Edited version of private advice

Authorisation Number: 1052219005655

Date of advice: 15 March 2024

Ruling

Subject: CGT - subdivision

Question 1

Will the profit made by the owners on the sale of the commercial buildings, constitute assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will any profit derived from the sale of the commercial buildings be considered the mere realisation of a capital asset under the capital gains tax (CGT) provisions in Parts 3-1 and 3-3 of the ITAA 1997?

Answer

Question 2 is not applicable as the answer to Question 1 is yes and the sale of the commercial buildings is not considered mere realisation of a capital asset.

This ruling applies for the following period:

30 June 20YY

The scheme commenced on:

1 July 20YY

Relevant facts and circumstances

10 years ago, a block of land (title 1), was purchased, with a loan from a financial institution.

The contract was originally executed by company D, or nominee and later a nomination was executed for the trustee (the trustee of the unit trust) for the unit trust (the unit trust) to be the purchaser.

Two years later, the trust purchased a neighbouring block of land (title 2).

One year later in the 20YY-YY financial year, a planning permit for development of 10 commercial buildings was issued, this was later amended to 6 commercial buildings.

9 months later, an appraisal was completed by a real estate to estimate the total value of both title 1 and title 2 for a unitholder split for the trust.

In the 20YY-YY financial year, there was a change in ownership of the units of the unit trust, due to a business partner relationship breakdown between the partners of company B, the remaining partner (the family trust) purchased the other 50% of units to become the sole owner of the unit trust.

Company C grew in size and the owner was forced to reassess the original plan as it no longer suited the overall business operations due to the high working capital requirements of company C.

In the 20YY-YY financial year, title 1 and title 2 were consolidated into one title (the property).

The original intention of the land purchase was to construct the commercial buildings to generate a passive rental income after construction was completed, with the ancillary benefit of being able to save on storage in the interim for the affiliate business.

The property was rented and used by the unit trust's related entity company C, from the date of purchase of title 2 for 7 years, there was no formal rental contract in place. Company C conducts a commercial construction business.

In or around 20XX company D, changed its name to company C.

The unit trust engaged the services of company C to build the commercial buildings on the property for a development fee, the entities are connected via an individual (individual A) who is the director of company C and indirectly controls it.

Construction of the 6 commercial buildings commenced in 20YY-YY financial year.

Company C undertook all construction works to complete the build including the connection of services, carpark and crossovers. The business charged a development fee for these services.

The unit trust did not obtain finance to fund the build, the costs associated with the construction of the commercial buildings was funded by company C and was later recovered upon the sale of the 6 commercial buildings.

The 6 commercial buildings were sold off the plan prior to the completion of construction in 20YY-YY income year and were never used for the purpose of generating a passive rental income.

Construction of the commercial buildings was completed in 20YY-YY income year.

Summary of income and expenses

Trust (ex GST), Approx YTD

Cost base of land: $XXX,XXX

Sale of commercial buildings: $X,XXX,XXX

Development fees: $X,XXX,XXX

Capital gain:$XXX,XXX

Company C (ex GST), Approx YTD

Development fees:$X,XXX,XXX

Construction cost:$X,XXX,XXX

Gross profit:$XXX,XXX

Other expense:$XX,XXX

Net profit:$XXX,XXX

Entity and Affiliate Group Structure

Table 1: Entity and affiliate group structure.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 section 104-10

Reasons for decision

Carrying on a business

There are three ways the proceeds from a land subdivision can be treated for taxation purposes:

•         assessable ordinary income under section 6-5 as income from carrying on a business of property development

•         assessable ordinary income under section 6-5 as income from an isolated commercial transaction with a view to a profit, or

•         a realisation, often referred to as a 'mere realisation', of a capital asset, assessable under Parts 3-1 and 3-3.

Whether the proceeds are treated as income or capital will depend on the situation and circumstances of each particular case. 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

Carrying on a business of property development

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

The Commissioner's view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production?

