Property Dev - Income Tax Handbook(Elect) 25-3-03

Property Development Income Tax Handbook

Up to date to February 2003

Prepared by Keith Harvey B Bus, Dip CM, LLB Principal

Ambry Legal, Melbourne www.ambrylegal.com.au

About the author Keith Harvey B Bus, Dip CM, LLB, is the principal of the Melbourne law firm Ambry Legal. Keith is a Fellow of each of CPA Australia, the Australian Institute of Banking and Finance and the Taxation Institute of Australia. He is also a practising member of the Law Institute of Victoria and a member of the Financial Services Committee of the Law Institute.

Keith has significant corporations and taxation law experience acting for both listed and unlisted public companies in the mining, oil and transport industries and many small to medium-sized businesses in a wide range of industries. While his main area of practice has historically been project and structured finance he now spends most of his time advising on goods & services tax, capital gains tax, corporations law, financial sector reform and insolvency. He was Chairman of the Melbourne Indirect Tax Discussion Group for CPA Australia in 2001 and is currently a member of the Melbourne cell of the Tax Profession Industry Partnership.

Keith has held senior finance positions with three major Australian trading banks and immediately before commencing practice as a barrister and solicitor he was the chief finance officer of an unlisted public company with an annual turnover in excess of $450m.

Acknowledgment: Keith acknowledges the valuable research and drafting support given by Dana Poulos B Com, LLB and Davina Mighalls Dip Mod Lang, B Com, LLB.

Property Development Income Tax Handbook TAXability

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Contents

[Click on any chapter title to jump to that chapter]

Chapter

INTRODUCTION 1 CONDUCTING A BUSINESS 2 PROFIT-MAKING SCHEME OR CAPITAL GAIN? 3 CAPITAL GAINS TAX 4 SMALL SCALE DEVELOPMENTS 5 JOINT VENTURE DEVELOPMENTS 6 MAXIMISING DEPRECIATION CLAIMS 7 NON-COMMERCIAL LOSSES 8 COMPENSATION RECEIPTS AND PAYMENTS 9 TAXATION PLANNING 10 APPENDIX A BASIC JOINT VENTURE AGREEMENT

IMPORTANT NOTE

For copyright and disclaimer, see the end of this document.


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Chapter 1 Introduction 101 Introduction.............................................................................................................. 3 102 Interaction between CGT and income tax................................................................ 3 101 Introduction Since the 2002 Federal Budget, the Federal Government has directed a change in focus of the Australian Taxation Office (ATO) from implementation of The New Tax System to traditional audit and enforcement activities. The Federal Budget allocated an extra $2.25 billion funding and 2,200 extra staff, with the target of a projected additional $1.5 billion revenue through improved compliance over the next four years. This substantial financial commitment has been heeded by the ATO and once again numerous taxpayers are being aggressively audited. The ATO has already announced that the undisclosed income of individuals, and in particular undisclosed capital gains, will be an audit target in 2002/2003. Specific areas have been flagged including:

! BAS compliance;

! compliance with depreciation and prepayment rules;

! Division 7A compliance; and

! GST audits. These developments have given the ATO the mandate and resources to deal aggressively with the widespread non-compliance with income tax and GST. More than ever, it is a crucial time for tax professionals to be proactive and take steps to ensure that their clients comply with the law, or face the consequences of an ATO tax audit, investigation or enquiry. All section references are to the Income Tax Assessment Act 1997 (ITAA 97), unless otherwise stated. 102 Interaction between CGT and income tax When dealing with the development and sale of real property, aside from GST issues, five possible tax consequences must be considered. One or more of the following tax outcomes could apply to the sale:

If the transaction constitutes a business venture the profit will be ordinary income and assessable under sec 6-5.

(1) Section 15-15 will assess the net profit arising out of a profit-making undertaking or plan as income, except where the taxpayer acquired the property post-CGT.


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(2) Alternatively, sec 25A Income Tax Assessment Act 1936 (ITAA 36) will assess the net profit from the transaction as income if the taxpayer acquired the property pre-CGT for the purpose of profit-making by sale.

(3) The sale proceeds may be capital in nature as they flow from the mere realisation of an asset, therefore the CGT provisions in Division 104 will apply if the taxpayer acquired the property post-CGT.

(4) The sale proceeds may be capital in nature, but the property was acquired pre-CGT and is, therefore, tax free.

Normally where profit made from a sale is made in the ordinary course of the taxpayers business, the land will be treated as trading stock. If the trading stock provisions apply, then the gross proceeds from the sale would be included in the taxpayers assessable income under sec 6-5 and all expenses relating to the development would be deductible under sec 8-1. Where a transaction is not part of a taxpayers ordinary business activities, yet a profit is made on the isolated transaction, the amount is treated as ordinary income, not capital. This will be the case where it is established that the taxpayers intention to enter into that transaction was to make a profit. In this event the land is not treated as trading stock and only the net profit from the sale is included in the gross income of the taxpayer. The third possible tax treatment is that the sale will be treated as a capital gain. Therefore a crucial threshold issue is to determine whether the developer is carrying on a business of land development, undertaking a one-off profit-making scheme or merely realising a property on capital account.


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Chapter 2 Conducting a business 201 Introduction............................................................................................................... 5 202 When will land be trading stock?.............................................................................. 5 203 Land becoming trading stock .................................................................................... 7 204 Valuing land as trading stock.................................................................................... 8 205 Multistage developments ........................................................................................ 15 201 Introduction Section 995-1 defines a business as including any profession, trade, employment, vocation or calling, but not occupation as an employee. This definition is of little assistance and practitioners have had to refer to complex and often inconsistent case law for guidance. The courts are of the general opinion that whether a business is in existence or not is a question of fact and degree. Cases such as Evans v Federal Commissioner of Taxation 89 ATC 4540 and Ericksen v Last (1881) 8 QB 414 clearly state that each case depends upon its own facts and that there is no definitive principle of law which entails what constitutes a business. Before 1982, isolated or one-off transactions were likely to be characterised as involving the mere realisation of a capital asset so that it may be sold at the best price and therefore yielding non-assessable capital profits (after all, the CGT provisions were not in existence!). Pre-1982 it was highly unlikely that an isolated or one-off transaction would be caught as ordinary income. However, identifying whether or not a business exists became even more complicated following a spate of High Court decisions after 1982. These decisions held that a profit arising from an isolated transaction is assessable as ordinary income where the taxpayer acquired property with the intention to later realise it at a profit. These issues are discussed further at 301). 202 When will land be trading stock? Land will constitute trading stock under sec 70-10 when it is held for the purpose of sale or exchange in the taxpayers ordinary course of business. Thus, taxpayers not carrying on a business will not hold property as trading stock. The High Court upheld this view in the case of Federal Commissioner of Taxation v St Huberts Island Pty Ltd 78 ATC 4104 (St Huberts). In this case it was held that land would constitute trading stock when it has been acquired for the purpose of resale, including land that is purchased for the purpose of subdivision, development and resale. Where land is considered to be trading stock, the gross sale proceeds of the property are assessable under sec 6-5. CGT provisions do not apply to land held as trading stock. Pursuant to sec 118-25(1) any capital gain or loss made from a CGT asset will be disregarded if the asset is trading stock at the time it is sold.


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In TD 92/124, the Commissioner found that land will be trading stock where:

it is acquired for the purpose of resale; and

a business activity which involves dealing in land has commenced. Note that both elements must be present before the land will be treated as trading stock. The taxpayer need not be carrying on a business of land development before the land in question is purchased. However, the mere purchase of the land itself may be seen by the Commissioner as the commencement of the business of land development. Further, where the taxpayer has undertaken feasibility studies and made enquiries prior to the acquisition of the land, it may be concluded that the business commenced prior to the acquisition. The courts have found that even if land substantially changes between the time it is acquired and the time it is sold, it may still be trading stock. The analogy that may be applied is the conversion of raw materials in a manufacturing business into the final product. In a property development context, where land is subdivided and houses are built in individual allotments, then both the broadacres and the subdivided land may still be considered trading stock. In respect of a subdivision and sale, the Supreme Court of New South Wales held in Barina Corporation v FCT 85 ATC 4847, that individual allotments are only trading stock once they are in a marketable state, that is, once separate titles have been issued. Until this occurs, the land as a whole will be considered trading stock, not the individual allotments. Practice note The Full Federal Court in Gasparin v FCT 94 ATC 4280 (Gasparin) has confirmed that where land is trading stock the proceeds from the sale of the property are generally derived at settlement, not when the contract is entered into. All expenses are subject to the normal rules of deductibility in that they can be claimed in the year in which the expense is incurred.

