Private ruling: Capital gains tax – property development - income vs capital – 50% CGT discount
Date of advice: 11 September 2017
Published: January 2018
Ruling period: Income year ending 30 June 20XX.
Date scheme commenced: 1 July 20XX

Ruling: Q1: Will the gain made on the sale of your ownership interest in the land and dwellings be assessable under Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Will a capital gains tax event occur when you enter into a contract of sale for the disposal of your ownership interests in the land and dwellings under section 104-10 of the ITAA 1997? | A2: Yes. | Q3: Will you be entitled to apply the 50% capital gains tax discount to any capital gain made on the disposal of your ownership interests in the land and dwellings under Division 115 of the ITAA 1997? | A3: Yes.

Relevant facts and circumstances: After 20 September 1985, you purchased a property (House A), which was solely in your name. A number of years later a planning certificate was issued by the council to the then owner of the Property which was included in the contract provided to potential purchasers when the Property was put on the market. You and your spouse (Person A) obtained a pre-purchase building and pest inspection of the Property. During the following month, you and Person A entered into a contract to purchase the Property as joint tenants. You and Person A obtained an investment home loan to fund the purchasing of the Property which was for a 30 year term. You and Person A owned the property (House B) as joint tenants, in which you were residing when the Property was purchased. The Property was made available for rent after settlement occurred, with a lease being signed after a short time. During the following month, Person A obtained a feasibility study from Company XYZ to determine if you could build a number of dwellings (the Dwellings). After a period of time you and Person A entered into a contract with Company XYZ in relation to construction of the dwellings on the Property. A number of months later a rental appraisal was obtained which outlined the estimated rental amount that each of the Dwellings could receive per week. The council approved the construction of the Dwellings on the Property and the Property ceased being available for rent during the following month. The original house on the Property was demolished in the month after it had ceased being available for rent. A number of months later, Company XYZ sent a validation contract for the construction of the Dwellings on the Property for a specified amount, which was signed by you and Person A, and the construction of the Dwellings commenced during the following month. You and Person A obtained numerous bank loans to fund the purchase of the Property, potential renovations of the Property, and the construction of the Dwellings. You and Person A had substantial savings in the bank to meet the loan repayments and you were both in salaried employment. After the separation, Person A viewed that they had an entitlement/right to House A and lodged a claim against it during the divorce proceedings. During the divorce proceedings you lodged an application with the Family Court to finalise the Financial Separation in relation to the sale of all the shared properties in accordance with a Binding Financial Agreement signed during your marriage. The shared properties are the Property and House B. The Family Court found that: ● the Binding Financial Agreement was binding; ● House A was not one of the shared properties; and ● if you and Person A could not come to an agreement in relation shared properties, then they had to be sold. A number of months after the separation occurred, Person A moved out of House B. After a period of time an application for your divorce was filed with the Family Court with your divorce being granted a number of months later. Person A approached a bank to refinance the loans on the Property, however they were not successful. The Final Court Hearing for financials/claims was held with the judgement being that there were no provisions for the transfer of any property to either you or Person A. Subsequent negotiations between you and Person A were not successful as neither of you were in a financial position to either complete the construction of the Duplexes or retain them. A number of months later the construction of the Dwellings were completed, however building works and rectification were required by Company XYZ prior to the keys to the Duplexes being handed over. The keys were handed over to Person A after a period of time. An inspection of the duplexes was undertaken by Company ABC to obtain the Occupancy Certificate (the Certificate), however council refused to issue the Certificate as a number of things need to be completed before they would issue the Certificate. Person A remarried and acquired additional dependants. During the following month the council issued a rates notice for the Property which outlined that the rateable value of the Property was $XXX,XXX. The final hearing for the sale enforcement in relation to the terms of the sale of the Dwellings and House B was completed. An independent solicitor was appointed to oversee the sale of the properties to conclude the divorce proceedings. Neither you nor Person A opposed the sale of the Dwellings. It is anticipated that the Dwellings will be listed for sale in the coming weeks/months now that the Enforcement Order has been issued. The Dwellings have remained vacant since their construction was completed until the present time. Neither you nor Person A have undertaken any similar activities in the past and do not intend undertaking any similar activity in the future. You did not have a business or financial plan for the demolition of the original dwelling and the construction of the Dwellings. The Dwellings are still on a single title and will not be put into separate titles prior to them being sold. You estimate that the gain made on the sale of the Dwellings will be more than $XX,XXX based on real estate agent’s appraisal that the Dwellings will be sold on a single title for a sale price of not less than $X million.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 995-1 | Income Tax Assessment Act 1997 Part 3-1 | Income Tax Assessment Act 1997 Part 3-3

