Edited version of private advice

Authorisation Number: 1052079107132

Date of advice: 20 January 2023

Ruling

Subject: Sale of property - capital vs revenue

Question 1

Will the proceeds or profit from the sale of Property 1 be considered ordinary income of Company X pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the net capital gain from the sale of Property 1 be included in the assessable income of Company X as gain from mere realisation of a capital asset pursuant to subsection 104-10(4) of the ITAA 1997?

Answer

No.

Question 3

If the answer to Question 2 is yes, will additional costs, to complete the building that are incurred after the contract of sale was signed, form part of the cost base in the calculation of the net capital gain arising from the sale of Property 1 in the income year ended 30 June 20XX, pursuant to section 110-25 of the ITAA 1997?

Answer

Not applicable.

This private ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Business structure and the controller's group

1. You are private company incorporated in Australia.
2. Your sole director is the 100% owner of the ordinary shares you issued. You also have Class X redeemable preference shares on issue. The Class X shares are held by other investors.
3. Your director and their associated entities undertake a wide range of property related business services.
4. Your director and their private group have a history of property development, construction, subdivision and sale, since establishment of the group.
5. There currently are multiple entities under your director's control that have similar ownership structures. Each entity owns one or more parcels of land and is carrying on a land development project on the land.

The relevant asset and development plan

6. In 20XX, an offer and acceptance was signed by your director and/or nominee for you to acquire the land for development.
7. You provided an Information Memorandum (IM) on the proposed development to your Class X shares investors. The IM stated that the land development project you would be undertaking would deliver above-average investment returns and the returns would be distributed to investors upon the sale of completed assets.
8. This land development project consists of subdivision and development of more than one property.
9. According to the IM, you will commence paying dividends once you have achieved a net surplus from the sale.

Development processes

10. The overall project is managed by management team including your director as development manager and an assistant development manager. Your director is ultimately responsible for all property investment decisions and key client relationships. The assistant development manager provides major input into efficient project management and risk mitigation of regulatory hurdles.
11. You submitted a planning approval application for the proposed development and construction the properties on the land. Your application has been approved and you were issued a planning approval.
12. According to the proposed strata plan and site plan contained in the planning approval, you would first amalgamate the land and then subdivide it into multiple lots and construct a property on each lot.
13. You executed an agreement with a qualified builder to construct Property 1 on one of the proposed lots.
14. It was anticipated that the construction of Property 1 would be completed and ready for occupancy in 20XX.

Finance arrangements

15. You obtained bank loan facilities to assist with the purchase of the land and the construction of the properties.
16. You also obtained equity funding from Class X shareholders to assist with the construction of the properties.

Leasing activities

17. Prior to the completion of Property 1, you executed an agreement for lease with a prospective tenant to lease Property 1 to the tenant.
18. A long-term lease will be executed after the relevant conditions set out in the agreement for lease are satisfied.

Sale of Property 1

19. You had adopted a marketing plan to sell the developed properties before the construction commenced.
20. You have prepared feasibility reports for the construction and sale of the properties. The feasibility reports set out the projected income from the sale of the developed properties and projected development costs including purchase costs, construction costs, marketing fees, leasing fees, selling fees and so forth.
21. A purchaser approached you to indicate the interest to buy Property 1 prior to the completion of its construction.
22. Upon negotiations between you and the purchaser, a sale contract was executed under which you will sell Property 1 to the purchaser for a consideration amount.
23. Settlement of the sale will occur after the completion of the construction of Property 1 and upon satisfaction of the relevant conditions set out in the sale contract.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 15-15

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-25

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Legislative references are to the ITAA 1997 unless otherwise specified.

Broadly, profits from land development, subdivision and sale can be treated for taxation purposes in the following three ways:

•         As ordinary income under section 6-5 (revenue account) resulting from carrying on a business of land development and the sale of subdivided land as trading stock.

•         As ordinary income under section 6-5 (revenue account) resulting from isolated business or commercial transaction entered into by a non-business taxpayer, or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit-making purpose.

•         As statutory income under the capital gains tax (CGT) provisions.

Under section 6-5, your assessable income includes the ordinary income you derived directly or indirectly from all sources, during the income year. Additionally, section 15-15 includes profit arising from 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, 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) 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.