Land in one-off developments The purchase, subdivision, development and sale of land can still be considered trading stock even if it is part of a one-off development. As stated by the ATO in TD 92/124, it is not necessary that the acquisition of land be repetitive in order to evidence a business. For land to be trading stock, the key element is that the taxpayer has commenced a business of land development. That is, has the taxpayer embarked on a definite and continuous cycle of operations designed to lead to the sale of the land so that it constitutes a business? If so, the land will be treated as trading stock. The land itself does not have to be purchased for this purpose. It may become trading stock where the business of land development commences some years after the purchase.

Case study Alexis Alexis purchases 40 acres of land with the intention of subdividing it into 140 lots for sale. The development requires her to build footpaths, kerbing, parks and roads, etc. She is also required by the council to ensure that each lot is connected to power, water and sewerage.


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Although Alexis contracts professionals to undertake the various stages of work, she has substantial involvement in the subdivision, development and sale of the lots.

Alexis has no history in property development, and this is the only development she intends to undertake. Even if she does not undertake any other developments again, the land will be trading stock as the size, scale and nature of the development is such that she is carrying on a business. Alexis has embarked on a definite and continuous cycle of operations designed to lead to the sale of the land so that it constitutes a business and the land will be treated as trading stock.

Smaller developments will prove more difficult to categorise the question is whether the activities are of such a scale, are repetitious in nature, etc, so as to constitute the carrying on of a business. Alternatively, the activities may be commercial and business-like in character so that the profits are assessable following principles derived from Federal Commissioner of Taxation v Myer Emporium Ltd 87 ATC 4363 (Myer Emporium) (see 303). Positive factors that indicate a taxpayer undertaking a one-off development is carrying on a business include:

activities being conducted in an organised and business-like way;

commerciality of the manner in which the development is managed;

greater repetition and more regularity of the acts undertaken; and

a large scale of activities. (For a more detailed explanation of one-off transactions see 301.) 203 Land becoming trading stock

The previous requirement that an item had to be originally acquired as trading stock to be treated as trading stock was removed from the ITAA 97. Under the old definition, land could not become trading stock where it was not acquired as such. However, the new definition only requires that the item be held for the purposes of manufacture, sale or exchange in the ordinary course of business. Therefore, land not originally acquired as trading stock can be treated as such where it is later used in the ordinary course of the taxpayers business. Ordinary course of business

Before land will be considered trading stock, it must be held for sale in the ordinary course of business. A cattle farmer holding land, carrying on the business of cattle grazing will not meet this requirement. Not only is the farmer not in the business of dealing with land, but he also does not meet the further requirement of the trading stock provisions that the land must be held for the purpose of sale or exchange. The taxpayer must be carrying on a business of subdividing and selling land before it will be considered that they are holding the land as trading stock. It is important to remember that, in certain circumstances, undertaking a one-off development may be sufficient to characterise land as trading stock (see 301). Valuation of land that later becomes trading stock Where a taxpayer converts land that was not originally acquired as trading stock into trading stock, they will be deemed under sec 70-30 to have:


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sold the land for its market value or cost (the taxpayer may elect which value to use); and

immediately reacquired the land for the same amount. Market value is to be determined having regard to the highest and best use, as referred to by the Commissioner in TD 97/1. This comment reflects that in devising the market value it is appropriate to take into account the lands potential usages and the probability of council approval for any potential use. Cost is the value that the land would have been calculated at, pursuant to sec 70-45, if acquired as trading stock. The deemed disposal and acquisition of the land may have CGT implications. Pursuant to sec 118-25(2) there will be no CGT consequences if the taxpayer elects to apply the cost of the asset. However, if the taxpayer chooses market value, a capital gain or loss may arise. The applicable CGT provision is sec 104-220 which deems that a CGT event K4 will arise when a CGT asset starts being trading stock. Valuation of land that ceases to be trading stock The development costs attributable to a lot or apartment that the developer intends to keep for personal use will not be deductible and should not be included in the trading stock figure. The reason for this is that the lot or apartment is not being used for the purpose of manufacture, sale or exchange. The costs incurred in developing the lot or apartment are of a private nature and are therefore not deductible under sec 8-1. However, in circumstances where it is not decided until after the development has been completed that the lot or apartment will be retained by the developer, and the land has already been included in trading stock, sec 70-110 will apply. The section provides that where a developer stops holding land as trading stock but retains it for private purposes then the developer is treated as if:

just before it stopped being trading stock, the developer had sold it to someone else at arms length for its cost; and

the developer had immediately bought it back for the same amount. This means the developer is required to bring the current market value of the land to account as income. 204 Valuing land as trading stock The cost of acquiring trading stock is deductible under sec 8-1 as an ordinary revenue expense. Following the initial deduction for the cost of trading stock, there will be a re-inclusion of an amount in income to the extent that the stock remains on hand at the end of the year. In essence, recognition of the cost of trading stock does not take place until there is a disposal of the stock. Thus, where the value of stock on hand at the end of the year exceeds the opening value of stock, the difference is included in assessable income. Where the value of stock on hand at the end of the year is less than the value at the beginning of the year, the difference is an allowable deduction. Thus, for a property developer, the closing value of stock for one income year becomes the opening value for the next year.


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Section 70-45 states that when trading stock is held at year end by a taxpayer, it must be valued at:

cost;

market value; or

replacement cost. In each case it is the value net of GST that is taken into account.

Case study Bryan Bryan bought a working sheep farm in 1980 for $295,000. After having worked the sheep farm for 20 years, he decides that he wants to commence studies in electrical engineering. As a result, he decides to stop farming in order to devote his attention to his studies and to finance his studies. Bryan subdivides and sells the land in a manner such that he is carrying on a business. At the time he commenced the business in November 2000, the market value of the land was $1.8 million.

Under sec 70-30, Bryan is deemed to have sold his farm at cost or market value. He is further deemed to have re-acquired it at that same value, but as trading stock.

Cost price

If Bryan chooses to apply a cost price valuation, he may claim a deduction for $295,000 in the 2000/2001 tax year and then will be required to take the land up as trading stock on hand at year end. When each lot is sold, its sale price will be included in his assessable income. Market value A better choice is for Bryan to choose the market value to apply. As the land was acquired pre-CGT there will be no assessable capital gain to Bryan on the deemed disposal of the farm. He will be deemed to have acquired the land for $1.8 million and, when each lot is sold, the assessable profit will be less than if the deemed cost of the land had been $295,000. Bryan completes the 200-lot subdivision and commences sale of the allotments. Within three years all of the lots are sold except for two. Bryan decides to keep theses lots for himself and his sister. At this point the lots will cease to be trading stock and sec 70-110 will apply. Bryan will be deemed to have sold these lots at cost and reacquired them for the same amount. The cost of each lot will be the appropriate percentage of the $1.8 million (plus any additional costs included using absorption costing). As Bryan will be treated as buying the two remaining lots at the time they ceased to be trading stock, they will be post-CGT assets even though he originally acquired the land pre-CGT. When he eventually sells the lots, the CGT provisions will apply.

Cost price Currently, Federal Commissioner of Taxation v Kurts Development Limited 98 ATC 4877 (Kurts Development) is the leading case on the valuation of land at cost. However, prior to this case, TR 95/D15 was issued by the ATO dealing with the matter.