Reasons for decision: Detailed Reasoning - Taxation treatment of property sales: There are three ways profits from a land sub-division can be treated for taxation purposes: (1) As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock; or (2) As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of an isolated commercial transaction entered into by a non-business taxpayer or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose; or (3) As statutory income under the capital gains tax (CGT) legislation contained in Parts 3-1 and 3-3 of the ITAA 1997 on the basis that a realisation of a capital asset has occurred. Whether the proceeds are treated as income or capital depends on the situation and circumstances of each particular case. | Detailed Reasoning - Carrying on a business of property development: The Commissioners view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) Although TR 97/11 deals with the issues of determining whether a taxpayer is carrying on a business of primary production, the same principles can be applied to the question of whether a taxpayer is in the business of property development. Paragraph 13 of TR 97/11, uses the following indicators to determine whether a taxpayer is carrying on a business: ● whether the activity has a significant commercial purpose or character; ● whether there is repetition and regularity of the activity; ● whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business; ● whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit; ● the size, scale and permanency of the activity; and ● whether the activity is better described as a hobby, a form of recreation or a sporting activity. 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 flavor. | Detailed Reasoning - Isolated business transactions: Profits from isolated transactions will be assessable as ordinary income where the intention or purpose 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 out a business operation or commercial transaction Taxation Ruling TR 92/3 (TR 92/3) sets out the Commissioner’s view of the general principles and factors that have been considered in determining whether an isolated transaction is of a revenue nature, which include: ● the nature of the entity undertaking the operation or transaction; ● 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. In addition to the above factors, for the purposes of determining whether the activities undertaken in relation to real property and development equate to a profit-making undertaking or scheme, Miscellaneous Taxation Ruling MT 2006/1 (MT 2006/1) aligns itself with TR 92/3 and provides a list of factors which, if present may be an indication that a business or profit-making undertaking or scheme is being carried on. The intention of the taxpayers was a vital consideration for the court in McCurry v. FCT (1998) 39 ATR 121 ( McCurry ) in determining whether the taxpayer’s activities constituted a profit-making undertaking or scheme which was a business or commercial dealing. Broadly, McCurry involved two brothers acquiring land in rural South Australia and constructing three townhouses on the land financed from borrowings and their own funds. Although the taxpayers argued that the reasons for their sale was due to financial difficulties, a further affidavit supplied contradicted this by their admittance that one of their purposes was acquisition and sale for a profit and they considered it to be a good time to sell. The court in McCurry concluded that the taxpayers had entered into a profit-making undertaking or scheme and the profits were assessable under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936), the predecessor provision of section 6-5 of the ITAA 1997. In determining whether activities relating to isolated transactions are a profit making undertaking or are the realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. This may require a consideration of the factors outlined above; however there may also be other relevant factors that need to be weighed up as part of the process of reaching an overall conclusion. No single factor will be determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities. Application to your situation After 20 September 1985, you and Person A purchased the Property as joint tenants, being the land (the Land) and original dwelling. The Property was rented out for a period of time until the original dwelling was demolished and the Dwellings were constructed on the Property. You and Person A jointly borrowed funds to purchase the Property and to construct the Dwellings, with the loans now being in arrears. You and Person A separated after the original dwelling was demolished and are now divorced. An Enforcement Order has been issued for the sale of the Dwellings. The following statements have been made in the ruling: ● you purchased the Property with the intention of obtaining rental income from the Property and hold it long term; ● House B had developed a leaking roof after you had purchased the Property and Person A had engaged the service of Company XYZ to conduct a feasibility study to see if dwellings could be built on the Property for you and your family to live in one, with the other/s being rented out; ● you and your family were considering moving to the Property because of the good schooling, activities and employment and had selected nicer finishes and interiors for the duplex you intended living in; ● after your separation, Person A had intended living in the dwelling that you and your family had intended residing in while you would reside in one of the other dwellings so that your children could be close to Person A. However, you decided not to move into any of the Dwellings and had intended to renting the dwelling/s out long term as House A was closer to your children’s current school; ● Person A obtained a valuation from Company 123 for the largest dwelling as neither of you could afford to keep the Dwellings as a whole, with the intention of keeping the largest dwelling. You determined that you could not financially keep the other dwelling/s due to your financial issues; and ● you and Person A are unable