TR 97/11 provides the general indicators of a 'business' (in dot points below) established by the courts. The Ruling deals with carrying on a primary production business, however, the principles discussed in the Ruling apply to any set of operations.

The general indicators of a business are also covered in Taxation Ruling TR 2003/4: Income tax: boat hire arrangements (see paragraphs 15-23 and further at paragraphs 62-92). While no single indicator is determinative and the determination is based on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551), the prospect of profit is highly significant when assessing if an activity has the character of a business (Stone v. FC of T [2002] FCA 1492 at [68]).

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.

Section 70-10 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.

TD 92/124 at paragraph 1 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. The ruling at paragraph 6 states that profits on isolated transactions 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 or in carrying out a business operation or commercial transaction.

TR 92/3 at paragraph 7 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, if the taxpayer's land development activities amount to a business operation or commercial transaction.

Paragraph 42 of TR 92/3 provides the following example:

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:

•         as the capital of a business; or

•         into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction,

the activity of the taxpayer constitutes 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, 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, farmland 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 at paragraph 265 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 general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute 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, relating to the disposal of a CGT asset, will happen when you dispose of a property. You will make a capital gain if the capital proceeds from the disposal of the property are more than the cost base. You will make a capital loss if those capital proceeds are less than the reduced cost base of the property.

Section 118-20 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 of the property.

Application to your circumstances

Taking all relevant facts and circumstances into consideration, and on weighing the various factors, it is evident that you, together with your director and their private group in which you are a member, are carrying on a business of property development, construction, subdivision and sale. Accordingly, any profit from the sale of Property 1 will be accounted for on revenue account as ordinary income within the course of carrying on the business.

Your director and their private group have extensive experiences and a demonstrated history of undertaking property development business in a highly organised and systematic manner. For each property development project, the property development activities typically consist of the following key steps:

•         Your director, along with their management team, conduct research and identify appropriate land development opportunities.

•         An entity is established to purchase and hold the land to be developed.

•         The entity obtains the requisite development approval from relevant authorities.

•         Bank loans are used to fund the land acquisition and development. In most cases, equity funding is also sought from special class share investors to assist with the development.

•         The entity enters into agreements with skilled entities such as surveyors, town planners, designers, engineers, and builders to carry out the development works.

•         Your director is ultimately responsible for the management and delivery of the overall project.

•         Properties are marketed and sold either before or upon the completion of the development works.

In your situation, you are a private company that was established specifically for the land development project which included the construction of Property 1. Your property development activities and processes are similar to and consistent with the broader business model and strategy adopted by your director's private group. There is no evidence indicating that the activities you have engaged in materially differ from those of the other entities in the same private group in which you are a member. That is, a number of entities in the group have either completed or are undertaking property development projects.

Specifically, the Commissioner's view as to how the main indicators of carrying on a business that are outlined in the table at paragraph 18 of TR 97/11 apply to your circumstances is detailed as follows.

In conclusion, based on the facts and weighing up all main indicators, your activities constitute carrying on a business of land development, construction, subdivision and sale.

Profits from carrying on the business of land development, construction, subdivision and sale of developed assets as trading stock are assessable to you as ordinary income under section 6-5.

Question 2

Subsection 108-5(1) provides that a CGT asset is:

•         any kind of property; or

•         a legal or equitable right that is not property.

Property 1 is a property. Therefore, the disposal of the Property 1 has triggered the application of CGT event A1 under section 104-10.

However, Section 118-20 contains anti-overlap provisions which operate to reduce capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1, for example, as ordinary income under section 6-5.

Where profits from the sale of properties are assessable as ordinary income, section 118-20 will operate to reduce any capital gains by any amounts which are included in your assessable income.

In this case, while CGT event A1 occurred on the disposal of Property 1, the disposal of the property will be treated as a transaction within the ordinary course of carrying on a business for income tax purposes. Therefore, any profit from the sale will be assessable as ordinary income under section 6-5. Where the profit is included in assessable income as ordinary income under section 6-5 there will be no CGT consequences pursuant to section 118-20.

Question 3

Question 3 is not applicable as the answer to Question 2 is no and the sale of Property 1 is not considered mere realisation of a capital asset.