Private ruling: Income tax ~~ Assessable Income ~~ Capital gains tax ~~ Income vs Capital
Date of advice: 30 June 2016
Published: September 2016
Ruling period: 1 July 2015 to 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Will the gain made on the sale of the property be solely assessable under Part 3-1 of the Income Tax Assessment Act ( ITAA 1997 )? | A1: Yes | Q2: Will section 118-20 or section 118-25 of the ITAA 1997 apply to disregard or reduce the gain from the sale of the property? | A2: No | Q3: Will any part of the gain from the sale of the property be assessable income under section 6-5 of the ITAA 1997? | A3: No | Q4: Will Section 15-15 of the ITAA 1997 apply to the sale of property? | A4: No | Q5: Will Section 25A of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the sale of property? | A5: No

Relevant facts and circumstances: The transaction 1. In 20XX, the taxpayer sold a business facility (property) and made a gain on the sale. Chronology of key events 2. During 200X, the taxpayer was forced to consider their level of involvement in their business for personal reasons. 3. The taxpayer expressed their interest to a commercial real estate agent to acquire a commercial property with secure, high yielding income streams to supplement their reduced business activity. 4. The taxpayer was informed by the real estate agent that the property was listed for sale and would be a suitable investment as it was subject to a long term lease. 5. The property is a purpose built facility. The property incorporates accommodation, offices with carparks. 6. The property was marketed as a "low risk, tax effective investment with significant depreciation allowances". 7. Rent was set with annual rental increases. 8. The contract for purchase of the property was executed and settled in 200X. 9. The property is financed by the bank through a Commercial Bill Facility. 10. The terms of the loan facility were in line with the lease term. 11. During the course of a routine maintenance discussion between the taxpayer and the tenant in 200X, a representative of the tenant advised the taxpayer that there may be the need to move to larger premises to meet an expected increase in business requirements. In an effort to secure the tenant for the succeeding lease renewal period, the taxpayer approached architects to design an extension of the property's business facilities. 12. The planned extension to the existing facilities was to be achieved through a reduction in on-site carparks. However, through the later stages of the design and planning process the taxpayer was informed that a larger premise was not sought by the tenant. 13. Endeavouring to reduce sunk costs on the planning and design process incurred to date, the architects advised the taxpayer to complete their plans and lodge a development application in the event the tenant required additional space in the future. 14. In 20XX, the extension plans were approved and a planning permit issued. 15. In 20XX, a lease variation was executed to extend the lease. Rent was also revised with incremental increases each year. 16. The bank appointed the real estate agency to value the property in preparation for the facility expiry. 17. Based on the above valuation, the bank provided a loan facility which expired in line with the renewed lease term. 18. The taxpayer did not draw on the revised loan facility, rather choosing to capitalise interest and facility fees. Significant events 19. The taxpayer was informed by a commercial real estate agent of a recent surge in demand for quality tenanted commercial properties. The property was estimated to be worth in the current market XX% over the most recent valuation. 20. The taxpayer was offered a marketing program to test the value in the open market. 21. At no other time during the taxpayer's ownership period was the property marketed for sale, nor any other offers made. 22. In early 20XX the taxpayer became aware that a new purpose built business facility was to be constructed. This was earmarked to be the last business facility of its kind. 23. The taxpayer was concerned with the increased tenancy risk that the new facility placed on the property beyond the lease expiry. Furthermore, being purpose built, the capital expenditure required to convert the building to be fit for another commercial purpose would be substantial. 24. With consideration of the above, the taxpayer proceeded with the marketing program offered. 25. Due to the heightened risks caused by the events above and offers significantly over prevailing market values, the taxpayer accepted an offer. 26. On sale the loan facility was repaid. 27. The taxpayer's intention is to use the capital derived from the sale of the property to invest in another long term passive asset to complement their investment portfolio. Overview of taxpayer's business activity 28. Throughout the ownership period of the property, the taxpayer has focused on a construction business. 29. The taxpayer is a non-controlling shareholder and director of the construction company. Detailed reasoning Question 1 Will the gain made by the taxpayer from the sale of the property be solely assessable under Part 3-1 of the ITAA 1997? Summary The sale of the property is a mere realisation of a capital asset and will be solely assessable under Part 3-1 of the ITAA 1997. Capital gains tax A CGT asset includes any kind of property (section 108-5 ITAA 1997). A capital gain is made from the disposal of a CGT asset if the capital proceeds are more than the assets cost base (section 104-10 ITAA 1997). A capital gain will be reduced in the circumstances where the gain on disposal of the asset constitutes assessable income by any other section in the tax acts (section 118-20 ITAA 1997) A capital gain will be disregarded if at the time of disposal the CGT asset is trading stock (section 118-25 ITAA 1997). Assessable income An amount of income is "assessable income" if it is income