Private ruling: Sale of commercial property - revenue vs capital
Date of advice: 4 December 2023
Published: 29 January 2024
Ruling period: Year ended 30 June 20XX
Date scheme commenced: Year ended 30 June 20XX

Ruling: Q1: Will any part of the proceeds or profit from the disposal of the interest in Subdivided Lot Aheld by each Individual Owner, upon exercise of the Call Option Agreement, constitute ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Will the gain on the disposal of the interest in Subdivided Lot A held by each Individual Owner, upon exercise of the Call Option Agreement,be assessable as the mere realisation of a capital asset? | A2: Yes.

Relevant facts and circumstances: Parcels of land were originally acquired as a 5-lot industrial strata scheme, being Lots 1 to 5 (each referred to as a Lot). Lots 2, 3, and 4 were purchased by Individual A, Individual B and Individual C (the Individual Owners) as tenants in common as to A% B% and B%. The Individual Owners formed a partnership (the Partnership) in order to receive income jointly. The Individual Owners do not consider themselves to be in business as a common law partnership. Lots 1 and 5 were purchased by Entity X, an associate of Individual A. Various entities associated with Individual A including Entity Y have conducted property developments. The private ruling application states that when Entity X and the Individual Owners acquired their respective Lots, they each had the intention of conducting leasing enterprises. Further, t no pre-acquisition investigations were conducted into the Lots potential for redevelopment. For a continuous period of many years, Entity X and the Individual Owners conducted leasing enterprises in relation to their respective Lots. The Lots were marketed for lease by a professional letting agent. The collection of rent, management of leasing agreements and management of tenants was outsourced to Entity Y who has charged a management fee. The Individual Owners have not held any other land together as co-owners and do not conduct any other commercial activities together as partners. After approximately ten years of ownership Individuals B and C both expressed their desire to exit from the Partnership. Individual A was amenable to this provided the land could be realised in an optimal manner. Planning schemes released shortly after this time identified the area where the Lots are located as a health and education precinct. Entity X engaged Entity Y to prepare development applications (the DA) for the Lots. The DA proposed merging the five Lots with a subsequent subdivision into 2 Lots. The DA contemplated that Entity X would engage Entity Y to develop one of the two Lots as a seniors' living and mixed used residential development. As owners of 3 of the Lots subject to the DA, the Individual Owners were required to provide their consent to Entity Y to lodge the DA. The Individual Owners collectively decided to allow Entity X and Y to seek a development approval as it was anticipated that enhancement of the whole of the Property may occur as a result. The DA was lodged by Entity X for its own purposes and at its own expense. The Individual Owners did not have an active role. The DA was initially refused by local council (the Council), however Entity Y, had this decision successful reviewed. Entity Y subsequently lodged an application to modify the DA consent (the Modified DA). This was approved allowing for the subdivision of the Property into two separate title lots (Subdivided Lot A and Subdivided Lot B). All cost relating to the development approval for the subdivision of the Lots were incurred by Entity Y. An application to terminate strata scheme was lodged. This had the following implications under the state development act: a) The existing strata scheme was terminated and the owners' corporation for that strata scheme was dissolved. b) The folios for the Lots and common property in the strata scheme were cancelled. c) the land vested in the Lot owners of the former strata scheme as tenants in common in shares determined in accordance with the unit entitlement of each owner immediately before termination of the strata scheme. d) A new folio was created for the Property in accordance with an approved plan of subdivision for the land. Consequently, Entity X and the Individual A, Individual B and Individual C became tenants in common in relation to the whole of the Property. The parties subsequently agreed to sever the co-ownership of the Property done by way of Partition Deed (the Partition Deed) such that: a) Individual A, Individual B and Individual C owns Subdivided Lot A as tenants in common in their respective proportions (60%, 20% and 20%). b) Entity X would own outright Subdivided Lot B. It is proposed that Entity X will develop Subdivided Lot B as a seniors' living development in accordance with the Modified DA, subject to viability. Pursuant to a call option agreement (Call Option Agreement), the Individual Owners have granted a call option over Subdivided Lot A to Entity Z. Entity Z is an associate of Individual A. Under the Call Option Agreement, Entity Z may exercise its option to purchase Subdivided Lot A at any time before the call option expiry date. Entity Z will lodge a DA to develop a new seniors' living development on Subdivided Lot A. All costs in relation to the proposed development will be incurred by Entity Z.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 Part 3-1 and Part 3-3 | Income Tax Assessment Act 1997 section 70-10