to complete the Duplexes as you are both in financial distress. After reviewing the information and documentation provided, it is the Commissioner’s view that your activities are not those of an entity carrying on a business of developing and selling properties because the activities undertaken do not display the salient indicator of a business, which are transactions entered into on a continuous and repetitive basis. Your facts are not like the McCurry case as outlined above, and the information and documentation provided supports that your intention when the Property was purchased was to use it as an investment property, which later changed to the construction of the Dwellings, with one to be used as your main residence and the other to be rented out. It is viewed that as a result of your divorce and financial issues your intention to keep the Dwellings for both private and investment purposes changed to selling them due to the change in your financial situation. Additionally, an Enforcement Order has been issued for the sale of the Dwellings. While you may make a profit on the sale of the Land, and Dwellings, it cannot be said that the reason for their sale was to make a profit or gain based on the facts of your situation. In conclusion, after weighing up the indicators as outlined in TR 97/11 and the factors outlined in TR 92/3 and applying them to the facts of your situation we have determined that the profits arising from the sale of the Land and Dwellings will not be on revenue account in relation to either the carrying on of a business or a profit making undertaking. Therefore, any profit arising from the sale of the Land, and Dwellings, will be accounted for under the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997. | Detailed Reasoning - Capital gains tax: The capital gains tax (CGT) provisions include in your assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own. CGT event A1 happens if you dispose of your ownership interest a CGT asset. The time of the event is either when you enter into a contract for the disposal of the CGT asset, or when the change of ownership in the CGT asset occurs if there is no contract under subsection 104-10(3) of the ITAA 1997 . You will make a capital gain if the capital proceeds from the disposal of a CGT asset are more than the cost base of the CGT asset. You will make a capital loss of those capital proceeds are less than the reduced cost base of the CGT asset. Cost base The cost base of a CGT asset consists of the following 5 elements: ● The first element of the cost base, being the acquisition costs, is the total of the money paid, or required to be paid, and the market value of the property given, in respect of the acquisition; ● The second element of the cost base is the incidental costs that the taxpayer incurs in acquiring and disposing the asset of which relate to a CGT event that happens in relation to the asset; ● The third element of the cost base of an asset acquired after 20 August 1991 is the non-capital costs of ownership. The costs include, but are not limited to, interest on money borrowed to acquire the asset or to refinance such a borrowing, interest on money borrowed to finance capital improvements to the asset, repairs and maintenance, insurance premiums, rates and land tax. Note: You do not include costs if you have claimed a tax deduction for them in any income year, or omitted to claim a deduction but still can claim it because the period for amending the relevant income tax assessment has not expired; ● The fourth element of the cost base is capital expenditure you incurred to increase the assets value. However, the expenditure must be reflected in the state and nature of the asset at the time of the CGT event; and ● The fifth element is capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over the asset. When a CGT event happens to only part of a taxpayer's asset, such as the demolition of a dwelling, the taxpayer will be required to apportion the cost base or reduced cost between the land and the dwelling using the apportionment rules in subsections 112-30(2), (3) and (4) of the ITAA 1997. If the taxpayer receives no capital proceeds for the demolition of the dwelling, the combined effect of these provisions is that no amount is apportioned to the cost base or reduced cost base of the dwelling. 50% CGT discount In certain circumstances, you may be eligible to reduce the amount of tax payable on a capital gain by applying the 50% CGT discount. To be eligible for the discount on a capital gain you must: ● be an individual; ● have held the asset for longer than 12 months; and ● the CGT event happens after 11:45am ACT legal time on 21 September 1999. Application to your situation As outlined above, the profit made on the disposal of your 50% ownership interest in the Land, and Dwellings, will be assessed under the CGT provisions. CGT event A1 will occur when you enter into the contract for the sale of the Land. This CGT event will only be occurring in relation to the Land of the Property given that the original dwelling located on the Property was demolished. You have provided a list of expenses that you and Person A incurred in relation to the purchase of the Property, the demolition of the original dwelling, and the construction of the Dwellings. While we will not confirm the correctness of the amounts provided, they can be included in the cost base of your ownership interest in the Land, with the exception of the costs incurred in relation to the cost of advice/final calculations provided by a tax agent, which will be claimed as a deduction in accordance with section 25-5 of the ITAA 1997, and will be included at item D10 in your income tax return. In this case the Land was purchased prior to 20 September 1985, the contract for the construction of the Dwellings was entered into during the following year, with construction of the Dwellings being completed a number of years later. For the purposes of 50% CGT discount the Land, and the Dwellings, will be viewed as having been held for more than 12 months. Therefore, you will be entitled to apply the 50% CGT discount to the capital gain made on the disposal of your 50% ownership interest in the Land.