according to ordinary concepts (ordinary income) (section 6-5 ITAA 1997). The proceeds from the sale of an item of trading stock disposed of in the ordinary course of business will be ordinary income and included as assessable income under section 6-5 ITAA 1997 (section 70-80 ITAA 1997). Trading stock Trading stock is defined widely to include anything produced, manufactured or acquired that is held for the purpose of manufacture, sale or exchange in the ordinary course of business (section 70-10 ITAA 1997). An asset will only be trading stock if both the required purpose and the business activity are present. When assessing whether an item is held for the purposes of resale, the previous activities of the taxpayer, the taxpayer's controlling mind and the activities of related entities are relevant factors ( R&D Holdings Pty Ltd v. Deputy Commissioner of Taxation [2006] FCA 981, (2006) 2006 ATC 4472; (2006) 64 ATR 71). Property cannot be trading stock unless it is an asset of a business trading in property of that kind ( Federal Commissioner of Taxation v. St Hubert's Island Pty Ltd (in liq) (1978) 138 CLR 210; 78 ATC 4104; (1978) 8 ATR 452). ATO guidance provides that land will be treated as trading stock for income tax purposes if it is held for the purpose of resale and a business activity which involves dealing in land has commenced (Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as "trading stock"? ). Isolated transactions ATO guidance in Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides that the term "isolated transaction" refers to: • transactions outside the ordinary course of business of a taxpayer carrying on a business; and • transactions entered into by non-business taxpayers. TR 92/3 paragraph 6 states that whether a profit from an isolated transaction is income according to the ordinary concepts depends on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present: • the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and • the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction. Intention to make a profit In Westfield Ltd v. Federal Commissioner Of Taxation [1991] FCA 86; 91 ATC 4234; 21 ATR 1398 the Full Court said that although a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that every profit made by a taxpayer in the course of his business activity will be of an income nature. This would eliminate the distinction between income and a capital profit. The Court said that if the transaction or operation which gives rise to the profit is part of the ordinary business of the taxpayer then a profit-making purpose is imprinted on the transaction. The same applies if the transaction is an ordinary incident of the business activity of the taxpayer, even though it is not directly its main business activity. But in cases where a transaction is not part of the taxpayer's ordinary business activity or a necessary incident of that business activity, it is necessary to find that the transaction was 'commercial' and also that there was, at the time the transaction was entered into, the intention or purpose of making a profit. The relevant intention or purpose of the taxpayer of making a profit or gain can be discerned from an objective consideration of the facts and circumstances of the case ( August v. Federal Commissioner of Taxation [2013] FCAFC 85; (2013) 2013 ATC 20-406; (2013) 94 ATR 376). If a transaction or operation is outside the ordinary course of a taxpayer's business, the intention or purpose of profit making must exist in relation to the transaction or operation in question ( Federal Commissioner of Taxation v. Spedley Securities Limited 88 ATC 4126; 19 ATR 938). Controlling mind The intention or purpose of an entity taxpayer is to be ascertained by reference to the intention or purpose of its controllers at the relevant time ( Federal Commissioner of Taxation v. Whitfords Beach Pty Ltd (H.C.) (1982) 150 CLR 355; 82 ATC 4031; 12 ATR 692). The purpose of an acquisition by the taxpayer needs to be established, in the case of a trust, via the controlling minds of the Trustee. ATO guidance contemplates the concept of a controlling mind in TR 92/3, in example 8. A situation where a person involved in property development, mainly through a company group which he controls, makes gains from selling property within the company group. The profits derived from each company are income (in circumstances where acquisitions of property by the group has been affected by a different company). It is stated that each company in the group has been involved in only one acquisition, development and sale of property. TR 92/3, paragraph 91 concludes that " the profits derived by each of the companies from the development and sale of property are income. In determining whether a company has the purpose of profit making, the acts and intentions of the natural persons who control the company should be examined". In the course of carrying on a business A transaction may take place in the course of carrying on a business even if the transaction may not be within the ordinary course of that business ( Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693 ). Where a taxpayer carrying on a business enters into a transaction or operation that is not in the course of that business, it is necessary to consider whether the transaction is part of a business operation or commercial transaction. Whether a transaction has a business or commercial character depends on the circumstances of the case (Myer ). Even if an operation or transaction lacks repetition or recurrence, it may be a business operation or commercial transaction ( Whitfords Beach ). TR 92/3 outlines factors which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following: • the nature of the entity undertaking the operation or transaction. [For example, if the taxpayer is a corporation with substantial assets rather than an individual that may be an indication that the operation of taxation was