Edited version of private advice

Authorisation Number: 1051969050903

Date of advice: 4 April 2022

Ruling

Subject: Treatment of gains on realisation of land

Question 1

When originally acquired, is it correct for the Site to be classified as a capital gains tax (CGT) asset, and not as a revenue asset or trading stock?

Answer

Yes.

Question 2

In relation to the sale of the Site to an unrelated third party, per the sales contract, should Company A only treat the amount received (in calculating any gain or loss from the disposal) as capital proceeds under subsection 100-40(1) of the Income Tax Assessment Act 1997(ITAA 1997) arising from CGT event A1 happening under Division 104, and not:

(a)  also treat the amount received as what Company A got for the disposal of an item of trading stock under Division 70, and include that amount in its assessable income under section 6-5 (pursuant to subsection 70-80(1)); or

(b)  also treat the amount received as the proceeds from the sale of a revenue asset in its calculation of the net gain (or net loss) to be included in its assessable income under section 6-5?

Answer

Yes.

This ruling applies for the following periods:

Income Tax Year ended 31 XXXX 20XX

Income Tax Year ended 31 XXXX 20XX

Income Tax Year ended 31 XXXX 20XX

Income Tax Year ended 31 XXXX 20XX

Income Tax Year ended 31 XXXX 20XX

The scheme commences on:

31 XXXX 20XX

Relevant facts and circumstances

General

Company A is an Australian incorporated company listed on the Australian Stock Exchange (ASX). Company A is the head company of the Company A income tax consolidated group.

The Company A group is active in Australia and New Zealand. The principal activities of Company A are manufacturing and sale of manufactured products.

Property Division

Company A owns numerous freehold sites and leasehold sites. Generally, the approach of Company A is to:

•         Own manufacturing sites, given the significant capital investment and long-term tenure required at these locations, and

•         Lease properties for retail, warehouse and distribution purposes.

Company A's various business units are responsible for the daily management and operation of the leasehold and freehold sites. Given the large number of sites which Company A owns and leases there is a dedicated Property Division of X0 people (out of several thousand employees of Company A).

The Property Division assists in overseeing the property portfolio and provide advice and expertise in relation to the challenges and opportunities the business faces on property related matters.

The various roles of the Property Division are summarised as:

•         Business support for current sites

•         Strategic site planning

•         Advice regarding impact on business operations

•         Government interactions

•         Asset divestment.

Performance of Property Division

An annual financial target based on forecast property earnings before interest and tax (EBIT) is determined for the Property Division

Levels of Authorisation

The function of Company A's Board include:

•         Considering management recommendations on proposed acquisitions, divestments and significant capital expenditure;

•         Considering the environmental impact of Company A's activities and monitoring compliance with Company A's sustainability policies and practices; and

•         Monitoring internal governance including delegated authorities.

Asset disposals above a certain level must be authorised by the Company A Board

The Company A Board and the authorised employee always needs to be satisfied that a proposal to sell a site, is in line with the strategy of Company A's Manufacturing Division and allows for its future growth. Priority is given to the Manufacturing Division before management provides the Property Team with approval to sell a site.

The 'Site'

Company A has owned the Site since 20XX.

The land was acquired for Company A's main business purpose in the manufacturing sector.

Theland has been used for the same purpose, a significant period of time before Company A acquired it, up until 20XX when it became surplus to business requirements.

Zoning of the Site

The land is currently zoned residential (prior to 20XX it was zoned Industrial)

Investigations by the local Council determined parts of the site were suitable for urban development - subject to appropriate works of upgrading existing infrastructure networks.

In 20XX, following public consultation, the local Council released its plan which identified the Site as transitioning to an urban residential outcome.

The State Government rejected the Council's proposed amendments to the Planning Scheme. However the Council was still able to accept Development Applications (DA) from landowners and accept them on their merits.

Company A lodged a rezoning application in 20XX

The Council approved Company A's rezoning DA from Industrial to Residential, subject to specific variations and conditions.

Despite the Council approving the DA, Company A found the approval conditions to be too onerous to proceed with the development. Conditions included Company A to bear the cost of major infrastructure works outside of its landholdings.

Company A applied to Council to amend these conditions. However the approval conditions remained commercially unacceptable to Company A.