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TR 95/D15 considered the taxation treatment of expenditure incurred in the conversion of broadacres land into subdivided allotments, with a focus on what expenditure will form part of the cost price of trading stock on hand. The Commissioner withdrew this draft ruling as Kurts Development addressed the major issues in the draft ruling, with much agreed upon between the Commissioner and the Court. However, the draft ruling did discuss some issues that were not covered in Kurts Development. Although taxpayers may clearly not rely upon any of the commentary in the draft ruling, it may give some non-binding indication of how certain circumstances may be treated by the Commissioner. When land is acquired, the land as broadacres is the item of trading stock that should be recorded. However, after the plan of subdivision has been registered and separate titles created for each allotment, this item of trading stock is converted into subdivided allotments, and recorded as such. In agreement with TR 95/D15, Kurts Development indicates that absorption costing is the appropriate method of valuing the land at cost for trading stock purposes. When using absorption costing, all the costs of development that are specifically related to conversion of the land from broadacres into subdivided allotments must be absorbed into the cost price of the land for trading stock purposes. Costs should only be included on a GST-exclusive basis as any input tax credits will be disregarded, pursuant to sec 70-45(1A). Costs that should be included are:

direct labour costs;

infrastructure costs;

material costs including the cost of the land; and

direct production overhead costs such as costs of depreciation of plant and machinery. Indirect overhead costs should NOT be included. Costs which are incurred prior to the commencement of a property development are known as preparatory expenses. These expenses are treated differently for the purposes of income tax, CGT and GST. The expenses are afforded special treatment as in certain circumstances it is considered that they are incurred too far in advance of the property development activity. The following should be noted:

For the purposes of income tax, these preparatory costs are rarely deductible expenses.

These preparatory expenses are usually capitalised and included in the cost price of the land in the calculation of capital gains.

In respect of GST, taxpayers may usually claim input tax credits for preparatory expenses that are incurred for a creditable purpose.

Absorption costing checklist A number of costs commonly occur in property development, and guidance has been given in the form of IT 2350 released by the ATO in 1986. General reference should also be made to Kurts Development. The costs that should not be included in the value of the trading stock


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would usually be deductible under sec 8-1 or another provision in the year in which they are incurred.

Cost Should it be included for absorption

costing purposes?

Accounting fees* No

Compliance with fire brigade orders Yes

Construction engineering survey Yes

Contribution to Telstra for cable laying Yes

Council application fees Yes

Demolition costs Yes

Depreciation on plant and equipment owned and used during construction

Yes

Electricity and other utility services used on-site Yes

Engineering design plan for roadworks, sewerage and water supply, storm water drainage

Yes

Environmental Impact Statement Yes

Erosion and settlement control during construction Yes

External infrastructure costs for example, contributions to council for offsite works such as sewerage and water supply

Yes

General administration expenditure No

Insurance for plant and equipment used during construction Yes

Insurance of building being developed Yes

Interest expenses relating to funding development costs No Interest expenses relating to land acquisition No Internal infrastructure costs for example: stormwater drainage channelling, electricity, roads and kerbing, parks, roads, sewerage, telephone and water supply

Yes

Land Yes Land Titles Office fees Yes Landscaping and tree screen planting Yes Legal fees associated with obtaining a separate title to each lot Yes Legal fees associated with acquiring the land Yes Legal fees associated with the disposal of the land No Legal fees in respect of the project development contracts Yes Marketing, advertising and selling expenses No Motor vehicle expenses* No Non-refundable electricity deposit Yes Office expenses* No Pegging and final survey plans Yes Printing and stationery* No Professional fees such as architects, draftsmen, surveyors and engineers

Yes


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Rates and land tax No Reticulation of electricity supply Yes Salary and wages of construction employees including payroll tax, SGC and WorkCover

Yes

Salary and wages of directors* No Salary and wages of general office employees No Site clearance Yes Soil testing Yes Stamp duty on the acquisition of the land Yes Taxation advice No Telephone expenses* No Travelling expenses* No *These costs will form part of the cost price of the trading stock where they are directly attributable to and identified with the specific property development project. Cost price and interest on borrowed funds Interest on borrowed funds will not form part of the cost price of the trading stock as determined in TD 92/132. However, interest will be deductible under sec 8-1 as the cost is incurred in carrying on the business of land development. A scenario that developers often face is where, after land has been acquired, unexpected problems delay the actual development works. A common example is the delays in obtaining planning approval for inner city projects because of residents objections. Where the land is acquired as trading stock by a taxpayer carrying on a business of land development, the interest should be deductible under the second limb of sec 8-1. That is, the expense is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Although a considerable amount of time may pass before the allotments are sold, the relevant nexus still exists. This view is supported by the findings of the High Court in Federal Commissioner of Taxation v Steele 99 ATC 4242 (Steele) and the Commissioner in TR 2000/17. A number of tests are set out in TR 2000/17 that indicate when interest is incurred in the gaining or producing of assessable income. The following circumstances are required:

continuing efforts are undertaken in pursuit of the gaining or producing of assessable income;

the interest expense is incurred with one end in view the gaining or producing of assessable income;

the interest expense is not incurred too soon, is not preliminary to the income earning activities and is not a prelude to those activities;

the interest is not private or domestic; and

the period of interest outgoings prior to the derivation of relevant assessable income is not so long (taking into account the kind of income-earning activities involved) that the necessary connection between outgoing and assessable income is lost.

Practice note It should be noted that interest incurred in respect of one-off developments may still be immediately deductible based on TR 2000/17 and the High Courts findings in Steele.


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Interest after the business ceases

It may often be the case that by the time the last allotment in a property development has been sold, the business of land development by the taxpayer relating to the allotment has already ceased. If a taxpayer attempts to claim interest in relation to a development after the business ceases, the ATO may challenge this deduction. Fortunately, the recent case of Federal Commissioner of Taxation v Brown 99 ATC 4600 (Brown), indicates that this interest should still be deductible. The interest will be deductible as the relevant occasion of the outgoing is to be found in the original transaction of the original loan and purchase of trading stock. This transaction would have been entered into in the carrying on of the business for the purpose of producing assessable income. However, it should be noted that the Federal Court indicated that if the financing arrangement had been a facility that rolls over from time to time (for example, a bill facility), the case would have been treated differently. The Court indicated that the relevant occasion of the outgoing would have been the election to roll over the loan on each payment date, not the original loan agreement establishing the terms of the roll over facility, which may have led to a different finding. Furthermore, the Federal Court indicated that it was significant that the taxpayers did not have any other available assets of the business to discharge the loan, even after the business ceased. This suggests that post-cessation interest may not be deductible if assets are retained after the cessation of a business, rather than being sold and applied towards reducing the outstanding loan. Where the loan is refinanced, the Federal Courts findings in Brown indicate there may be a breakdown in the required nexus. However, Dowsett J of the Federal Court found in Federal Commissioner of Taxation v Jones 2001 ATC 4607 that refinancing did not break the relevant nexus in the circumstances of that case. This position was wholeheartedly affirmed by the Full Federal Court on 8 March 2002 when the appeal lodged by the Commissioner was dismissed. Practitioners should be aware that the Commissioners approach in TR 2000/17 is not totally consistent with Brown. This ruling indicates that interest incurred after a business ceases will only be wholly deductible where: the funds were borrowed for an income-earning purpose and not used for any other

purpose; and the taxpayer has no legal entitlement to repay the principal and as a result is saddled with

an unavoidable stream of interest outgoings. External and internal infrastructure costs

Internal infrastructure costs

When land is acquired by a property developer for subdivision and development, a number of works will need to be carried out in order to obtain council approval for subdivision. The costs of these works are known as internal infrastructure costs. The developer will be required to bear the cost of these works, and then transfer title of these items to the local council. Therefore, it is important for developers to be able to claim such items, or to include them in the trading stock valuation of the land.


