a business operation or commercial transaction.
• Taxation Ruling TR 92/3 outlines that the relevant intention or purpose of the taxpayer, of making a profit or gain, is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

Profits on the sale of subdivided land can therefore be income according to ordinary concepts within section 6-5 of the ITAA 1997 if the taxpayer's subdivisional activities amount to a business operation or commercial transaction.

Paragraph 42 of Taxation Ruling TR 92/3 provides that if a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset either:

a)    as the capital of a business; or

b)    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 or a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity is income although the taxpayer did not have the purpose of profit-making at the time of acquiring the asset.

At paragraphs 56 and 57, Taxation Ruling TR 92/3 explains that a profit is income where it is made in any of the following situations:

• a taxpayer acquires property with a purpose of making a profit by whichever means prove most suitable and a profit is later obtained by any means which implements the initial profit-making purpose; or
• a taxpayer acquires property contemplating a number of different methods of making a profit and uses one of those methods in making a profit; or
• a taxpayer enters into a transaction or operation with a purpose of making a profit by one particular means but actually obtains the profit by a different means.

Furthermore, 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 deals in part the taxation consequences of isolated transactions relating to the sale of land and states in paragraph 263:

The issue to be decided is whether the activities are an enterprise in that they are of a revenue nature as they are considered to be activities of carrying on a business or an adventure or concern in the nature of trade (profit making undertaking or scheme) as opposed to the mere realisation of a capital asset.

MT 2006/1 refers to the cases of Statham & Anor v. Federal Commissioner of Taxation (Statham) and Casimaty v. Federal Commissioner of Taxation (Casimaty) as cases that provide guidance on when activities to subdivide land may amount to a profit-making undertaking or scheme. In both cases, farm land was subdivided and sold and based on the facts of those cases, the courts held that the sales of the subdivided lots were a mere realisation of a capital asset.

MT 2006/1 notes that from the Statham and Casimaty cases a list of factors can be ascertained that provide assistance in determining whether an activity is a profit-making undertaking or scheme. Those factors are:

• 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.

In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations.

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 newly created unit. 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.

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

Taking all of the facts into consideration, and on weighing the various factors, where you are not carrying on a business of property development, any profit from the sale of the newly created units at the Property will be accounted for on revenue account as an isolated commercial transaction.

We acknowledge that the Property was originally acquired to be your residence, and subsequently used to derive rental income. Following this, you did not have any active involvement in the rezoning of the Willandra Road Property. You attempted to develop the Property yourself to increase your rental income, but this did not eventuate.

You subsequently entered into agreements with developers to carry out development works. However, although you contend that your role may be passive, you are ultimately undertaking the risk involved, including the profits, losses and overall success of the development.

The development is of the same kind and carried on in a similar manner to that of property development and the project is planned, organised and carried on in a businesslike manner in order to make a profit; showing that the development has a significant commercial purpose.

Once the new units have been completed, it is you who will enter into the contracts to sell the newly created units under the pre-sale arrangement. This shows a level of sophistication, complexity and commerciality, while you also carry risk if for example, the contracts fall through.

Although the Develop Q will bear the costs of the development, you have retained a level of financial risk in the development as legal owner. Furthermore, clause X of development agreement deals with details around the funding of the development and provides that a mortgage will be registered over the Property. While you stand to profit from the overall development, in the event the development fails, you will be subject to the losses or resulting liabilities. Clause X of the development agreement states that in the event of defined default by you, the developer may deal with the Property in any way it deems appropriate and without limiting the generality of the foregoing may mortgage, sell, lease, cleanse, repair, renovate, alter, add to or demolish it.

You have explained that the unimproved value of the Property is approximately $X, you expect to receive approximately $X from the sale of the new created units. While there appears to be little range between these figures, the complexity involved to receive what you believe to be the market value of the Property goes beyond merely realising a capital asset. Under clause X of the development agreement Developer Q receives payment for its development costs before any payments are made to you. Subsequently you will receive $X, with a percentage of the net project return paid to Developer Q, and the balance to you. Therefore, depending on movements in land values, the total amount you will receive is uncertain and dependent on market forces, and a degree of risk remains.

The significant work and construction of the units for the purpose of sale and indicates that by undertaking the development, there is an intention to make a profit, rather than the sale being a capital transaction to realise the value of the land. The objective intention is that the development will be undertaken for the purpose of producing a profit. There will be some level of repetition, throughout the development as you intend to sell off newly created units through the use of a real estate agent, and the earlier mentioned pre-sale arrangement.

Where you are not carrying on a business of property development, the Commissioner is satisfied the proceeds from the sale of the newly created units at the Property will be those from an isolated transaction. Although the Property was originally acquired for domestic use and as a rental property, this intention is not definitive and based on the facts, it can be concluded that on balance, the development is being entered into with the intention of profit in carrying out a commercial transaction.

Therefore, proceeds from the sale of the newly created units will constitute a profit from an isolated transaction and should be included as ordinary income under section 6-5. Following this, where you are not carrying on a business the land would not be treated as trading stock.

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