Reasons for decision: Summary: The disposal of the part interest held by the Individual Owners in Subdivided Lot A upon exercise of the Call Option Agreement is considered by the Commissioner to be a mere realisation of a capital asset. The Individual Owners have not commenced a business of property development and sale in relation to the Lots, nor did they have the requisite profit-making purpose when they originally acquired their interest in Lots, 2, 3 and 4. No part of the gain or proceeds from disposal of their part interest in Subdivided Lot A will be assessable under section 6-5 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: In general, there are three ways by which the proceeds or gains from dealing in land gain be treated for income tax purposes: • Sale proceeds are treated as ordinary income under section 6-5 of the ITAA 1997, where the land is held as trading stock and sold as part of carrying on a business of property development and sale; • Profits are treated as ordinary income under section 6-5, where land is not trading stock and is sold as part of an isolated commercial transaction entered into with a profit-making intention; and • Gains are treated as statutory income under the CGT provisions in Part 3-1 and Part 3-3, where the land is neither trading stock nor the subject of an isolated profit-making scheme or undertaking and the proceeds of sale are the mere realisation of a capital asset. Section 6-5 of the ITAA 1997 provides that the assessable income of an Australia resident includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia. 'Ordinary income' is defined in section 6-5 of the ITAA 1997 to mean 'income according to ordinary concepts'. In general, a receipt will constitute income according to ordinary concepts if it is a receipt arising out of a taxpayer's employment or in the normal scope of a taxpayer's business. In limited circumstances, gains not within the ordinary scope of a taxpayer's business may form part of ordinary income. Where the sale of property is held to be a 'mere realisation' the sale is on capital account to which the CGT rules in Part 3-1 and Part 3-3 of the ITAA 1997 will generally apply. These proceeds are not ordinary income. | Detailed Reasoning - Do subdivided Lots A or B constitute trading stock of a business of property development and sale?: Under section 70-10 of the ITAA 1997, 'trading stock' is defined as including 'anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business'. In order to determine if the Property constitutes 'trading stock', it is necessary to firstly consider whether the Individual Owners are carrying on a business of property development and sale. Whether a business is being carried on is a question of fact and degree. The courts have considered this issue extensively over the years developing a series of indicators that are applied to determine the matter on the particular facts. A leading authority on 'mere realisation' of a capital asset is the case of Scottish Australian Mining Co. Limited v FCT (1950) 81 CLR 188 ( Scottish Australian Mining ) . In this case, the taxpayer was formed for the purpose of mining coal and purchased land in 1863 to carry on that business. After mining operations ceased in 1924, the taxpayer subdivided the land; built roads and a railway station; made sites available for schools, churches and parks; and sold the subdivided parcels at a considerable profit. The court held that the profits should not be included in assessable income as the taxpayer had not acquired the land for the purpose of profit-making by sale, nor was it engaged in the business of selling land. It had merely taken 'the necessary steps to realise the land to the best advantage'. The decision in FC of T v. Whitfords Beach Pty Ltd (1982) 150 CLR 355; 82 ATC 4031 ( Whitfords Beach ) has narrowed the scope of the 'mere realisation' doctrine. In this case, Justice Mason stated at paragraph 385 that: However, apart altogether from this factor, the facts previously mentioned show that there was involved more than mere realization of an asset. Deane J. was right in pointing to the circumstance that the asset was divided and improved in the course of a business of dividing and improving the asset. In this respect I do not agree with the proposition which appears to be founded on remarks in some of the judgments that sale of land which has been subdivided is necessarily no more than the realization of an asset merely because it is an enterprising way of realizing the asset to the best advantage. 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 roads, the provision of parklands, services and other improvements. All this amounts to development and improvement of the land to such a marked degree that it is impossible to say that it is mere realization of an asset. We need to bear in mind that the subdivision of broad acres into marketable residential allotments involves much more in the way of planning, development and improvement than was formerly the case. The Federal Court has since endeavoured to reconcile those decisions. For example, in Stevenson v FCT 91 ATC 4476 ( Stevenson ), the taxpayer owned and worked on a farm of approximately 446 acres that had been in his family since 1904. The taxpayer sold 26 acres to a statutory body in 1965, and later sold a further 360 acres to a company for farming. Of the remaining 90 acres, the taxpayer decided to keep a few acres for himself and his family and the rest would be subdivided, which was conditional on the provision of water and sewerage reticulation. After attempts to sell the whole area marked for subdivision (as an en globo development site) failed, the taxpayer decided to subdivide the land into more than 180 blocks. Jenkinson J upheld the Tribunal's finding that the taxpayer's activities went beyond what could be accepted as the mere realisation of a capital asset. The Tribunal had particular regard to the degree of the taxpayer's personal involvement in the planning, in the negotiations with the shire council, in obtaining finance, in employing contractors, in the marketing of the blocks and in their actual sale. Jenkinson J accepted the Tribunal's observations and said: ' It is, I think, difficult to discriminate between mere realisation and the conduct of a business by reference directly to the magnitude of the physical activity or the physical effect of the activity, although Mason J does seem to regard the degree of development and improvement of the land as critical. The magnitude of a substantial subdivisional enterprise does, however, commonly entail such a degree of systematic organisation, planning, management and repetition of purposeful profit-making activity that the carrying on of a business may be more clearly