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Internal infrastructure costs are incurred in the provision of: drainage; electricity; parks; roads; sewerage; and telephones. It is clear that the cost of the portion of land and the costs of providing these services and facilities are deductible under sec 8-1 as they are incurred in the carrying on of the property developers business. The treatment of internal infrastructure costs was considered in Kurts Development. The Full Federal Court was of the opinion that the cost of infrastructure land and internal infrastructure costs should be included at two different points in time: first, in the cost of the land as trading stock when it is broadacres; and secondly, when the trading stock converts from broadacres land to subdivided lots. In Kurts Development, Emmett J stated:

Once it is accepted that the Infrastructure Land is never at any state a separate article of trading stock, the issue concerning Infrastructure Costs is resolved quite simply. The Taxpayers business involves converting one form of trading stock into a different form of trading stock. One cost of so doing is the Infrastructure Costs, another cost is the cost of the Infrastructure Land. Those costs are, therefore, property to be characterised as part of a cost price of the resultant individual lots. Once the Taxpayer has exercised the option of valuing trading stock for the purposes of section 31(1) of the Act [now sec 70-45], those costs are part of the value of an individual subdivided lot for the purpose of section 28 of the Act [now sec 70-35].

This case is authority for the fact that internal infrastructure costs should not be valued separately as an article of trading stock at the end of a tax year. The internal infrastructure costs and cost of infrastructure land should be apportioned appropriately between the subdivided allotments, to be included in the cost of the land. This is the case even when it means part of the infrastructure costs will be allocated to land that will be vested in the council. External infrastructure costs External infrastructure costs refer to payments that are made to local councils and other authorities for works which are physically external to the land of the developer. These payments are generally a condition of being granted approval from the local council for subdivision. Examples include the following: work undertaken by the taxpayer to upgrade roads, sewerage and water mains, etc, which

are adjacent to, as opposed to on, the taxpayers land; and


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financial contributions made by the taxpayer to local councils and other authorities towards the upgrading of these external services and facilities in the future.

Once again, the leading case is Kurts Development. The Full Federal Court was of the opinion that as these costs had to be incurred as a condition of subdivision approval from the local council, they are to be regarded as a cost of development and should be included in the cost of the trading stock on hand at the end of each tax year. As with internal infrastructure costs, all external infrastructure costs are to be apportioned among the subdivided allotments on a cost basis. 205 Multistage developments Completion of a multistage development raises the issue of how and when to bring the income and land to account. Whether the land is developed in stages or all at once, it will still be trading stock as consistently indicated by the High Court in St Huberts and Kurts Development. The ATO has taken the position that each stage of development should be treated as a separate project and that the accounts of each stage should be closed off as it is completed. However, it seems that where large headwork costs are incurred in the early phases of a multistage development, any part of these costs that will be of benefit to the whole development should be apportioned to the later stages that will receive the benefits. This apportionment will usually be based upon engineering estimates of the proportion of each cost that benefits each stage of development. Types of costs that would benefit the development as a whole include:

construction of a reservoir to service the whole project;

construction of oversized sewers and water mains for the whole project;

contributions to municipal authorities for the upgrading of an access road; or

downstream drainage in order to take stormwater run-off from the whole project to a lawful point of discharge.

Unfortunately for developers this position can significantly delay the recognition of a deduction for the expense. This can create a significant cash flow problem for the developer, particularly if later stages of a multistage development will not be undertaken for many years, as is often the case.

Case study Leigh Leigh, a property developer, plans to subdivide and develop eight hectares of land into residential allotments in four stages. Stormwater drainage for the whole project is necessarily incurred during the development of stage one and costs Leigh $2 million.

Leigh can claim a deduction for the cost of installing the drainage as an external infrastructure cost but he must allocate the cost across the whole eight hectares. This expenditure is incurred immediately; however, Leigh can only claim a deduction for one-quarter of the drainage costs in stage 1, even though it may be some years before the other stages are completed.


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Costs must be allocated across each lot on a reasonable basis. The Commissioner accepts that one of the following methods would usually be reasonable:

anticipated selling price;

metre frontage costs are allocated to the blocks in the proportion the metre frontage of each block has to the total metre frontage of the development;

number of lots costs are allocated in proportion to the number of lots being developed; or

area costs are allocated on the basis of the total saleable area and development.


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Chapter 3 Profit-making scheme or capital gain? 301 Introduction............................................................................................................... 17 302 FCT v Whitfords Beach Pty Ltd 82 ATC 4031 (Whitfords Beach) ...................... 17 303 FCTv Myer Emporium 87 ATC 4363 (Myer Emporium)..................................... 18 304 Stevenson v FCT 91 ATC 4476 (Stevenson) ........................................................ 19 305 Casimaty v FCT 97 ATC 5135 (Casimaty) ........................................................... 19 306 McCorkell v FCT 39 ATR 1112 (McCorkell)....................................................... 19 307 Checklist of relevant factors...................................................................................... 20 308 Calculation of assessable income for a profit-making scheme ................................. 22 309 Calculation of capital gain ........................................................................................ 25 310 When is the income/capital gain derived?................................................................. 27 301 Introduction The following cases highlight the practical difficulty with properly characterising a transaction as being that of conducting a business, a profit-making scheme or a capital gain. When determining questions of this nature it is essential that the practitioner carefully reviews their clients situation in the context of its own facts. 302 FCT v Whitfords Beach Pty Ltd 82 ATC 4031 (Whitfords Beach) This 1982 case was a landmark decision because it expanded the scope for receipts from isolated and one-off transactions to be treated as ordinary income and limited the instances where the mere realisation of an asset was accepted. In this case the taxpayer company (Whitfords) purchased 1,584 acres of land in 1954 so that the shareholders who were fishermen could access fishing shacks on a beach. In 1967, three development companies acquired the land for subdivision and sale at a profit. An outright purchase of the land by the developers and subsequent subdivision and sale at a profit would clearly have been assessable under sec 25A(1) ITAA 36. To avoid being assessable under the ordinary income provisions, the developers decided instead to buy shares in Whitfords and then, once in control of the company, have it subdivided and sell the land. They believed that in Whitfords hands such a subdivision would be seen as a mere realisation of an asset as the land was not bought for a profit-making purpose by the fishermen. The company subsequently embarked on a large scale re-zoning and development of the land. The subdivided land was eventually sold at a significant profit. The majority of the High Court held that the profit was assessable under sec 25A(1) ITAA 36. Gibbs CJ held that once the developers took over Whitfords, the company transformed from one which held land for the domestic purposes of its shareholders to one that was purely driven to engage in a commercial venture to make a profit. In his view it was this transformation that turned the development from a mere realisation to an assessable transaction. Mason and Wilson JJ went so far as to indicate that the previous landmark case, Scottish Australia Mining Co Ltd v Federal Commissioner of Taxation (1950) 9 ATD 135 (Scottish Mining), may have been wrongly decided.


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In the case of Scottish Mining the taxpayer, after giving up its mining business, devoted itself to the subdivision of its land. This entailed, amongst other things, the construction of roads and the building of a railway station. It was held that the company, by engaging in the subdivision and other activities, had merely taken the necessary steps to realise the asset in the most profitable way and therefore the amounts were not assessable. In Whitfords Beach Mason J acknowledged the change in the companys ownership but also observed that the activity of the taxpayer went further than a mere realisation of an asset:

That 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 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 mere realisation of an asset

303 FCTv Myer Emporium 87 ATC 4363 (Myer Emporium) In this case the taxpayer, as part of its plan to diversify, lent $80 million to one of its subsidiaries at a commercial rate. Only a few days later, the taxpayer assigned its right to receive interest under the loan to another company for a lump sum of $45 million. The High Court held that even though this was an isolated transaction, the $45 million received was part of a profit-making scheme and was therefore treated as ordinary income, not capital. It was held that a profit from an isolated transaction will be assessable as ordinary income if:

there is a profit-making intention on the part of the taxpayer when entering into the transaction; and

the transaction was entered into, in the course of carrying on a business, or in carrying out a business operation or commercial transaction.