Adjacent Site

Company B owns a large parcel of land which is it uses in its business operations, which is adjacent to Company A's site.

Company A's Property Division identified the potential benefits of acquiring Company B's site and combining the two properties.

Company A made two offers to Company B to purchase their land which were both rejected by Company B. Company A made no further offers for Company B's land.

Capital works / Remediation works at the Site

Substantial geotechnical rework is required at the Site to return the land to an acceptable landform.

This remedial site work had commenced and was predicted to take a number of years to complete.

No further substantial capital works has been undertaken by Company A

Alternate plans for the Site

Company A's Property Division considered a number of alternate plans for the Site. These included:

•         selling the property 'as is where is' once the land rehabilitation was completed;

•         developing the property in accordance with the Council conditions; and

•         continuing to work with Council to amend the conditions to achieve a more favourable outcome.

Sale of the Site

Following more than a year of negotiation with the Council regarding Company A's rezoning application, the approval conditions remained commercially unacceptable to Company A.

On the recommendation of the Property Division, Company A's Board approved the investigation of other sale options against the original subdivision project plan, including the gauging of external interest.

Company A then entered into a binding contract with an unrelated third party for the sale of the Site.

Reasons for decision

Legislation in the following reasoning refers to the Income Tax Assessment Act 1997 ('ITAA 1997'), unless otherwise indicated.

The income tax consolidation provisions allow certain groups of entities to be treated as a single entity for income tax purposes. Under the single entity rule (SER) in section 701-1 the subsidiary members of an income tax consolidated group are taken to be parts of the head company. As a consequence the subsidiary members cease to be recognised as separate entities during the period that they are members of the income tax consolidated group, with the head company of the group being the only entity recognised for income tax purposes.

The meaning and application of the SER is explained in Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997.

As a consequence of the SER the actions and transactions of the subsidiary members of Company A's income tax consolidated group are treated, for income tax purposes, as having been undertaken by Company A as the head company of the tax consolidated group.

Question 1

Detailed reasoning

CGT Asset

Section 108-5 defines a 'CGT asset' as being:

(a)  Any kind of property; or

(b)  A legal or equitable right that is not property.

'Land and buildings' are included as an example of a CGT asset in Note 1 to section 108-5.

Section 108-5 states that 'an asset is not a CGT asset if the asset was last acquired before 26 June 1992 and was not an asset for the purposes of former Part IIIA of the Income Tax Assessment Act 1936: see section 108-5 of the Income Tax (Transitional Provisions) Act 1997.[1]

The Site is real property (acquired after 26 June 1992) and thus meets the definition of a 'CGT asset'.

Landcan also be considered as trading stock or a revenue asset.

Trading Stock

The term trading stock is defined in subsection 70-10(1) to include anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business.

There is no one definition or test for determining what is in the 'ordinary course of a business'. Taxation Ruling TR 2019/1 Income Tax: when does a company carry on a business? (TR 2019/1), while intended for determining whether a company carries on a business for the purposes of applying section 328-110 (and section 23 of the Income Tax Rates Act 1986), TR 2019/1 also details generally applicable indicia from relevant case law in identifying whether a person is carrying on a business (at paragraph 21):

•         whether a person intends to carry on a business

•         the nature of the activities, particularly whether they have a profit-making purpose

•         whether the activities are:

­   repeated and regular

­   organised in a business-like manner, including the keeping of books, records, and the use of a system

•         the size and scale of a company's activities including the amount of capital employed in them, and

•         whether the activity is better described as a hobby, or recreation.

In Federal Commissioner of Taxation v St. Hubert's Island Pty. Limited (in liq) (1978) 19 ALR 1 it was concluded that land can be trading stock according to its ordinary meaning if the land was held by an entity that was involved in selling land as part of its ordinary business activities.

In John v Federal Commissioner of Taxation (1989) 166 CLR 417; (1989) 63 ALJR 166; (1989) 83 ALR 606; (1989) 20 ATR 1; 89 ATC 4101; [1989] ACL 36017; [1989] HCA 5 (John v FCT), the High Court was required to consider whether shares sold by a partnership were trading stock. Per Mason CJ, Wilson, Dawson, Toohey and Gaudron JJ:

The relevant issue is not the nature of the business carried on but whether the person is a trader in the goods which are claimed to be trading stock. This is a question of fact. If trading has commenced and the activities reveal a discernible trading pattern, then the motive for undertaking the activities or a particular transaction cannot serve to characterise the person engaging in those activities as a non-trader generally, or in relation to a particular transaction.

