property development: practical income tax, cgt … entities..... 9 restructuring ..... 10...

Property Development: Practical income tax, CGT and GST issues

This paper was presented to The Tax Institute, Victorian Division, 29 October 2015

The distinction between ‘property development’ and ‘property investment’ is often difficult to divine in practice.

This paper uses examples to illustrate and explain the income tax, CGT and GST treatment of common property development transactions including:

distinguishing between and the taxation of trading stock, profit making schemes and capital gains

property development;

the selection of ownership and development structures to undertake property development;

main residence projects;

mixed investment and sale projects;

private property syndicate projects;

partition and exchange and in-specie distribution investment projects;

GST residential development classifications; and

GST going concern project disposals.

Introduction .................................................................... 2

Overview ..................................................................... 2

Introduction to taxation ................................................. 2

Overview ..................................................................... 2

Trading stock ............................................................... 3

Profit making schemes ................................................. 5

Capital gains tax .......................................................... 7

Differences in expense treatment ................................. 7

Mere realisation ........................................................... 8

Introduction to structuring ............................................ 8

Tax planning ................................................................ 8

Landowner entities ....................................................... 9

Restructuring ............................................................. 10

Development entity .................................................... 11

Builder entity .............................................................. 11

Practical examples ....................................................... 12

Main residence projects ............................................. 12

Mixed investment and sale projects ........................... 14

Private property syndicate projects ............................ 15

Partition and exchange and in-specie distribution projects 16

GST residential development classifications .............. 17

GST going concern project disposals ......................... 18

Glossary ....................................................................... 19

© Ron Jorgensen 2015 of 19

Introduction

Overview

The distinction between ‘property development’ and ‘property investment’ is often difficult to divine in practice.

‘Property development’ is used to mean the development of property for the purpose of sale (including subdividing the family’s ½ acre block, broad acre subdivision and high-density strata developments). ‘Property investment’ is used to mean the development of property for the purpose of retention and use to derive assessable income (including as premises of a trading business and to derive rental).

The diversity of a property project makes it impossible to deal comprehensively with the topic in a paper of this nature.

This paper uses examples to illustrate and explain the income tax, CGT and GST treatment of common property development transactions including:

distinguishing between and the taxation of trading stock, profit making schemes and capital gains

property development;

the selection of ownership and development structures to undertake property development;

main residence projects;

mixed investment and sale projects;

private property syndicate projects;

partition and exchange and in-specie distribution investment projects;

GST residential development classifications; and

GST going concern project disposals.

Introduction to Taxation

Overview

The income taxation of a property project is complex as up to three taxation regimes may apply to levy tax. The transfer of land may be taxable:

1. as a disposal of trading stock of a property development business;1

2. as a profit making scheme;2 or

3. as a taxable gain on the disposal of a CGT asset.3

The application of these regimes leaves little scope for the transaction to be considered a non-taxable ‘mere realisation’ of a capital asset. It is usually only simple developments of pre-CGT Assets4 that will qualify for this treatment.

Accordingly, most analysis by practitioners concerns whether:

1 Div. 70 ITAA 1997. 2 Sec. 6-5 ITAA 1997.

3 Pt 3.1 and 3.3 ITAA 1997. 4 i.e. land acquired before 20 September 1985.


1. the taxpayer is carrying on a business of property development (i.e. whether the trading stock rules

apply);

2. the taxpayer had a profit making motive at the time of acquisition (i.e. whether there is a profit

making scheme); or

3. a specific statutory provision (e.g. profit making undertaking or plan)5 applies.

The trading stock regime provides an exclusive regime for the taxation of land that constitutes trading stock. The CGT regime expressly exempts trading stock (i.e. land) from being a CGT Asset.6 The trading stock regime only operates on stock held in the ordinary course of business. Accordingly, the trading stock regime and the profit making scheme regime (which has a residual operation for ‘revenue assets’ that are not trading stock)7 or the CGT regime (which operates for ‘capital assets’) cannot operate concurrently.

Where the acquisition of land is for a profit making purpose, the land is considered a revenue asset and its realisation a revenue profit.8 However, the fact that the land is a revenue asset does not preclude it from being a CGT Asset. Land is a concurrent CGT Asset.9 Accordingly, the profit making scheme regime and the CGT regime apply concurrently. The ordinary income regime has legislative priority over the CGT regime, because, where a receipt is taxable as ordinary income and a capital gain, the capital gain is reduced by the amount of the revenue profit.10 Where the net profit under the profit making scheme regime is calculated differently to the CGT regime, concurrent taxation operation is arguable possible.

If these provisions do not apply, the adviser must determine whether:

1. the CGT provisions apply; or

2. the realisation will be a non-taxable mere realisation.