Therefore, profits from an isolated transaction will be treated as assessable income where a profit-making intention exists at the time the transaction is entered into. In TR 92/3 the Commissioner takes the view that it is not necessary that the profit-making be the sole or dominant intention of the taxpayer, it need only be a significant purpose. Furthermore, the ruling states that the taxpayer must have the profit-making motive when entering into the transaction. However, in contrast to Myer Emporium, the Commissioner states that if a transaction or operation involves property, it is usually, but not always, necessary that the taxpayer has the purpose of profit making at the time of acquiring the property. Some factors to take into account when determining whether an isolated transaction amounts to a business operation are:

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

the amount of money involved in the transaction;

the nature of the entity undertaking the transaction;

the nature, scale and complexity of the transaction;


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the timing involved in the transaction;

the type of activities usually run by the entity; and

whether there is any connection between the relevant taxpayer and any other party to the transaction.

304 Stevenson v FCT 91 ATC 4476 (Stevenson) In this 1991 case the taxpayer had decided to scale back his farming activities and sell most of the property. After his efforts to find a purchaser for his land at the requested price failed, he commenced the subdivision himself. He obtained finance and engaged in extensive activities to redevelop the lots. The taxpayer personally dealt with the councils and engineers and advertised the sale himself, bypassing the services of a real estate agent. The taxpayer ultimately subdivided 220 blocks and sold 180. Jenkinson J of the Federal Court held that the taxpayer was carrying on a business of subdividing, developing and selling land. Profits made on land sales were correctly assessed as ordinary income under sec 25(1) ITAA 36 (now sec 6-5). Jenkinson J agreed with the view expressed by Mason J in Whitfords Beach that the magnitude and scale of the development was a relevant indicator as was the degree of personal involvement of the taxpayer in carrying out the subdivision. 305 Casimaty v FCT 97 ATC 5135 (Casimaty) The taxpayer in Casimaty was given his fathers farm to continue primary production activities. Around 15 years later, he had not succeeded in making a living out of the farm and had accumulated a considerable amount of debt. At this time his health was deteriorating. From 1975 to 1995 the taxpayer slowly disposed of separate subdivisions of the property. He completed minor work such as developing water connections, entrances and fencing. All the while he continued to farm as much as possible, taking into account his poor health. He did not personally deal with any of the sales and delegated all necessary work to the relevant professionals. The Commissioner assessed the profits under sec 25(1) ITAA 36 as income from a business activity. However, Ryan J of the Federal Court held that the amounts were the result of a mere realisation of part of the farmers property. The Court noted that there was no profit-making motive or business-like methodology, the subdivision was completed in a disjointed manner in response to the taxpayers poor health and increasing debt, there was no plan in place to effect the subdivision and sale and that, right up to the end, a considerable portion of the property had still not been subdivided. 306 McCorkell v FCT 39 ATR 1112 (McCorkell) The taxpayer in this 1998 case inherited an orchard from his father which he continued to operate. Twenty years later the taxpayer decided to retire and sell the land as he did not have anyone who could take over the orchard. In this instance the taxpayer decided to subdivide and sell the property. All necessary works were undertaken by qualified professionals with the taxpayer having little involvement in the development. The taxpayer did not have a site office.


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Again the Commissioner assessed the profits from the sale of the subdivision under sec 25(1) ITAA 36. However, the Administrative Appeals Tribunal held that the taxpayer did not carry on the business of subdividing and selling land due to the lack of involvement in the development by the taxpayer. Therefore the profit realised upon sale was a capital gain because the taxpayer had merely attempted to realise the property in the most advantageous manner considering he could no longer operate it as an orchard. 307 Checklist of relevant factors These cases and the discussion at 201 can be summarised into the following checklist of factors that should be taken into account when characterising whether a transaction amounts to a business operation, a profit-making scheme or the mere realisation of a capital asset. The checklist also includes tax planning tips.

# Amount of actual work completed in developing the land

In order to be taxed as a mere realisation of land in an enterprising manner the land should only be developed to the minimum required by the council in respect of a subdivision. Limited earth works and clearing may indicate a transaction on capital account. Additional development such as building extensive roads, houses and creating parks will often indicate a business venture.

# Amount of borrowing to finance the development

The greater the level of borrowings required to finance the development, the more likely that the development will be considered a business venture.

# Any attempt to sell the land as broad acres before subdivision

An unsuccessful attempt to sell the land without subdivision and development will indicate that the development was not driven by a profit motive and should therefore be considered a capital transaction.

# Taxpayers previous history in relation to property development

If the taxpayer (or the principals behind a special purpose entity) has a history of land development, this points towards a business venture being undertaken.

# Bookkeeping and recording of transactions

Courts will look to see if the taxpayer is carrying on their activities in a business-like manner. This will often involve organising trading activities as efficiently as possible in order to maximise profit. For example, if someone is employed to keep books of account, the transactions are recorded on a revenue account or interest on money borrowed to finance the subdivision is claimed as a tax deduction, this will indicate a business venture.

# How were the lots released onto the market?

The calculated release of lots onto the market, so as not to create a glut in the market at any one time, will indicate a business venture.

# Involvement of taxpayer in actual sale of lots

If the taxpayer is actively involved in the marketing and sale of the property, this will indicate a business venture.


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# Magnitude of the development

The greater the size of the land and the number of lots created, the more likely it will be considered that the development is a business venture.

# Manner in which lots are sold

If the subdivided lots are listed with multiple real estate agents as part of a planned, concerted advertising campaign, this will indicate a business venture. However, if the lots are simply sold by listing them with a local real estate agent who is given a modest marketing budget this might indicate a capital transaction.

# Nature of the entity undertaking the development

If the taxpayer is a company with substantial assets, this may indicate the development is a business venture, particularly if the taxpayer was specifically established to undertake the development. Similarly, creating a joint venture is indicative of embarking on a business venture.

# Number of contractors engaged by the taxpayer

The more contractors that are engaged, the more likely the project will be considered a business venture. If one person, such as a shire engineer assumes control of the project using a handful of subcontractors this will indicate that any gains should be considered as capital.

# Number of stages in the development

Staged developments will indicate a business venture, thus the number of stages should be kept to a minimum.

# Overall nature, scale and complexity of the development

The larger and more complex the development, the more likely it is that it will be considered a business venture. In Stevenson it was held that in the context of the subdivision and sale of land, the magnitude of a substantial subdivisional enterprise does commonly entail such a degree of systematic organisation, planning management and repetition of a purposeful profit-making activity that the carrying on of a business may be more clearly discerned.

# Profitability and a profit motive

A profit motive is often seen as an indicator that a business is in existence. However, a lack of profit does not necessarily indicate that there is no business. Furthermore, it appears Australian courts have taken the view that a taxpayer may be carrying on a business even where there is no likelihood of profits being made (see Ferguson v Federal Commissioner of Taxation 79 ATC 4261).

# Purpose for which the taxpayer originally acquired the land

If the land was acquired for the purpose of, say, farming or another non-sale related purpose this will indicate capital. This includes purchasing the land as a rental property. If one of the purposes was to subdivide and sell, then the profits are likely to be assessable as ordinary income.


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# Reason for sale of the land

A non-profit-making reason will indicate capital; however, if the motive is to make a profit on the sale then this will indicate income. Non-profit-making reasons may include retirement or requiring money to purchase new farming equipment or repay debts, or changed circumstances have made it too expensive to retain ownership of the undeveloped land.

# Site offices or other building erected on the land

A site office or other building erected on the land will indicate a business venture.

# Subsequent land developments by the taxpayer

The Commissioner has the benefit of hindsight and if the taxpayer undertakes any other similar types of land development activities, subsequent to the development in question, it will indicate that the development under consideration was a business venture. However, subsequent development merely to the extent of additional subdivision of the same land will not be a decisive factor.

# The taxpayers involvement in the actual development

The greater the involvement of the taxpayer in the actual development, the more likely it is to be considered a business venture. For example, if a taxpayer takes time off from their usual occupation to undertake the project this will indicate a business venture. If subcontractors carry out the works with minimal supervision this will indicate it is not a business venture.

# The occupation of the taxpayer

If the taxpayers occupation has some connection with land development, such as a real estate agent or builder, then this will indicate a business venture.