Whether profits made from the disposal of real property are made in the ordinary course of business, is established by determining if a taxpayer is carrying on a pattern of trading and whether trading has commenced.

Taxation Determination TD 92/124 - Income tax: property development: in what circumstances is land treated as 'trading stock'? (TD 92/124) presents the Commissioner's view that land is treated as trading stock if:

(1) the land is acquired for the purpose of resale; and

(2) a business activity which involves dealing in land has commenced.

TD 92/124 specifies the Commissioner's view that before land is able to be treated as trading stock, both the requisite purpose and the business activity must be present. When a taxpayer beginsa 'definite and continuous cycle of operations' designed to lead to the sale of land, the business activity is considered to have commenced. It is not necessary for repetitive purchasing or selling of land to establish that a business of property acquisition, development and sale is being undertaken.

Revenue Assets

A CGT asset may also be a revenue asset where it is held for the purpose of realising a profit upon its disposal, in an isolated transaction.

Under paragraph 40-30(1)(a)), land cannot be a depreciating asset. If land is not trading stock (held for purposes within subsection 70-10(1) in the ordinary course of business), then land will be a revenue asset if it is used in an isolated transaction that is included in the taxpayer's assessable income (or losses).

Taxation Ruling TR 92/3 - Income tax: whether profits on isolated transactions are income (TR 92/3) provides the Commissioner's view of whether such a transaction is attributable to assessable income. TR 92/3 applies the principles established in Federal Commissioner of Taxation v The Myer Emporium Ltd (1987) 163 CLR 199 (Myer). Paragraph 32 of TR 92/3 states that a profit or gain made in the ordinary course of a business includes:

•         a profit or gain arising from a transaction which is itself a part of the ordinary business of a taxpayer (judged by reference to the transactions in which the taxpayer usually engages); and

•         a profit or gain arising from a transaction which is an ordinary incident of the business activity of the taxpayer, although not a transaction entered into directly in its main business activity.

TR 92/3 states that profits from an isolated transaction are generally income when both:

(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.

An objective examination of the facts and circumstances must be undertaken when considering the intention or purpose of a taxpayer in making a profit when entering into the applicable transaction.

Application to the Site

The Site was originally acquired for manufacturing purpose. Evidence supporting that original purpose is provided by the subsequent actions of Company A.

The Commissioner accepts as fact the Site was not, at the time of purchase, held to be sold as part of its ordinary business or ordinary business activities, and therefore was not trading stock at the time it was acquired.

The Commissioner also accepts as a fact the Site was not originally acquired for a purpose of resale, or for the purpose of developing with view to making a profit, as part of an isolated transaction.

Therefore at the time of acquisition, the Site was correctly classified as a CGT asset under section 108-5 and was not trading stock or a revenue asset.

Question 2

Detailed reasoning

For income tax purposes, the profit from the sale of land will generally be taxed:

•         as statutory income under the CGT provisions in Part 3-1 and 3-3, where the land is neither trading stock nor the subject of an isolated profit-making scheme or undertaking and the proceeds of sale are the mere realisation of a capital asset; or

•         as ordinary income under section 6-5, where the land is held as trading stock and sold as part of carrying on a business of property development; (the requirements for a CGT asset to be 'trading stock' are provided under that heading in the detailed reasoning provided for Question 1); or

•         as ordinary income under section 6-5, where land is not trading stock and is sold as part of an isolated commercial transaction entered into with a profit-making intention.

Where the land is sold as part of carrying on a business of property development or as part of an isolated profit-making scheme, the proceeds will be included in assessable income in accordance with subsection 6-5(1).

Where the sale of the land is considered to be the mere realisation of a capital asset, only the net capital gain will be included in assessable income in accordance with subsection 6-10(1).

CGT

Capital gain from mere realisation

When an asset which is subject to CGT is sold, a CGT event occurs. Land is a CGT asset under section 108-5. However, to the extent that an amount is included in the taxpayer's assessable income, section 118-20 will reduce any gain to the extent that amount is so included.