Although TR 97/11 deals with the issues of determining whether a taxpayer is carrying on a business of primary production, the same principles can be applied to the question of whether a taxpayer is in the business of property development

Paragraph 13 of TR 97/11, uses the following indicators to determine whether a taxpayer is carrying on a business:

•         whether the activity has a significant commercial purpose or character

•         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

Whether a business is being carried on depends on the large or general impressions gained from looking at all the indicators and whether these indicators provide the operations with a commercial flavour

Application to your circumstances

The table at paragraph 18 of TR 97/11 provides a summary of the main indicators of carrying on a business. These are set out below alongside their application to the trustee for the unit trust's circumstances:

Table 2: Main indicators for carrying on a business.

The activities the trustee for the unit trust undertakes, as well as its plans and intentions, feature many of the factors that align them to carrying on a business including:

•         a significant commercial activity

•         a purpose and intention of carrying on a business

•         an intention and expectation of profit

•         the activity is carried on in a manner similar to ordinary trade for this type of activity

•         the activity is organised and businesslike. It is carried on in a systematic manner and records are kept

•         the size and scale of the activity is significant

•         it is not a hobby, recreation or sporting activity

•         there were commercial sales of product

•         Individual A had the necessary education, knowledge and skill. Where additional skills are needed, professionals were engaged to provide these

•         Company C, is a connected entity of the unit trusts and is in the business of commercial property development for clients

Weighing up the relevant factors above it is considered that the unit trust went beyond a mere realisation and was carrying on a business of property development and the profit made from selling the commercial buildings is assessable under section 6-5 of the ITAA 1997 either in the unit trusts own right or as part of the related group of entities, one of which is in the business of commercial construction.

Profits from an isolated transaction

Alternatively, the Commissioner considers the transaction to be an isolated commercial transaction. In FC of T v The Myer Emporium (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693 (Myer Emporium), the Full High Court expressed the view that profits made by a taxpayer who enters into an isolated transaction with a profit making purpose can be assessable income.

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income considers the assessability of profits on isolated transactions in light of the principles outlined in Myer Emporium. According to Paragraph 1 of TR 92/3, the term isolated transactions refers to:

a)            those transactions outside the ordinary course of business of a taxpayer carrying on a business, and

b)            those transactions entered into by non-business taxpayers.

TR 92/3 provides guidance in determining whether profits from isolated transactions are income and therefore assessable.

A profit from an isolated transaction will generally be income when:

a)            the intention or purpose of a 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 on a business operation or commercial transaction.

The relevant intention or purpose of the taxpayer (of making a profit or gain) referred to in Myer 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 (paragraph 38 of TR 92/3).

It is also not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. Paragraph 40 of TR 92/3 provides that it is sufficient if profit-making is a significant purpose. However, the profit-making purpose must be more than a mere possibility. In Westfield v FCT 91 ATC 4234, Hill J said:

While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised ... But, even if that goes too far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit-making scheme, where, in the case of the scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold.

Paragraph 41 of TR 92/3 states that if a transaction or operation involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However, this is not always the case, as there may be special circumstances where the requisite profit-making purpose arises sometime after acquisition of a property.

An example is provided in paragraph 42 of TR 92/3 where 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. In such circumstances, the activity of the taxpayer would constitute 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 would be income despite the taxpayer not having the purpose of profit-making at the time of acquiring the asset.

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

a)            the nature of the entity undertaking the operation or transaction.

b)            the nature and scale of other activities undertaken by the taxpayer.

c)            the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained.

d)            the nature, scale and complexity of the operation or transaction.

e)            the manner in which the operation or transaction was entered into or carried out.

f)            the nature of any connection between the relevant taxpayer and any other party to the operation or transaction.

g)            if the transaction involves the acquisition and disposal of property, the nature of that property; and

h)            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 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.

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

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.

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.

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.

Application to your circumstances

The nature of the entity undertaking the operation or transaction

In this case the nature of the entities involved in the operation and transaction need to be considered. Unit trusts are business structures typically used in business. In addition, the unit trust used a related entity, company C, to conduct the development of the commercial buildings.