# Whole business organisation of the taxpayer

If there is any administrative structure, such as a manager, an office, a secretary or letterhead, this will indicate the presence of a business venture.

308 Calculation of assessable income for a profit-making scheme In relation to a subdivision, it is the net profit made on each lot that is included in the taxpayers assessable income for the year in which the lot was sold. The following items may be included in determining the net profit per lot from an isolated transaction: 1. The cost of the land This amount is assessed as being the market value of land at the time it was committed to or ventured into the relevant business.

In Whitfords Beach the taxpayer attempted to argue that the value of the land should be taken as at June 1969 when the land was actually rezoned and so only at that point subdivision really became possible.

However, the Federal Court disagreed and held the relevant date to be December 1967 as that was when the intention to take steps to develop and subdivide in relation to the land occurred


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and activities directed to that end began. The Court also stated that to determine such a question, it is necessary to look at not only the taxpayers purposes but also to its activities.

It therefore appears that each case must be considered in isolation and both the intention and activities undertaken by the taxpayer need to be taken into consideration. Market value Once the relevant date has been decided in relation to the development, it is then necessary to determine the market value of the property at that date. The widely accepted meaning of market value is the price that a willing but not anxious buyer would have to pay to a willing but not anxious seller for the item. A detailed analysis of the concept is found in the cases of Spencer v The Commonwealth (1907) 5 CLR 418 and Abrahams v Federal Commissioner of Taxation (1944) 70 CLR 23. The Commissioner outlines his view in relation to determining market value in TD 97/1 and expands the concept by introducing the highest and best principle. That is, market value should also be determined in relation to the highest and best use that can be made of the land. For example, if the local council has indicated that rezoning of the land is intended in the near future, this must be taken into account and would most likely lead to an increase in market value. IT 2378 states that a market must always exist, as it is accepted that where one does not exist then one needs to be assumed. 2. Development costs The following development costs may be taken into account when determining net profit:

advertising;

any engineering fees in relation to design of any works;

construction labour;

costs associated with any construction labour;

costs associated with getting approval for the subdivision;

legal fees;

legal work;

levy for any statutory authorities, for example local council fees;

site clearing;

soil and water conservation works; and

surveyor fees. Other costs necessarily incurred in developing the land should also be taken into account when determining net profit, such as:

accounting fees;


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interest on borrowings to fund the development;

land tax;

motor vehicle expenses;

printing/stationery;

rates;

salary and wages;

telephone expenses;

travelling expenses. Therefore, where a profit derived from an isolated transaction is considered to be ordinary income, the above items will not be deducted when incurred. Instead, they will be carried forward and used to determine the net profit calculation.

Land treated as trading stock in one-off developments The purchase, subdivision, development and sale of land can still be considered trading stock even if it is part of a one-off development. As stated by the ATO in TD 92/124, it is not necessary that the acquisition of land be repetitive. The Commissioner takes the view that a single acquisition of land for the purpose of development, subdivision and sale by a business commenced for that purpose would lead to the land being treated as trading stock. In order to establish whether a taxpayer who is undertaking a one-off development is actually carrying on a business of land development it is necessary to consider the elements outlined above at 307.

Case study Nick Nick purchased 80 acres of land and intended to make a profit by subdividing the land into 180 lots. He sold his engineering consultancy and has engaged solely in the property development of the land. As there is no infrastructure in connection to the land, Nick is required to undertake a fairly extensive scale of development. This includes the provision of kerbing and channelling, sewerage, footpaths, and the like. He has also set up a site office at the development and has collaborated with various professionals to ensure the development runs smoothly. Although it is Nicks intention to dabble in property development this one time, the land will be treated as trading stock. As outlined in TD 92/124, it is a definite and continuous cycle of operations designed to lead to the sale of the land. This is because a consideration of the size and nature of the operation is such as to indicate that Nick is running a business of property development.

(For a more detailed explanation of the trading stock provisions see 202.)


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Apportionment According to the Commissioner in TR 95/D15, in order to determine the profit to be assessed on each lot it is necessary to apportion the costs across the lots and then the net profit on the sale is included in the assessable income in the year in which the lot is sold. The costs should be apportioned to the individual lots on the basis that will give the most reasonable determination of the profit associated with each lot. Therefore, where a developer can ascertain a cost to a particular lot, then the cost should be allocated directly to that lot. The Commissioner is generally flexible in regard to the method used to apportion costs as long as it is reasonable and appropriate in the circumstances. The following methods may be used in apportioning costs:

anticipated selling price;

metre frontage costs are allocated to the blocks in the proportion the metre frontage of each block has to the total metre frontage of the development;

number of lots costs are allocated in proportion to the number of lots being developed; or

area costs are allocated on the basis of the total saleable area and development. In TR 95/D15 the Commissioner states that the number of lots method is the one least likely to represent an accurate allocation of the costs and is the one least likely to be accepted by the ATO. Alternatively, the anticipated selling price method is considered to be the most appropriate where specific identification is not possible.

Case study Amanda Amanda conducts a subdivision of 25 lots at a cost of $250,000, including the cost of the land. It is anticipated that 10 lots will sell for $30,000 each, the other 10 will sell for $20,000 each as they are much smaller in size. She elects to use the anticipated selling price method as this is the most acceptable to the Commissioner. The total sale proceeds expected are $500,000. Of this amount, $300,000, or 6/10, is expected to be derived from the larger blocks. Therefore, 6/10 of the costs, being $150,000, should be apportioned to the larger lots. The costs apportioned to each of these lots by Amanda will be $15,000. The 10 smaller lots are only expected to derive $200,000, or 4/10, of the total sale proceeds. Therefore, Amanda should apportion 4/10 of the costs, being $100,000, to the smaller lots. The costs apportioned to the smaller lots will be $10,000.

309 Calculation of capital gain Profits derived from a one-off development where it is considered that the sale was not made for a profit-making purpose or in the ordinary course of the taxpayers business, will be assessed as a capital gain. In this instance there is a mere realisation of an asset in an enterprising way. Tax will be payable on the sale proceeds under the CGT provisions of the Act and sec 6-5 will not apply. A one-off transaction that is considered to be a business venture will require all proceeds from the sale to be treated as income under sec 6-5. However, the CGT provisions will ALSO apply to the sale. In this instance, if the capital gain exceeds the amount of net profit only


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the excess will be assessable as a capital gain. In the alternative, if the capital gain is equal to or less than the net profit, then there will be a nil capital gain (see sec 118-20). Pre-CGT land subdivided after 19 September 1985 It is important to consider sec 108-70 when looking at the tax implications of land owned before the introduction of CGT, yet subdivided after the introduction of CGT. Basically, any capital improvements made to the land after the introduction of CGT will be treated as a separate CGT asset if the cost base of the improvement is:

more than 5% of the capital proceeds from the sale of the property; and

more than the improvement threshold for the income year in which the sale of the land took place.

The improvement threshold for the year ended 30 June 2003 is $101,239. The threshold is indexed and published annually.

Year of income

ended 30 June

Threshold

$

Year of income

ended 30 June

Threshold

$

Year of income

ended 30 June

Threshold

$

1986 50,000 1992 78,160 1998 89,992

1987 53,950 1993 80,036 1999 89,992

1988 58,859 1994 80,756 2000 91,072

1989 63,450 1995 82,290 2001 92,802

1990 68,018 1996 84,347 2002 97,721

1991 73,459 1997 88,227 2003 101,239 If the above conditions are met, the capital improvements to the land are treated as a separate asset and are subject to CGT. The capital proceeds from the sale of the development must be apportioned between the original asset and the improvements. It is important to note that capital improvements may include intangible improvements as was indicated by the Commissioner in TD 5. More specifically the determination states that a Councils approval to rezone and subdivide land will be regarded as a capital improvement and may be subject to CGT. However, the determination does not assist in explaining how practitioners can value this type of improvement for the purposes of determining a CGT liability. It is advisable to have an independent valuer make the apportionment. It is only required that the apportionment be reasonable under sec 116-40(1). Therefore, assuming the expert valuer uses appropriate and recognised methods, the Commissioner will not have effective grounds to challenge the apportionment. See 402 for further discussion of capital improvements. Post-CGT land To the extent that land acquired after the introduction of the CGT provisions does not fall within trading stock, the sale of the development will attract CGT. The land and any improvements will be treated as a single asset for the purposes of the CGT provisions.