Section 104-10specifies that CGT event A1 occurs when a taxpayer disposes of a CGT asset. Subsection 104-10(4) stipulates that a taxpayer makes a capital gain if the capital proceeds from the disposal are more than the asset's cost base. Alternatively, a capital loss is made if those capital proceeds are less than the asset's reduced cost base.

Where the disposal of land is a 'mere realisation', the CGT rules will generally apply to the sale and the profits will not be ordinary income. In contrast, if the transaction is undertaken in a business operation with a profit-making motive, these proceeds would be considered as ordinary income.

Trading Stock

Original purpose at acquisition

The Site was originally acquired and held for manufacturing purposes - i.e., for the purposes of generating revenue as part of Company A's operation. The Site was not originally acquired as trading stock or a revenue asset. Accordingly, the disposal of the Site will be a realisation of a CGT asset unless Company A's motivation for profit in disposing of the land went beyond the realm of 'mere realisation' of a capital asset.

Alternatively, if it is determined that Company A has entered into the business of property development, with the Site being part of its trading stock, then the disposal of the Site would require an amount be included in Company A's assessable income under section 6-5, in accordance with subsection 70-80(1).

Purposes at the time of sale

The Commissioner's view in TD 92/124 (as amended by TD 92/124A) provides that land is treated as trading stock for income purposes if it is both:

• held for the purpose of resale; and
• a business activity which involves dealing in land has commenced.

The purpose of resale

Whether the land at the site was held for a purpose of resale is a matter of fact and requires consideration of the activities of Company A and its property division.

Whether or not a business is carried on by a taxpayer is a question of fact, but common law provides assistance in pointing to certain factors which can provide a useful guide. As Webb J held inMartin v FC of T (1953) 90 CLR 470, continuity and repetition of transactions pointing to a systematic course of conduct are important factors.

The decision in FC of T v N.F. Williams (1972) 127 CLR 226 (Williams)highlights that options being explored by engaging parties with expertise, and including preparatory work necessitated in this exploration, is not a sufficient indicator that the taxpayer has entered into a profit-making transaction. In Williams,Gibbs J found that it was essential the proceeds from the realisation of land were received in the course of a business venture or an isolated commercial profit-making transaction. Per Gibbs J:

An owner of land who holds it until the price of land has risen and then subdivides and sells it is not thereby engaging in an adventure in the nature of trade, or carrying out a profit-making scheme. The situation is not altered by the fact that the landowner seeks and acts upon the advice of an expert as to the best method of subdivision and sale or by the fact that he carries out work such as grading, levelling, road-building and the provision of reticulation for water and power to enable the land to be sold to its best advantage

In considering the above, and the relevant indicia for determining whether a company is in business (per paragraph 21 of TR 2019/1), the Commissioner considered the following factors to be relevant:

Business activity - size and scale of activities, and capital employed

Company A's property division performs a number of different roles, providing support to other business lines on matters relating to property. The property division consists of a relatively small number of staff compared to the total number of employees.

Similarly, the EBIT from the property division has been relatively small in comparison to the EBIT for the Company A group.

The property division is not authorised to make decision on assets beyond a maximum value (with Board approval required for disposals above a certain amount). The intentions of the property division in exploring various options for use (such as for the Site), including the submission of a DA, are therefore not indicative of a decision by Company A to commit the property to any particular purpose.

Business activity - nature of activities and profit-making purpose

The procurement of land for sale or development as part of a business cycle would suggest a business that is engaged purposefully in selling land or property development as part of its ordinary activities. While Company A has sold or engaged in several large-scale property developments, Company A has not, as an ordinary business function, acquired large tracts of land with a purpose of developing that land.

Business activity - repetition and regularity

The Commissioner accepts as fact, that the requirements of Company A's core business lines are prioritised over the requirements of the property division. While Company A reports on the activities of the property division as a discrete business unit, previous decisions made by Company A where land has become unusable for its original purpose have resulted varying outcomes. There is no pattern that readily suggests a predetermination by Company A that such land will be held and entered into a business cycle that results in development of that land.

The Commissioner concludes that the Site was not being held for sale as part of Company A's ordinary business activities at the time it was sold, and therefore is not trading stock.

