Private ruling: Property development - revenue versus capital
Date of advice: 22 November 2019
Published: February 2020
Ruling period: 1 July 2018 - 30 June 2019
Date scheme commenced: 1 July 2018

Ruling: Q1: Is the realised loss of the discretionary trust in relation to the purchase and sale of a property, purchased in partnership with a third party, a loss that is deductible under section 8-1, as a loss arising from an isolated transaction? | A1: Yes.

Relevant facts and circumstances: X is a discretionary trust. The trustee of the trust is Y Pty Ltd (the trustee). A is the sole director and secretary of the trustee. The trustee owns 50 per cent of the shares in X Pty Ltd, a building and construction company, and has previously been involved in the purchase, renovation and sale of a property in partnership with two other entities, which occurred between July 20XX and August 20XX. On XX August 2018, the trustee successfully bid on a residential property (the property) at auction, which was settled in September 2018 for $X million. The property was purchased in partnership with Z Pty Ltd. Z Pty Ltd is an unrelated party. The property had an existing structure on it. Prior to the purchase of the property, Mr B acting as project manager on behalf of the trustee, discussed a plan with Mr C, director of Z Pty Ltd, to: purchase a property with an existing structure, knock the existing structure down, build a new house and then sell the property for a profit within a year of the original purchase of the property (the project). Prior to the purchase of the property, Mr B and Mr C discussed with real estate agents the prospects of making a profit from the project. In September 2018, Mr B and Mr C identified best and worst case scenarios for the project, believing they could realise between $XX,000 and $XXX,000 profit from the project. The trustee never had the intention of holding the property as an investment property. Prior to the purchase of the property, the trustee, together with Z Pty Ltd, obtained preapproval from X Bank for a loan to purchase the property. The approval was given on the basis of the short term profit realisation plan. In September 2018, the trustee engaged a construction company for the construction of a new house on the property. In October 2018, the trustee engaged a demolition company to remove the existing structure. In October 2018, the trustee also engaged a construction company for the construction of a swimming pool. Due to unforeseen circumstances, Z Pty Ltd was not able to secure lending in order to continue with the building process for the property. On the basis that the original plan to knockdown, rebuild and resell was no longer achievable due to insufficient funds, both parties agreed to sell the property without completing the project. The property was sold in May 2019 for $X million. The total loss from the project was approximately $XXX,000.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 6-5

Reasons for decision: Summary: When determining how gains or losses in relation to real property are to be treated for tax purposes, it is necessary to consider whether the income and/or expenditure is of a revenue or capital nature. Generally the proceeds from transactions involving the sale of real property will be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or deductible under section 8-1 of the ITAA 1997 where they relate to carrying on a business activity or an isolated commercial transaction. Alternatively, where the sale of real property is not part of a business or an isolated commercial transaction, any profit or loss will be subject to the capital gain tax provisions. | Detailed Reasoning - Carrying on a business: The Commissioner's view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 (TR 97/11) which 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. Based on the information provided, we do not consider the trustee is carrying on a business of property development. The intended project is on a small scale, being the demolition and construction of a single dwelling. The trustee has only once previously engaged in buying, renovating and selling property, over five years earlier and the trustee has not indicated the intention of engaging in future developments. It is therefore the ATO's view that the loss has not been incurred from the carrying on of a business. | Detailed Reasoning - Isolated transaction: It is the ATO's view that a loss from an isolated transaction is generally deductible under section 8 -1 if the taxpayer expected the transaction to produce a profit which would have been income assessable under section 6-5. Profits arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business ( FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693( Myer Emporium )). Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 of the ITAA 1997 as ordinary income. TR 92/3 should be read in conjunction with Taxation Ruling TR 92/4 Income tax: whether losses on isolated transactions are deductible. TR 92/3 defines the term 'isolated transactions' as: · transactions outside the ordinary course of business of a taxpayer carrying on a business, and · transactions entered into by non-business taxpayers. If a taxpayer makes a profit or loss from a transaction or operation, that profit or loss is income under section 6-5 or deductible under section 8-1 if the transaction or operation is not in the course of the taxpayer's business but: the intention or purpose 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 or loss was made, in carrying out a business operation or commercial transaction. Whether an isolated transaction is business or commercial in character will depend on the circumstances of each case. TR 92/3 lists the following factors to be considered: a) the nature of the entity undertaking the operation or transaction; if a taxpayer is a corporation with substantial assets rather than an individual, that may be an indication that the operation is commercial in nature; b) the nature and scale of other activities undertaken by the taxpayer; c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained; d) the nature, scale and complexity of the operation or transaction; e) the manner in which the operation or transaction was entered into or carried out; this factor would include whether professional agents and advisers are used; f) the nature of any connection between the relevant taxpayer and any other party to the operation or transaction; g) if the transaction involves the acquisition and disposal of property, the nature of that property; and h) the timing of the transaction or the various steps in the transaction, for example, if the relevant transaction consists of the acquisition and disposal of property, the holding of the property for many years may indicate that the transaction was not business or commercial in nature. In applying TR 92/3 and TR 92/4 to the trustee's circumstances: | Detailed Reasoning - Entered into the transaction with intention to derive a profit: The actions of the property manager acting on behalf of the trustee indicate that the trustee entered into the transaction with the intention to derive a profit. Prior to the acquisition of the property, the trustee developed a plan to purchase a property with an existing structure, knock down the existing structure, build a new house and resell the property within 12 months of the original purchase. The trustee obtained advice from local real estate agents to estimate the profit that could be realised from such a project and also developed a profitability model to assess best and worst case scenarios. Shortly after purchasing the property, the trustee took initial steps to realise the intended plan for the property, including the demolition of the existing structure and engagement with construction companies to build a new house and a pool. The Commissioner accepts that the trustee had a profit-making intention in purchasing the property and a plan that involved improving the property and increasing its value. | Detailed Reasoning - The transaction was entered into in carrying out a business operation or commercial transaction.: In applying the facts to the relevant factors outlined in TR 92/3 on whether an isolated transaction is business or commercial in character, it is the Commissioner's view that the trustee purchased the property in carrying out a business operation. While certain factors point against the transaction being a business or commercial operation, such as the nature of the entity as a trustee of a discretionary trust, the majority of factors identified support the Commissioner's conclusion. The trustee appointed Mr B an experienced builder and part owner of Z Pty Ltd, as the property manager in charge of the project. The trustee had a plan in place to obtain professional services to demolish the existing property and build a new house and pool, prior to its resale. The project's timing and steps taken were commercial in nature. Within one month of the purchase of the property, the trustee had engaged professionals to perform services, and the trustee had a plan to resell the property within 12 months of the original purchase. Other activities of the trustee are also indicative the trustee is carrying out a business operation. The trustee has previously purchased, renovated and sold a property, and holds 50 per cent of the shares in X Pty Ltd. | Detailed Reasoning - Incomplete development: The fact that the trustee's plan to build a new house and pool was never realised does not impact on the nature of the losses. TD 92/126 identifies that if in an isolated commercial transaction, land is acquired for the purpose of development, subdivision and sale, but the development and subdivision do not proceed, the profit on the sale of the land is treated on revenue account for tax purposes. While the trustee did not plan to subdivide in this case, the loss relates to an isolated commercial transaction from land acquired for the purpose of development and sale. The project was never completed due to unforeseen circumstances and the property was sold without a dwelling on it.