commercial in nature. However, if the taxpayer acts in the capacity of trustee of a family trust, the inference that the transaction was commercial or business in nature may not be drawn so readily]; • the nature and scale of other activities undertaken by the taxpayer; • the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained; • the nature, scale and complexity of the operation or transaction; • the manner in which the operation or transaction was entered into or carried out; • the nature of any connection between the relevant taxpayer and any other party to the operation or transaction; • if the transaction involves the acquisition and disposal of property, the nature of that property; and • the timing of the transaction or the various steps in the transaction. Mere realisation of a capital asset The distinction between a mere realisation of a capital asset and a transaction that is done in carrying on a business is not always clear and is a question of fact. The issue was addressed in Californian Copper Syndicate v. Harris (Inspector of Taxes) (1904) 5 TC 159 at 165 where Lord Justice Clerk stated: It is quite a well settled principle in dealing with questions of assessment of Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtain a greater price for it than he originally acquired it at, the enhanced price is not profit assessable to Income Tax. But it is equally well established that enhanced value obtained from realisation or conversion of securities may be so assessable, where what is done it truly carrying on, or carrying out, or a business. What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being - Is the sum of gain that has been made a mere enhancement of values be realising a security, or is it a gain made in an operation of business in carrying out a scheme of profit making? The determination of whether an amount is from a mere realisation or from a business operation is an objective test that requires a close examination of all relevant circumstances. In London Australia Investment Co Ltd v. Federal Commissioner of Taxation (1977) 138 CLR 106, Gibbs J, when considering the criterion of whether a sale was a business operation carried out in the course of the business of profit-making, stated that: To apply this criterion it is necessary 'to make both a wide survey and an exact scrutiny of the taxpayer's activities': Western Gold Mines N.L v C. of T (W.A) (1938) 59 C.L.R 729, at p 729, at p. 740. Different considerations may apply depending on whether the taxpayer is an individual or a company. In the latter case it is necessary to have regard to the nature of the company, the character of the assets realized, the nature of the business carried on by the company and the particular realization which produced the profit: Hobart Bridge Co. Ltd v F.C. of T. (1951) 82 C.L.R. 371, at p. 383, citing Ruhamah Property Co. Ltd. v F.C. of T. at p. 154. The mere realisation of a capital asset will not give rise to ordinary income even where the realisation is carried out in an enterprising way to secure the best price. ( Scottish Australian Mining Co Ltd v. Federal Commissioner of Taxation (1950) 81 CLR 188). In Statham & Anor v. Federal Commissioner of Taxation (1988) 20 ATR 228; 16 ALD 723; 89 ATC 4070 (Statham) it was found that a mere realisation of assets had been effected even though the owners had applied themselves in an enterprising way to the realisation with the consequence that proceeds from the sale of land were not assessable income. The Full Federal Court held at 4077 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 . In circumstances where there is an absence of profit-making intention, the likelihood of any profit made on the eventual sale of an asset being ordinary income is greatly diminished. The reasons prompting the sale may be a relevant consideration. In Casimaty v. Federal Commissioner of Taxation (1997) 97 ATC 5135; (1997) 37 ATR 358, the taxpayer acquired a farming property. The next year, the taxpayer purchased more land on which he erected a homestead and for many years conducted a farming business. Due to growing debt and ill health, the taxpayer subdivided and sold off a large part of the property. Most of the subdivisions required the taxpayer to construct roads, provide water and sewerage facilities and to fence the boundaries. Although the subdivisions were numerous and ultimately were a large part of the original property, the court held that the sales from the subdivisions occurred as part of the mere realisation of a capital asset of the taxpayer. The court was primarily influenced by the fact that the taxpayer continued to use the property as a farm and a residence. The court said that it did not detect any change in the purpose for which the property was acquired. The taxpayer did not undertake any works or developments on the land beyond that which was necessary to secure approval for each subdivision. Application to taxpayer: The sale of the property is a mere realisation of a capital asset and solely assessable as a capital gain pursuant to Part 3-1 of the ITAA 1997. The acquisition of the business facility was not part of a business operation or commercial transaction and there was no profit making intention. Mere realisation of a capital asset This position is determined by the following factors: • The property was held by the taxpayer long term. • The intention on acquisition and throughout the ownership period was to hold the property for the derivation of a passive income stream in the form of rent. This is evidenced through: • The taxpayer's reduced level of involvement in his business for personal reasons. • The loan application extract prepared by the bank evidences that the terms of the loan facility were in line with the lease term. • The property was leased for the whole ownership period, and positive actions were undertaken to extend the lease during the ownership period. • Only depreciation, repairs and