The nature and scale of other activities undertaken by the taxpayer

The unit trust is not a trading entity and was used for the purpose of buying the two titles of land and to generate a passive rental income, the unit trust rented the land to company C from 20YY to 20YY for storage and issued monthly invoices for to company C for rent, after the intention changed as previously discussed the unit trust then sold the commercial buildings.

The amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained

The amount of money involved in the operation or transaction needs to be considered, substantial funds have been spent on the development. The total development costs exceeded $X.X million and there was a significant profit for the unit trust, received from the sale of the commercial buildings of approximately $XXX,XXX after deductions, that being the cost price of the land, and development and construction costs.

The nature, scale and complexity of the operation or transaction

The activity was significant commercially, financially and in terms of the complex work that was carried out. The scale of the project involved consolidation of land and the development and construction of 6 commercial buildings, substantial funds have been spent on the development exceeding $X.X million.

The manner in which the operation or transaction was entered into or carried out

Company C a related entity to the unit trust carried out and funded the construction costs associated with the development and construction of the commercial buildings. Company C recovered these costs from the sale of the commercial buildings. As discussed previously the purpose in developing the commercial buildings changed and the commercial buildings were sold off the plan and not used for the initial intended purpose of generating passive rental income.

The nature of any connection between the relevant taxpayer and any other party to the operation or transaction

The unit trust engaged the services of company C to construct the commercial buildings, a related entity, and both are controlled by the same individual, individual A.

If the transaction involves the acquisition and disposal of property, the nature of that property

The land could have been held long term or it could have been used as trading stock as part of a property development business. Therefore, this factor has no bearing either way.

The timing of the transaction and the various steps in the transaction

Title 1 was held for X years prior to consolidation with title 2, which was held for X years prior. Once the two titles were consolidated the property was held for X years prior to the start of the construction of the commercial buildings. Once construction began in 20YY, the sale of the commercial buildings occurred off the plan within 1 year. The relationship breakdown would explain the delay in starting the construction of the commercial buildings, however once the construction began the timeframe for completion was short. In addition, the commercial buildings were sold off the plan before construction was completed.

It is considered there was a change in purpose for which the land was held, subsequently the commercial buildings were sold without being used for their originally intended purpose. Weighing up the above factors, it is considered the development went beyond a mere realisation and was entered into with the intention of profit in carrying out a business or isolated commercial transaction. The use of a related entity to conduct the development, the nature and scale of the development, the amount of money involved, and profit made indicate the activity went beyond a mere realisation. Therefore, the income derived from the sale of the commercial buildings is assessable under section 6-5 of the ITAA.

Capital gains tax

A capital gain or a capital loss may arise if a capital gains tax (CGT) event happens to a CGT asset you own. Land, or an interest in land, is a CGT asset (section 108-5 of the ITAA 1997).

CGT event A1 happens if you dispose of a CGT asset (section 104-10 of the ITAA 1997). You dispose of a CGT asset if a change in ownership occurs from you to another entity, whether because of some act or event or by operation of law (subsection 104-10(2) of the ITAA 1997). The time of the event is when you enter into the contract for the disposal, or if there is no contract, when the change of ownership occurs (subsection 104-10(3) of the ITAA 1997.

Section 118-20 of the ITAA 1997 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 of the ITAA 1997, for example, as ordinary income under section 6-5 of the ITAA 1997.

Conclusion

Taking all of the facts into consideration, and on weighing the various factors, the Commissioner considers the activity went beyond a mere realisation. The unit trust is considered to be carrying on a business of property development, any profit from the sale of the commercial buildings will be accounted for on revenue account. Alternatively, we consider it is an isolated commercial transaction. Regardless of whether it is business or isolated transaction, the income from the activity is assessable under section 6-5 of the ITAA 1997.

There was a change of purpose for which the land is held, we acknowledge that the original purpose was to construct the commercial warehouses to generate a passive rental income and subsequently rented by the unit trusts related company, company C, for storing building equipment and supplies from 20XX to 20XX via informal agreement. However due to a relationship breakdown in the related entity company C and the change in the ownership structure, the family trust purchased the other 50% of units in the unit trust to make them sole owners, the original plan no longer suited the requirements of company C's operations due to working capital requirements.