discerned than in a case 'where an area of land is merely divided into several allotments.' It was the magnitude of the enterprise that led Jenkinson J to find that the taxpayer had commenced carrying on a business. Jenkinson J distinguished the situation in that case from one where 'land is merely divided into several allotments' . The principles were also applied in Statham & Anor v. Federal Commissioner of Taxation (1988) 89 ATC 4070 ( Statham ), where it was held that the sale of a rural property that had been subject to four stages of subdivision was a mere realisation of the property. In their joint judgment, Woodward, Lockhart and Hartigan JJ provided at page 4076 that: There is nothing surprising in the fact that they went about this realisation in a manner calculated to maximise their receipts. The fact that this occurred does not necessarily make the proceeds either profits from an undertaking or scheme, or income from a business. Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) discusses the Commissioner's view on whether a taxpayer is carrying on a business. Ultimately, the question of whether the activities of a taxpayer amount to a business is decided on the facts of each case. The Commissioner considers that the following matters (listed at paragraph 13 of TR 97/11) are relevant in determining whether a taxpayer is conducting a business of property development and sale: • 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, and • the size, scale and permanency of the 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 profile. Based on the statements made in support of the application, the Commissioner accepts that the activity undertaken to secure subdivision and development approvals in this has been undertaken Entity X for its own benefit. The involvement of the Original Owners in their individual capacity was limited to: • consenting for the development applications to be made; • agreeing to amalgamate their interests with Entity X on cancellation of the strata title; and • agreeing to partition this interest with Lot B to Entity X into Lot A to the Original Owners. Having regard to the factors highlighted in paragraph 13 of TR 97/11 and the above case law, the Commissioner is of the view that the Original Owners are not carrying on a business of property development and sale. Their part interest in Subdivided Lot A would not constitute 'trading stock' under section 70-10 of the ITAA 1997. | Detailed Reasoning - Profits from an isolated transaction: It is well settled law that a profit or gain made by a taxpayer outside the ordinary course of carrying on a business, but which arises from a transaction entered into by that taxpayer with the intention or purpose of making a profit or gain, will constitute assessable income, even where the transaction is an isolated one, " if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit... "( FC of T v. Myer Emporium Ltd (1987) 163 CLR 199 ( Myer ) at 209-210). Taxation Ruling 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) provides guidance in determining whether profits from isolated transactions are ordinary income and therefore assessable under section 6-5 of the ITAA 1997. There is a strong line of reasoning through the judgments in Whitfords Beach and Myer that suggests that profits made by a taxpayer who enters into an isolated transaction with a profit-making purpose can be assessable income. In Myer , (at 163), the High Court had this to say about the nature of profits from isolated transactions: It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realisation. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction. Paragraph 16 of TR 92/3 summarises the relevant authorities providing that if a taxpayer not carrying on a business makes a profit from an isolated transaction or operation, that profit is assessable ordinary income if both of the following elements are present: • the intention or purposes of the taxpayer in entering into the transaction or operation was to make a profit or gain; and • the transaction or operation was entered into and the profit was made in carrying out a business operation or commercial transaction. The relevant intention or purpose of the taxpayer (of making a profit or gain) referred to in Myer is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case (paragraph 38 of TR 92/3). It is also not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. Paragraph 40 of TR 92/3 provides that it is sufficient if profit-making is a significant purpose. However, the profit-making purpose must be more than a mere possibility. In Westfield v FCT 91 ATC 4234 , Hill J said: While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised ... But, even if that goes too far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit-making scheme, where, in the case of the scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold. Paragraph 41 of TR 92/3 states that if a transaction or operation involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However, this is not always the case, as there may be special circumstances where the requisite profit-making purpose arises some time after acquisition of a property. An example is provided in paragraph 42 of TR 92/3 where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset either as the capital of a business or into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction. In such circumstances, the activity of the taxpayer would constitute the carrying on of a business or a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity would be income despite the taxpayer not having the purpose of profit-making at the time of acquiring the asset. Further, in Whitfords Beach , the High Court found a 'profit-making scheme' even though land was originally acquired by a company for the passive recreational use of the shareholders. However, in that case, the company came under the ownership and control of new shareholders whose purpose was to use the company's asset for a profit-making undertaking or scheme. In Casimaty v FCT 97 ATC 5135, it was held that significant changes in organisational structure or control