Profit Making

The sale of the Site was not the result of an isolated profit-making scheme

The question of whether land held for one purpose but subsequently sold or subdivided constitutes more than mere realisation (to best advantage) of a capital asset has been heard numerous times.

The decision in Scottish Australian Mining Co Ltd v FC of T (1950) 81 CLR 188 (Scottish Australian Mining), for many years provided the prevailing view that land that had been held for one purpose (in that case, coal mining) but was subsequently sold via a subdivision that required building of roads, was simply a mere realisation of the land to best advantage, per the comments of Williams J:

The facts would, in my opinion, have to be very strong indeed before a court could be induced to hold that a company which had not purchased or otherwise acquired land for the purpose of profit-making by sale was engaged in the business of selling land and not merely realizing it when all that the company had done was to take the necessary steps to realize the land to the best advantage, especially land which had been acquired and used for a different purpose which it was no longer businesslike to carry out.

Williams J also commented that:

If it is advantageous to the sale of the land as a whole to set aside part of the land for parks and other amenities, this does not convert the transaction from one of mere realization into a business. It is simply part of the process of realizing a capital asset.

The broad view in Scottish Australian Mining (that all activities would fall within the definition of 'mere realisation') was directly addressed in Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355 (Whitfords Beach), which narrowed the view indicating that the size and scale of such activities was a factor in determining whether the development constituted a profit-making transaction. As Mason J remarked in Whitfords Beach:

That [mere realisation] may be so in the case where an area of land is merely divided into several allotments. But it is not so in a case such as the present where the planned subdivision takes place on a massive scale, involving the laying out and construction of roads, the provision of parklands, services and other improvements. All this amounts to development and improvement of the land to such a marked degree that it is impossible to say that it is mererealization of an asset. We need to bear in mind that the subdivision of broad acres into marketable residential allotments involves much more in the way of planning, development and improvement than was formerly the case

In Kenneth A Summons Pty Ltd & Ors v FC of T 86 ATC 4979,the taxpayer set up a joint venture company for the purposes of subdividing suburban land. The taxpayer was forced to sell the shares due to factors beyond the taxpayer's control. It was found that the sale of the shares in the joint venture company was found to be a mere realisation, and thus the proceeds were not assessable income, as the taxpayer never contemplated nor wished for the sale of the shares while carrying out the business venture. Ormiston J stated:

...the sales of the...shares were not made in the course of the company's business activities, for they terminated its activities in each of the ventures in a manner not originally contemplated. Of course, it can be said that every activity of a company engaged in commercial activities may fairly be described as a business activity, but that description fails to take account of the clearly accepted possibility and, indeed, likelihood that a company will, from time to time, realize its capital or structural assets without the profit becoming taxable. Nor does it matter that the company uses those capital assets to produce income, for it is hard to conceive of assets which a company would hold but which would not be used in that way. If realization was a part of or ''an integral element'' of a wider transaction, in the language used in the judgment in the Jennings Industries case (at p. 4294), then the situation would be different, but, if, as I consider the realization was not part of that wider transaction, then it seems that the principle stated above from the Whitfords Beach case (at ATC pp. 4034-4035, 4040; C.L.R. pp. 360-361, 372) must apply.

The Commissioner accepts as a fact that Company A is disposing of land that is no longer viable for use for the original purpose. It is evident that Company A activities continued at the Site for an extended period of the time. This gives further credence that the site was being used for its original purpose up until it was no longer viable to do so, rather than Company A holding the site for a profit making motive through the development of the land.

Company A decided to sell the Site in an undeveloped state. Based on information provided to the Commissioner, significant funds or capital have not been allocated toward the pursuit of the development project.

Conclusion

When Company A sold the Site to the unrelated third party, per the sales contract, the proceeds received did not represent an amount Company A got for the disposal of the Site as an item of trading stock under Division 70, nor did they represent the proceeds from the sale of a revenue asset (which otherwise would be included in Company A's assessable income under section 6-5).

When Company A sold the Site to the unrelated third party, per the sales contract, the proceeds received under that contract should be treated as the capital proceeds received when CGT event A1 happened. Any net capital gain should be included in Company A's assessable income under section 6-10.

[1] Note 2 to section 108-5 ITAA 1997.