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The disposal of a subdivided block is treated as the disposal of an asset in its own right, and not as a disposal of part of an asset. This is the view taken in TD 97/3 where the ATO states that the act of registering separate new titles results in the division of the original land parcel into two or more assets. The subdivided blocks are then treated as separate assets for CGT purposes; however, the simple act of creating separate titles is not a CGT event. Indexation of any development expenditure only occurs from the date it is incurred, not from the date the land was acquired. Practice note It is important to remember that indexation is frozen for any assets acquired after 21 September 1999. The cost base of an asset cannot be indexed past this date.

310 When is the income/capital gain derived? The net profit on each lot will be assessable to the taxpayer in the year in which each lot is sold. Pursuant to Gasparin, for income tax purposes this is the year in which the contract is settled, not the year in which it is made. In Gasparin, blocks of land ceased to be trading stock of a developer on settlement of the contracts of sale and not when the contracts became unconditional. The case was authority for the view that net profits are assessable in the year in which the contract for the sale of land is settled, not the year in which it is made. However, in respect of the CGT provisions (sec 104-10(3)), where an asset is disposed of under a contract, for example the sale of land, the time of disposal is the date the contract is entered into. Therefore, subject to Part IVA considerations, it is possible for taxpayers to defer their tax liability by agreeing on settlement terms that would push the settlement into the next financial year. This is particularly suitable for land sold in the months close to the end of the financial year. Practice note Taxpayers who subdivide and develop their land may defer part of their tax bill by agreeing to settlement after 1 July. This should certainly be possible where lots are sold towards the end of the financial year; that is, April onwards.

Case study Melissa Melissa finally subdivides and sells 50 lots of her land. In April 2002 Melissa sold her last five blocks. The lots were sold on specific terms agreed upon between the parties so that settlement was not due until August 2002.

The net profit will not be included in her assessable income until the contract is settled. Therefore, the net profit on each lot will be included in Melissas assessable income for the year ending 30 June 2003. However, if the CGT provisions were to apply, Melissa will need to include the capital gain in her tax return for the year ending 30 June 2002.


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Chapter 4 Capital gains tax 401 Income or capital? .................................................................................................. 28 402 Pre-CGT land ......................................................................................................... 28 403 Post-CGT land........................................................................................................ 31 404 CGT concessions.................................................................................................... 31 405 CGT flowchart ....................................................................................................... 38 406 How to maximise the cost base.............................................................................. 39 401 Income or capital? To summarise the issues discussed at 301, when real property is sold the developer is either: 1. carrying on a business of land development; 2. undertaking a one-off profit-making scheme; or 3. merely realising a property on capital account. It is clear that where the taxpayer is in the business of selling land the land will usually be treated as trading stock. Where the taxpayer is not conducting a business of selling land, however he enters into a profit-making scheme, the net profit from the scheme will be taxed as ordinary income. Where the land was not acquired for the purpose of profit-making by sale, but a taxpayer later realises the asset in an enterprising way, the profits will usually be the mere realisation of a capital gain. 402 Pre-CGT land Property acquired before 20 September 1985 will not attract capital gains tax when sold. In respect of a subdivision, if the land was acquired pre-CGT the mere act of subdivision will not constitute a change in ownership (or trigger a CGT event) and the sale of the lots, prima facie, will not be subject to CGT. However, if buildings or other structures are constructed on the land after 20 September 1985, then sec 108-55(2) will apply and the structures will be considered a separate asset and subject to CGT upon sale. For example, the erection of a house post-CGT, on a vacant lot purchased pre-CGT, will bring into effect sec 108-55(2) and attract capital gains tax on the sale of the property. Capital improvement to an asset sec 108-70(2) In most subdivisions of pre-CGT land, sec 108-70(2) will apply when capital improvements are made post-CGT. Section 108-70(2) will apply where all of the following requirements are satisfied:

the taxpayer acquired an asset pre-CGT;

a capital improvement is made to the asset post-CGT;


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the cost base (after indexation) of the improvement exceeds the threshold limit (see 309); and

the cost base of the improvement exceeds 5% of the capital proceeds received by the taxpayer on the disposal of the improved asset.

If sec 108-70(2) applies then the improvement will be treated as a separate asset and subject to CGT on its disposal. If this provision is not triggered, then the improvement will be deemed to be part of the pre-CGT asset and treated as being acquired pre-CGT. The threshold limit in relation to capital improvements was $50,000 on 20 September 1985 and is indexed for each tax year after that. For the 2002/2003 financial year the threshold is $101,239 (see TD 2002/12).

Case study Mary Mary inherited her parents farm in 1984. In October 2002 she obtained approval to subdivide the farm as long as councils minimum requirements for development were met.

However, an anxious purchaser bought the land from Mary before she finished her construction works. Mary had already spent $75,000 in subdivision and development costs. The purchaser paid $280,000 for the land.

In this situation the sale proceeds of $280,000 will not be subject to the CGT provisions because the cost base of the capital improvements made by Mary, being $75,000, does not exceed the threshold limit of $101,239 for the 2002/2003 year.

What is a capital improvement? Section 108-70(2) will only apply to capital improvements. Improvements of an income nature, such as repairs, do not come within the sections ambit. ITAA 97 does not define capital improvement. However, in defining improvement the Oxford and Butterworths English dictionaries generally refer to enhancing the quality or value of property. Recent decisions such as McCorkell have clarified this definition to require that something be done to the land itself. For example, council approval to rezone and subdivide land is not something that is done to the land itself. Even if it has the effect of increasing the value of the land, it is not an improvement as it merely authorises certain acts to be done. Alternatively, McGeoch v FC of LT (1929) 43 CLR 277 stated that an improvement may result in the removal of something from the land, for example noxious weeds, rocks or waste. In contrast to the decision in McCorkell, the Commissioner in TD 5 states that approval to rezone or subdivide land can constitute a capital improvement. This view appears to indicate that a mere enhancement of the land, as opposed to something actually being done to the land, will constitute a capital improvement. Some examples given by the Commissioner of improvements of a capital nature include:

implementation of power, sewerage and water on the land;

clearing of the land of noxious weeds, rock, timber or waste;

construction of channelling, fences, kerbing or roads;


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construction of gardens, parks and recreational areas;

council approval to rezone and subdivide (according to the Commissioner!);

improvement of soil fertility or soil structure; and

levelling of the land. Problems with the application of sec 108-70(2) Threshold problems are one issue in the application of sec 108-70(2). In certain circumstances an improvement can be identified with a particular lot. However, at other times the improvement applies to the whole land, such as clearing and headworks. The problem arises in respect of a subdivision because one block of land has been turned into numerous lots. Consider the following example:

Case study threshold problems Pre-CGT land is subdivided into eight lots. During the subdivision process $150,000 of improvements are made to the land. As the improvements exceed the 2002/2003 threshold, will sec 108-70(2) apply to render the improvements a separate asset and subject to CGT? How does the threshold apply in respect of subdivided lots?

The cost base of the improvements, when considered as a whole, clearly exceeds the threshold for 2002/2003 of $101,239. However, the actual asset being sold is each individual lot. Therefore, an apportionment of the capital improvements across each lot is required when the plan of subdivision is registered (see 308) and the apportionment gives an amount lower than the threshold. However, if the land is sold before the subdivision is registered the apportionment will not have been made and CGT will be payable.