Despite the relationship breakdown and the change of ownership occurring prior to the consolidation of the 2 titles and the commencement of the development and construction of the commercial buildings. The trustee of the unit trust still proceeded and made the application to have the two titles consolidated into one, there was no attempt made to sell the two titles en-globo and the commercial buildings were not kept long term to generate a passive income.

The trustee of the unit trust subsequently entered into agreements with company C, an entity related to the unit trust, to carry out development works and construct the commercial buildings.

Although the trustee of the unit trust contends that their role may be passive and that company C is undertaking all works in the development, as the entities are closely related, we consider the close relationship between the entities where company C is a development business also is a factor towards the unit trust's activities amounting to more than a mere realisation

The development was of the same kind and carried on in a similar manner to that of property development. The project was planned, organised and carried on in a businesslike manner in order to make a profit; showing that the development has a significant commercial purpose. Key factors indicating this are:

•         Company C is in the business of commercial property development for clients.

•         The trustee for the unit trust has not undertaken any development of commercial property in its own right but as mentioned prior, the related entity which undertook the development of the warehouses has a usual course of business in commercial property development. It is not uncommon for related entities to undertake such development.

•         Finance was obtained from a financial institution to purchase the original property and the profit for the unit trust, received from the sale of the commercial buildings is approximately $XXX,XXX after deductions, that being the cost price of the land, and development fees. There is a gain, the significant work and complexity involved to receive that gain, goes beyond merely realising a capital asset.

•         Company C covered the costs of the development initially, the company recovered these costs after the sale of the commercial buildings, however the trust has retained a level of financial risk in the development as legal owner.

•         The unit trust stood to profit from the overall development. In the event the development failed, the unit trust would have been subject to the losses or resulting liabilities, demonstrating significant risk.

•         The commercial buildings were advertised and sold off the plan prior to completion and the unit trust entered into the contracts to sell the commercial buildings under a pre-sale arrangement.

•         Due to the 6 commercial buildings being sold prior to completion, they were never used to generate a passive rental income as originally intended. This shows the intention for the use of the commercial buildings changed, due to financial reasons and a business relationship breakdown, while the unit trust also carried risk if for example, the contracts fell through.

•         The trustee for the unit trust and company C are closely related entities ultimately controlled by same individuals, as mentioned above.

•         The property is in a commercial/industrial area, there was subsequent land acquired and consolidated for the purpose of developing the commercial buildings. There was a significant change in purpose for which the land was held, no attempt was made to sell the titles en-globo.

•         The length of time the property was held prior to development is at least partly explained by the relationship breakdown which contributed to the delayed development of the commercial buildings.

Although the property was originally acquired for generating a passive rental income and storage for company C, we consider this intention changed some time after the relationship breakdown due to the need to provide working capital to Company C. Based on the facts, it can be concluded that on balance, there was a change in purpose for which the land was held, subsequently the commercial buildings were sold without being used for their originally intended purpose and the development was entered into with the intention of profit in carrying out a business or isolated commercial transaction. The proceeds from the sale are considered to be ordinary income, derived either in the course of carrying on a business, or in carrying out a business operation or commercial transaction. As such, the sale proceeds will be included in your assessable income under section 6-5 of the ITAA 1997.

CGT event A1 will happen when the trustee of the unit trust entered into the contracts and disposed of the commercial buildings; however, any capital gain made by the unit trust will be reduced under section 118-20 of the ITAA 1997 to the extent that the profit from the sale of the land is included in your assessable income under section 6-5 of the ITAA 1997.

Question 2

Will any profit derived from the sale of the commercial buildings be considered the mere realisation of a capital asset under the capital gains tax (CGT) provisions in Parts 3-1 and 3-3 of the ITAA 1997?

Summary

Question 2 is not applicable as the answer to Question 1 is yes and the sale of the commercial buildings is not considered mere realisation of a capital asset.