Private ruling: Income tax - property developer trading stock
Date of advice: 5 August 2016
Published: September 2016
Ruling period: 1 July 2015 to 30 June 20CC
Date scheme commenced: During the income year ended 30 June 20BB

Ruling: Q1: Did the X residential units built by the Trust constitute trading stock of the Trust pursuant to section 70-10 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Can the Y residential units transferred by the Trust to the controlling individual for their, and their family's, personal use be treated as if they were sold for their cost in accordance with subsection 70-110(1) of the ITAA 1997? | A2: No

Relevant facts and circumstances: The Trust purchased Y commercial properties during the quarter ended 30 June 20AA. Upon its acquisition, the Trust held these properties as capital assets and used them for rental purposes (i.e. as office and storage areas). The Trust subsequently obtained information on the development potential of the premises from the local council and, based on that information, decided to undertake a property development project on them. The Trust then proceeded to purchase an adjacent property and commenced the subdivision and development of a number of residential units (the development) by lodging a subdivision development application with the local council during the 20BB income year. The development involved the construction of Z new residential units, X of which were sold for profit in the 20CC income year. The applicant has advised that the development was planned, organised and carried out in a business-like manner by the Trust, as evidenced by the following factors: • a feasibility of project profit was prepared and evaluated pre-commencement of the development • the development was conducted from an office with sales, expenses, invoices, receipts and accounts all being properly recorded • the development had a business-like employment structure employing a team of people including a site foreman, a project manager, a bookkeeper, an administrative officer, and sales and marketing staff • the sales of the residential units and the building works were properly documented in written contracts/agreements • GST was charged on the sales of the residential units, and • supplies of materials were ordered through a supplier trade credit account. In their capacity as director of trustee company, the controlling individual, who has approximately 20 years of experience as a builder/developer and holds a relevant State builder licence and a membership of Master Builders Association: • worked full time on the development, spreading their time between the construction site and their office • was the sole decision maker of all day-to-day development activities, and • supervised the process of purchases, the subcontracting of tradesman and their works, and the payment of the development and construction costs. The Trust is a discretionary trust and the beneficiaries are the controlling individual, their spouse and their children. Legal ownership of Y of the residential units within the development was transferred by the Trust to the controlling individual at cost price during the 20CC income year. The market value of these Y residential units was significantly higher than the cost price paid by the controlling individual. The Y residential units transferred to the controlling individual were never developed or held by the Trust for the purposes of sale at any stage of the development. The controlling individual and their family moved into the Y residential units as their main residence during the 20CC income year upon their transfer. The controlling individual and their family occupied the Y residential units for more than five months until April 20CC, at which time she/he and their family moved out of the Y residential units and rented them out as rental properties (i.e. for the purpose of producing assessable income). The Y residential units are on separate titles and are the only Y units on the same level of a unit block on the development. There are no other residences or units on that level. The Y residential units adjoin and are connected by a common hallway which is private and not accessible to the public or others residing in any of the X residential units sold by the Trust. The elevator door on that level has a security door with keys that were only available to the controlling individual and their family. Internal doors and what would normally be the usual front doors of the Y residential units are situated two meters away from each other and they were left open as a matter of usual practice. The controlling individual paid for all expenses on behalf of their spouse and children who resided in the Y residential units on a daily basis. The whole family used one residential unit primarily as a bedroom area and the other one as living area. The Y residential units may be sold separately but can be sold together under one contract.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 70-10 | Income Tax Assessment Act 1997 Section 70-30 | Income Tax Assessment Act 1997 Paragraph 70-30(1)(a) | Income Tax Assessment Act 1997 Section 70-110 | Income Tax Assessment Act 1997 Subsection 70-110(1) | Income Tax Assessment Act 1997 Section 104-10 | Income Tax Assessment Act 1997 Section 104-220 | Income Tax Assessment Act 1997 Subsection 116-30(2) | Income Tax Assessment Act 1997 Paragraph 116-30(2)(b) | Income Tax Assessment Act 1997 Subsection 118-25(2) Further issues for you to consider | Dealing with CGT assets which start being trading stock | Section 70-30 of the ITAA 1997 applies where an item which is already owned by the taxpayer (but is not held as trading stock) starts being held as trading stock. Just before the item becomes trading stock, the taxpayer is treated as having sold it to someone else (at arm's length) at either cost or market value (at the taxpayer's election), and as having immediately reacquired it for the same amount. | If the taxpayer elects under paragraph 70-30(1)(a) of the ITAA 1997 to be treated as having sold the asset for its cost (as worked out under section 70-30 of the ITAA 1997), any resulting capital gain or loss is disregarded pursuant to subsection 118-25(2) of the ITAA 1997. | If the taxpayer elects under paragraph 70-30(1)(a) of the ITAA 1997 to be treated as having sold the asset for its market value, CGT event K4 under section 104-220 of the ITAA 1997 will happen in respect of the taxpayer. The taxpayer will make a capital gain from this event if the asset's market value (just before it became trading stock) exceeds its cost base, or a capital loss if that market value is less than its reduced cost base. | The application of these provisions, as relevant, should have been considered for the Trust in respect of the year within which the land, originally held as CGT assets (and not held as trading stock), started to be held as trading stock. | Application of the market value substitution rule to determine capital proceeds from transfer | The market value substitution rule under subsection 116-30(2) of the ITAA 1997 provides: | The capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if: | (a) some or all of those proceeds cannot be valued; or | (b) those capital proceeds are more or less than the market value of the asset and: | (i) you and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event; or | (ii) the CGT event is CGT event C2 (about cancellation, surrender and similar endings). | (The market value is worked out as at the time of the event.) | The Trust's transfer (a disposal) of Y residential units to the controlling individual, who is both the director of the trustee company and a beneficiary of the Trust, for cost price (being an amount less than the market value of the units) constitutes a non-arm's length dealing. | The Trust's capital proceeds from the disposal of the Y residential units (which give rise to a CGT event A1 under section 104-10 of the ITAA 1997) are therefore, in accordance with paragraph 116-30(2)(b), replaced with the market value of those units as at the time of the disposal.