maintenance, minor capital expenditure and interest on long term debt were claimed by the taxpayer. • The property was marketed as a "low risk, tax effective investment with significant depreciation allowances". • There were no plans at acquisition to develop this property, it was purchased with a lease in place to derive passive rental income. • There was no intention on acquisition or throughout the ownership period to suggest implementation of profit making by sale evidenced by the fact: • No substantial capital works, alternations or actions were carried out to increase the value in an enterprising manner; • The property was not otherwise marketed during the taxpayer's ownership period. • The only proposed improvement to the property was in response to tenant requirements and was not progressed when the tenant indicated it was not required. • Realisation of the property only arose due to exceptional circumstances being: • The sale price was significantly above prevailing market values. • Tenancy risk beyond lease period of 2019 due to the construction of a new purpose built business facility. No part of the gain is assessable income The profit arose from the mere realisation of a capital asset and will not be assessable under any other provisions of the tax act for the following reasons: • The asset was not trading stock at the time of the sale: • Property cannot be trading stock unless it is an item held for the purpose of sale. • It is clear with reference to the background facts that the property was never held for the purpose of sale as it was not otherwise marketed for sale throughout the ownership period. The property was not held as trading stock at the time of sale, nor was it ever held as trading stock during the ownership period. • The sale was not made in the ordinary course of the taxpayer's business: • With reference to the background facts, no actions were undertaken by the taxpayer that would indicate that the sale of the property was in the ordinary course of the business • The controlling mind is in the construction business. • The profit was not an ordinary incident of the business activity of the taxpayer: • The sale of the property was not an ordinary incident of the taxpayer's business, rather it was an extraordinary event realised through the exceptional sale price coupled with heightened levels of risk surrounding the property's future value due to: - Tenancy risk triggered by the construction of a new business facility being constructed; - Shift in the tenants requirements towards different facilities; - The substantial refit costs of the purpose built facility if the tenant should leave. • The asset was not acquired for the purpose of profit making by sale: • The taxpayer's intention is to acquire property for the derivation of a passive income stream. • The taxpayer financed the property using long term debt finance. • The taxpayer purchased the property tenanted. No changes occurred in relation to tenancy during the ownership period other than extensions to the lease terms in accordance with the agreement would indicate the purpose had changed. • Plans were approved to extend the premises to meet an expected increase in requirements of the tenant. This was done in an effort to secure the tenant for the succeeding lease renewal period rather than of a profit making purpose. This is evidenced by the fact that when the taxpayer was subsequently informed the tenant did not require additional space, only actions to recover sunk costs were undertaken i.e. lodgement of plans so potential future needs of the tenant could be met. • Only routine maintenance was undertaken on the property during the ownership period and no substantial capital works or alterations were carried out to prepare the property or improve value for sale; • The property was not otherwise marketed during the taxpayer's ownership period. The acquisition of the business facility was not part of a business operation or commercial transaction and there was no profit making intention. The proceeds from the sale of the property will not be ordinary income or assessable income in any part of the tax acts, the gain will be solely assessable under Part 3-1 of the ITAA 1997. Question 2 Will section 118-20 or section 118-25 of the ITAA 1997 apply to disregard or reduce the gain from the sale of the property? Summary Section 118-20 or section 118-25 of the ITAA 1997 will not apply to disregard or reduce the gain. Detailed reasoning As outlined in question 1, the proceeds from the sale of the business facility is solely assessable under Part 3-1 of the ITAA 1997. Therefore, the gain made on the sale of the property will not be reduced or disregarded by section 118-20 or section 118-25 of the ITAA 1997. Question 3 Will any part of the gain from the sale of the property be assessable income under section 6-5 of the ITAA 1997? Summary No part of the gain from the sale of the property will be assessable income under section 6-5 of the ITAA 1997. Detailed reasoning As outlined in question 1, the proceeds from the sale of the business facility is solely assessable under Part 3-1 of the ITAA 1997. Accordingly, proceeds from the sale of the property are not assessable as ordinary income under section 6-5 of the ITAA 1997. Question 4 Will Section 15-15 of the ITAA 1997 apply in relation to the sale of property? Summary The proceeds from the sale of the property will not be assessable under section 15-15 of the ITAA 1997. Detailed reasoning Section 15-15 of the ITAA 1997 has no application to a profit arising from the sale of a property acquired after 19 September 1985. Question 5 Will Section 25A of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the sale of property? Summary The proceeds from the sale of the property will not be assessable under section 25A of the ITAA 1936. Detailed reasoning Section 25A of the ITAA 1936 has no application to the sale of property acquired after 19 September 1985.