of a landholding entity may alter the timing for the requisite profit-making purpose. Where there is no such change, it is apparent from the decision of the Full Court in Westfield that the profit-making purpose must be present when the asset is first acquired. It was held in that case that: Once it is clear that the activity of buying and selling, which generated the profit, was not an activity in the ordinary course of business, or, for that matter, an ordinary incident of some other business activity, the profit in question will only form part of the assessable income of the appellant, by virtue of it being income in accordance with the ordinary concepts of mankind, if the appellant had a purpose of profit-making at the time of acquisition. Based on an objective consideration of the facts provided, the Commissioner is of the view that - while the proposed sale of the Subdivided Lot A could constitute a profit-making undertaking the Individual Owners did not have the requisite profit-making purpose when they acquired their interests in Lots 2, 3 and 4. This is supported by the length of time the ownership interest was held prior to any attempts to sell the property. Further, the Commissioner considers that the requisite profit-making purpose also did not arise at any time after the Individual Owners acquisition of interests in Lots, 2, 3 and 4. This is supported in the first instance by the Commissioner's earlier conclusion above that the Individual Owners have not carried on a property development business (involving the purchase and sale of real property) since the interests in the Lots were acquired. Therefore, the first condition (profit-making purpose) of paragraph 16 of TR 92/3 is not satisfied. Of the two conditions in paragraph 16 of TR 92/3, both must be satisfied in order for a profit from an isolated transaction (where a business is not being carried on) to be classified as income. As the first condition (profit-making purpose) of paragraph 16 of TR 92/3 is not satisfied, it is not necessary to discuss further the second condition (business operation or commercial transaction) of paragraph 16 of TR 92/3. As both of the conditions of paragraph 16 of TR 92/3 are not satisfied in respect of the scheme, any net profit the Individual Owners receive from the disposal of their interests in Subdivided Lot A, upon exercise of the Call Option Agreement, will not constitute income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Mere Realisation: Proceeds from the sale of property more often represent the mere realisation of capital assets, which will fall for consideration under the CGT provisions in Part 3-1 and Part 3-3 of the ITAA 1997. Paragraph 36 of TR 92/3 states the courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. The expression 'mere realisation' is used to contradistinguish a business operation or a commercial transaction carrying out a profit-making scheme. A 'mere realisation' of assets was found to have been effected in the full federal court decision in Statham , with the consequence that no income was assessable. The taxpayers were the trustees of a deceased estate. The deceased had acquired 270 acres in 1970 on which to raise his family. In 1976, the deceased sold a half interest in part of the property to a company controlled by his sister and her husband. The deceased and the company entered into a partnership to raise cattle on the property but, for a number of reasons, the business failed and, in 1979, it was decided to subdivide and sell the property. The subdivision work was carried out by the local council and local real estate agents handled the advertising and sale of the lots. The deceased died in 1980 and the subdivided lots were sold between 1980 and 1986. The Full Federal Court held that what occurred was: ... the mere realisation, by the most advantageous means, of the asset which the owners had on their hands when they abandoned the intention of farming the subject property. The court was satisfied that the owners did not enter into the business of selling land and said there was nothing surprising in the fact that the owners applied themselves in an enterprising way to the realisation of a capital asset, in a manner calculated to maximise their receipts. But the fact that this occurred does not necessarily make the proceeds either profits from an undertaking or scheme, or income from a business. The court said: It is well established... that the mere realisation of an asset at a profit does not necessarily render the profit taxable. The profit must arise from the carrying on of a business or a profit-making undertaking or scheme. The mere magnitude of the realisation does not convert it into such a business, undertaking or scheme; but the scale of the realisation activities is a relevant matter to be taken into account in determining the nature of the realisation, ie in determining whether the facts establish a mere realisation of a capital asset or a business or profit-making undertaking or scheme. The Individual Owners did not have a profit-making purpose at the time of acquiring their respective interests in Lots 2, 3 and 4. This was particularly demonstrated by the Individual Owners having held their interests in the Property (the only property they held together) for many years. The mere magnitude of the realisation does not convert the activities of the Original Owners into a business (as held in Statham ). Therefore, in applying the principle held in Myer as stated above, as the interests in the Property are deemed to be a capital asset, and not a revenue asset, and in the absence of a profit-making intent by the Individual Owners, it is the Commissioner's view that the disposal of the interests in Subdivided Lot A would more accurately represent the mere realisation of a capital asset. As a mere realisation of a capital asset, any gain or proceeds from the disposal of the interests in Subdivided Lot A, upon exercise of the Call Option Agreement, will not be assessable as ordinary income under section 6-5 of the ITAA 1997. Any gains will be subject to the CGT provisions provided in Part 3-1 and Part 3-3.