Reasons for decision: Summary: The X residential units developed for the purpose of sale are treated as trading stock pursuant to section 70-10 of the ITAA 1997 for the Trust. | Detailed Reasoning - Detailed reasoning: The meaning of trading stock is defined in section 70-10 of the ITAA 1997 and includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business. With specific regard to whether land is treated as 'trading stock' for property development purposes, the Commissioner states in Taxation Determination TD 92/124 that land is treated as trading stock for income tax purposes if: • it is held for the purpose of resale, and • a business activity which involves dealing in land has commenced. A building held by a property developer for sale in the ordinary course of their development business is trading stock of the developer. Expenditure incurred on trading stock in the ordinary sense of that term will be on revenue account 'in almost all cases that can be envisaged' ( Federal Commissioner of Taxation v. Raymor (NSW) Pty Ltd (1990) 24 FCR 90; 90 ATC 4461; (1990) 21 ATR 458). | Detailed Reasoning - Carrying on a business of property development: The Commissioner's view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11. TR 97/11 identifies the following indicators for consideration to determine whether a taxpayer is carrying on a business: • whether the activity has a significant commercial purpose or character • whether the taxpayer has more than just an intention to engage in business • whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity • whether there is 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. In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. 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. In this case, the Commissioner is satisfied that the Trust was carrying on a business of property development, as primarily indicated by the following factors: • the Trust's intention to profit from the development upon the sale of the residential units • the prospect of a profit from the development, as established prior to its commencement • the Trust's intention to be carrying on a property development business • the Trust's undertaking of the development in both a planned, organised and business-like manner, and as ordinarily carried on by property developers • the Trust's (via the controlling individual) involvement in the daily management of, and decision making in respect of, the development, and • the relative significant size and scale of the development, all of which, combined, provided the development with a significant commercial purpose or character. Based on the above, the Trust was undertaking a business activity involving dealing in land held for the purpose of resale. Although the land acquired by the Trust was originally held for generating commercial rental income, TD 92/124 further explains (at paragraph 2) that both the required purpose of resale and the business activity must be present before land is treated as trading stock. For these purposes, the Trust's property development business is taken to have commenced when the Trust embarked on a definite and continuous cycle of operations designed to lead to the sale of the land (i.e. during the 20BB income year, around the time the subdivision development application was lodged). Accordingly, the X residential units were developed and held by the Trust for the purpose of sale in the ordinary course of a business and are therefore considered to be items of trading stock. The fact that the Trust has not acquired land on a repetitive basis does not alter this finding as 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 (paragraph 3, TD 92/124). For completion, it is noted that the Y residential units that were transferred by the Trust to the controlling individual at cost price were not items of trading stock as they were never held for the purposes of sale at any stage by the Trust in the ordinary course of its property development business. Accordingly, the Y units are considered to have been held on capital account (and not on revenue account) by the Trust. | Summary: The Y residential units transferred for cost price to the controlling individual by the Trust are not treated as if they were sold for that price in accordance with subsection 70-110(1) of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Subsection 70-110(1) of the ITAA 1997 provides that if you stop holding an item of trading stock but still own it, you are treated as if you had sold it to someone else (at arm's length and in the ordinary course of business) for its cost price and you had immediately bought it back for the same amount. For the reasons stated in response to Question 1, the Y residential units transferred to the controlling individual are not considered to have been items of trading stock of the Trust. The application of section 70-110 of the ITAA 1997 therefore has no relevance to the Y transferred units.