Trading stock

Trading stock includes articles acquired for the purpose of manufacture, sale or exchange in the ordinary course of business. Land may be trading stock for tax purposes.11

A taxpayer will account for trading stock on the following basis:12

1. acquisition and ancillary costs (e.g. development costs) of purchased trading stock are an allowable

general deduction13 in the year the trading stock is held for use in a business;14 and

2. disposal consideration of trading stock is assessable income in the year of disposal of the trading

stock;15 and

3. where the opening trading stock value (e.g. the previous year 30 June closing trading stock value)16

exceeds closing trading stock value (e.g. the current year 30 June closing trading stock value), an

allowable general deduction is incurred;17 or

5 Sec. 15-15 ITAA 1997; previously sec. 25A ITAA 1936. 6 Sec 118-25 ITAA 1997. 7 R. Parsons, Income Taxation in Australia, Law Book Company Ltd, 1985, para 12.3. 8 R. Parsons, Income Taxation in Australia, Law Book Company Ltd, 1985, e.g. para 12.8; FCT v Myer Emporium Ltd [1987] HCA 18. 9 Sec. 108-5(1) ITAA 1997 defines a ‘CGT Asset’ as ‘any kind of property’ and does not exclude revenue assets that are not trading stock.

10 Sec. 118-20 ITAA 1997. 11 FCT v St Hubert’s Island P/L 78 ATC 4104; (1978) 8 ATR 452. 12 Sec. 70-5 ITAA 1997. 13 Sec. 8-1 ITAA 1997. 14 Sec. 8-1 & 70-15 ITAA 1997. 15 Sec. 6-5 ITAA 1997. 16 Sec. 70-40 ITAA 1997. 17 Sec. 70-35 ITAA 1997.


4. where the closing trading stock value (e.g. the current year 30 June closing trading stock value)18

exceeds opening trading stock value (e.g. the previous year 30 June closing trading stock value),

assessable income is derived.19

Vacant land will constitute trading stock in globo even before it is converted into a subdivided and improved condition for sale.20 In globo trading stock will become converted to individual articles of trading stock upon subdivision.21

The key factors to weigh in determining whether the particular property project was part of a business of property development are:

1. the taxpayer’s purpose in acquiring and carrying out the project;22

2. the taxpayer’s history of property development or investment;23

3. the extent of personal involvement of the taxpayer;24

4. the reasons for developing the land;25

5. the duration of ownership;26

6. the scale of the sub-division;27 and

7. the extent of any construction work undertaken.28

Reasonable practitioners may differ on whether a particular property project was a property development business when weighing these factors resulting in potential dispute with the ATO.

Reasonable practitioners may differ on ddetermining the cost of land and improvements during a tax period and allocating costs to individual articles of trading stock upon subdivision resulting in potential dispute with the ATO.

The concept of ‘cost’ is directed at ascertaining the costs incurred in the course of a taxpayer’s materials purchasing and manufacturing activities to bring the article to the state in which it became trading stock held.29 It arguably excludes expenses and overheads that do not have a relationship with production (e.g. marketing, distribution and selling expenses and general administration expenses).30 Although many of these costs will be otherwise deductible,31 there are a number of expenses that may neither be included in the cost of trading stock nor deductible as a general business outgoing.

Generally, the following costs of subdivision should be characterised as part of the cost price of the broad acres before subdivision and, therefore, upon subdivision part of the cost price of the subdivided lots:32

1. the cost of ‘infrastructure land’ (i.e. that part of the broad acres land on which services and utilities

were to be build and transferred to the Council);

18 Sec. 70-45 ITAA 1997. 19 Sec. 70-35 ITAA 1997. 20 FCT v St Hubert’s Island P/L 78 ATC 4104; (1978) 8 ATR 452. 21 Barina Corporation Ltd v FCT (1985) 4 NSWLR 96. 22 FCT v Whitfords Beach P/L [1982] HCA 8 (new shareholders intent to develop) & Stevenson v FCT 91 ATC 4476; (1991) 22 ATR 56 (change in development purpose). 23 FCT v Whitfords Beach P/L [1982] HCA 8 (new shareholders had a history of developments) & Crow v FCT 88 ATC 4620; (1988) 19 ATR 1565 (multiple successive history of development). 24 Stevenson v FCT 91 ATC 4476; (1991) 22 ATR 56 (significant involvement of landowner); cf Casimaty v FCT 97 ATC 5135; (1997) 37 ATR 358 (most aspects delegated to contractors and agents). 25 FCT v Whitfords Beach P/L [1982] HCA 8 (systematic for a profit); cf Casimaty v FCT 97 ATC 5135; (1997) 37 ATR 358 (piecemeal as increasing debt and deteriorating heath dictated).