Another issue is where separate improvements are made to land over time. Section 108-70(3) provides that capital improvements that are related to each other are to be aggregated for the purposes of determining whether the threshold in sec 108-70(2) has been exceeded. A list of factors to take into account is provided in sec 108-70 and include:

nature of the CGT asset to which the improvements are made;

nature, location, size, value, quality, composition and utility of each improvement;

whether an improvement depends in a physical, emotional, commercial or practical sense on another improvement made to the asset;

whether the improvements are made within a reasonable period of time of each other;

whether the improvements are of the same nature; and

whether the improvements form part of an overall project. Continuing impact of sec 25A ITAA 36 Section 25A provides that the assessable income of a taxpayer shall include profit arising from:

the sale...of any property acquiredfor the purpose of profit-making by sale; or

the carrying onof any profit-making undertaking or scheme.


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Two recent cases have affirmed the continuing impact of sec 25A ITAA 36: Case 6/98 98 ATC 131 and Antlers Pty Ltd (in liq) v Federal Commissioner of Taxation 97 ATC 4201. Section 25A may still apply to property acquired pre-CGT even though the subdivision and development occurred after 20 September 1985. Although the second element of sec 25A ITAA 36 has been rewritten as sec 15-15, the first element has not been rewritten and thus still applies. Therefore, for property sales after 1 July 1997 (the commencement date of ITAA 97):

(1) Section 25A ITAA 36 will apply if the taxpayer acquired the property pre-CGT for a profit-making purpose by sale. The intention of the taxpayer at the time of acquisition of the land is essential.

(2) Section 25A ITAA 36 will not apply to the sale of property acquired on or after 20 September 1985 the CGT provisions will apply (refer to sec 25(1A) ITAA 36).

(3) Section 15-15 will apply to profits arising from the carrying out of a profit-making plan. However, it will not apply to a profit that is assessable under sec 6-5 (refer to sec 15-15(2)(a)) or in respect of profits arising from the sale of property acquired on or after 20 September 1985 (refer to sec 15-15(2)(b)).

403 Post-CGT land When land has been acquired post-CGT, any disposal of the land will be subject to the CGT provisions. The assessable capital gain will be the difference between the proceeds of disposal and the cost base of the land. Under the common law, any improvements made to the land merge to become part of the same CGT asset and will not be treated separately unless sec 108-55 or sec 108-70 applies. The type of works involved in the average land subdivision will not generally result in either of these provisions applying. Therefore, the normal CGT provisions will apply. Parks, paths and roads A taxpayer undertaking a land development is often required to construct channelling, kerbing, paths, parks, reserves and roads. It is normally a condition of council approval of the subdivision that any title to paths, roads, etc, is to vest in the council. This constitutes a disposal by the taxpayer of these improvements and areas of land to the council without receipt of consideration. These types of improvement have been noted as potentially triggering sec 108-70(2). If this provision is triggered, the taxpayer will not have received any consideration; however, they will be deemed to have received consideration equal to their market value under sec 116-30(1). The ATO via the Capital Gains Tax Sub-Committee of the Taxation Liaison Group has adopted a commercial approach by taking the position that there is unlikely to be any assessable capital gain as the deemed market value will equal the cost base of the improvements or areas of land. This approach may be interpreted from the Minutes of two meetings of the Sub-Committee on 2 March 1989 and 18 April 1990. 404 CGT concessions

CGT discount

Legislation has been enacted to provide that indexation for adjustments will be frozen as at 30 September 1999 for all taxpayers. Indexation will now only apply for assets which were acquired on or before 21 September 1999. This means that for assets acquired during the


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September 1999 quarter or subsequently, capital gains are determined as nominal gains without regard to CPI movements. For individuals, trusts and complying superannuation funds where assets have been acquired before 21 September 1999, there is now a choice to pay CGT on either the frozen indexed capital gain, or 50% of the nominal gain for individuals and trusts and 33% for complying superannuation entities. For individuals and trusts with assets acquired after 21 September 1999 and held for one year or more, CGT will be determined by bringing into their assessable income 50% of the net nominal gain. Division 115 sets out the circumstances in which a CGT discount may be obtained. To be eligible for a discount capital gain the following requirements must be met:

current and prior capital losses must be applied against the gain before the discount can be applied;

the gain must be made by an individual, a complying superannuation entity or a trust;

the gain must be worked out by reference to a cost base whose elements have not been indexed;

the gain must relate to a CGT asset that was held by a taxpayer for at least 12 months before the sale of the property; and

the gain must result from a sale of property taking place after 21 September 1999. Therefore, in order to work out net capital gains, it is important to establish which capital gains are discount gains and which are non-discount capital gains. Examples of non-discount capital gains are gains from the disposal of assets held for less than 12 months, or indexed capital gains. The 12-month holding period rule is relaxed where someone inherits property (see Division 128). In these circumstances the asset will be deemed to have been owned by the taxpayer for at least 12 months if the combined period of ownership is at least 12 months. Practice note

While eligible trusts and individuals will receive a 50% discount and complying superannuation funds receive a 33% discount, assets held by a company do not qualify for the Division 115 50% discount.


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Calculating the discount 1. Reduce your capital gains for the income year by deducting any capital losses you may

choose to use. 2. Reduce any discount capital gains by the discount percentage. 3. Apply the small business concessions, where applicable, to further reduce any capital gain

(see below). 4. Add any remaining non-discount capital gains and any remaining discount gains. 5. The total is your net capital gain. 6. Add your net capital gain to your ordinary income (Note: a separate CGT rate of tax no

longer exists.) Practice note You are entitled to choose whether to apply any capital gains losses to discount capital gains or to non-discount capital gains, assuming both types exist. Therefore, it is important to do the calculation set out above both ways to ensure the best choice is made.

Division 152 Small business CGT concessions As the CGT discount does not apply to companies, it is apparent that many small businesses that choose to operate their property developments through a company are at a disadvantage. However, these entities can qualify for the Division 152 concessions. The four CGT concessions for small businesses are: 1. the 15-year exemption; 2. the 50% active asset exemption; 3. the retirement exemption; and 4. the rollover concession. There are four basic conditions for relief that are common to each of the four small business concessions. They are:


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A CGT event happens in relation to an asset that the taxpayer owns.

The event would have otherwise resulted in a capital gain.

The maximum net asset test is satisfied.

The net value of assets owned by the small business and any related entities must not exceed $5 million. This is the total net value of CGT assets owned just before the CGT event for which the concession is being claimed occurs.

The asset is an active asset.

A CGT asset is an active asset if it is used, or held ready for use, by the entity or one of its affiliates in the course of carrying on a business. An active asset may also include intangible assets, for example Council permits for subdivision of land. The asset must have been active just before the CGT event and must have been active for at least half of the period of ownership. However, a property used only to derive rent cannot be an active asset as it is specifically excluded under sec 152-40 unless its main use for deriving rent was only temporary.

In addition to the above requirements, a taxpayer must meet the controlling individual test/stakeholder test where the asset being disposed of is a share in a company or an interest in a trust.

If the CGT asset being disposed of is a share in a company or an interest in a trust, the company or trust must be controlled by an individual. This will occur where the individual has shares amounting to 50% of the voting power of the company or 50% of the right to receive dividends or capital distributions. In respect of a trust this will occur where the individual is beneficially entitled to at least 50% of the trust's income or capital. Where the trust is a discretionary trust, then an individual is a controlling individual where they are entitled to at least 50% of the income or capital that was distributed by the trustee.

In addition to being a controlling individual in the trust or company, the taxpayer must also be a CGT concession stakeholder in the company or trust. This will occur where the individual is a controlling individual as stated above, or the spouse of a controlling individual.

Once the above criteria are satisfied, a small business may then be able to claim eligibility for one or more of the four small business concessions. The 15-year exemption CGT may not be payable by small businesses on assets sold that have been held for at least 15 years. The exemption does not apply to disposals of assets until 20 September 2000, as it is impossible for a CGT asset to be held for the 15-year period prior to that date. For the 15-year exemption to apply the following conditions must be satisfied by an individual:


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If the CGT asset is a company share or interest in a trust, there must have been a controlling individual during the whole ownership period.

The basic conditions for small business relief must be satisfied (see above).

The CGT asset must have been held continuously for

Property Dev - Income Tax Handbook(Elect) 25-3-03

Documents

Transcript of Property Dev - Income Tax Handbook(Elect) 25-3-03