26 Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188 & Casimaty v FCT 97 ATC 5135; (1997) 37 ATR 358; cf Stevenson v FCT 91 ATC 4476; (1991) 22 ATR 56. 27 FCT v Whitfords Beach P/L [1982] HCA 8 (magnitude of development does not convert it into a business); cf Stevenson v FCT 91 ATC 4476; (1991) 22 ATR 56 (magnitude of development is highly persuasive). 28 Stevenson v FCT 91 ATC 4476; (1991) 22 ATR 56 (extensive services and utilities provided); cf Casimaty v FCT 97 ATC 5135; (1997) 37 ATR 358 (minimal works to obtain council approval). 29 e.g. Philip Morris Ltd v FCT 79 ATC 4352; (1979) 10 ATR 44 (regarding costing generally and not specifically land). 30 Rulings IT 2350 & IT 2402. 31 Determination TD 92/132. 32 FCT v Kurts Development Ltd 98 ATC 4877; (1998) 39 ATR 493.


2. the costs of ‘infrastructure works’ (e.g. the cost of establishing services and utilities33 on the

‘infrastructure land’); and

3. the ‘external costs’ (e.g. the costs of ‘headworks’ including the provision of services and utilities34 to

the land, but on land not owned by the taxpayer).

It is unclear whether reinstatement costs may be used to reduce the market selling value of broad acres.35 The cost of, for example, reinstating excavation works and rectifying site contamination may markedly reduce the market value of land (at least for a period).

From year to year, the taxpayer may determine to value each article of trading stock at cost, market selling value or replacement price.36 Replacement price is generally not an appropriate method of valuing land that is trading stock.37 For an appreciating article of trading stock such as land where there will be an increase in value between the start of an income year and the end of the income year, the change from:

1. cost to market selling value, will likely derive assessable income; and

2. market selling value to cost, will likely incur a general deduction.

It may be possible to recognise a general deduction for the loss in value in a particular year (e.g. by reinstatement costs) by changing from cost to the market selling value method. The change back from market selling value to cost will reverse this general deduction and derive assessable income. Although relatively short term, this may create a cash flow benefit in the appropriate circumstances.

Profit making schemes

The ordinary income of a business operation or commercial transaction includes the ‘profit’ on certain isolated transactions entered into with the purpose of making a profit.38

Westfield Ltd v FCT 39 emphasised the distinction between a transaction occurring as part of ‘business operations’ (Business Limb) and as part of a ‘commercial transaction’ outside the ordinary business operations (Commercial Limb).

Arguably, the main difference between the Business Limb and Commercial Limb is that:

1. it will automatically be inferred at all times that the taxpayer had a profit-making intent under the

Business Limb; but

2. it will need to be positively establish at the time of entering into the transaction that the taxpayer

intended to make a profit in relation to the particular transaction by which the profit was in fact made

and not simply in a temporal sense under the Commercial Limb.40

The Commissioner considers that the sale of property will be a profit making scheme under both limbs if the taxpayer had a profit making intent at the time the sale transaction is entered into and it need not be established that the profit arose in the manner initially intended.41

33 e.g. internal access roads, internal street lighting, internal sewage and drainage and parklands. 34 e.g. external road works to the broad acres, downstream sewage and drainage to the broad acres and external parklands and contributions to civil services such as school improvements and expansions. 35 Refer to Case A42 69 ATC 235 where new Council requirements on developing land arguably reduced the land’s market value. The taxpayer was unsuccessful because the change occurred after the close of the income year the subject of the assessment.

36 Sec. 70-45 ITAA 1997. 37 e.g. Parfew Nominees P/L v FCT 86 ATC 4673 (1986) 17 ATR 1017. 38 FCT v Myer Emporium Ltd [1987] HCA 18; Westfield Ltd v FCT 91 ATC 4234; (1991) 21 ATR 1398; Ruling TR 92/3. 39 Westfield Ltd v FCT 91 ATC 4234; (1991) 21 ATR 1398. 40 FCT v Myer Emporium Ltd [1987] HCA 18; Westfield Ltd v FCT 91 ATC 4234; (1991) 21 ATR 1398; & FCT v Hyteco Hiring P/L 92 ATC 4694; (1992) 24 ATR 218. 41 Ruling TR 92/3.


The Commissioner’s position would significantly expand the operation of the profit making scheme regime.

The Commissioner considers the following factors to determine whether an isolated transaction constitutes a profit making scheme:

1. the nature of the entity undertaking the operation or transaction;

2. the nature and scale of other activities undertaken by the taxpayer;

3. the amount of money involved in the operation or transaction and the magnitude of the profit sought

or obtained;

4. the nature, scale and complexity of the operation or transaction;

5. the manner in which the operation or transaction was entered into or carried out;

6. the nature of any connection between the relevant taxpayer and any other party to the operation or

transaction;

7. if the transaction involves the acquisition and disposal of property, the nature of that property; and

8. the timing of the transaction or the various steps in the transaction.

‘Profit’ is calculated according to profit and loss accounting methodology and not receipts and outgoings tax accounting. The profit calculation assumes the profit arises from one transaction and not from a continuing business. The methodology of calculating the profit has not received much judicial comment.42 The profit is the difference between the price realised on disposal, less the costs of acquisition and the costs of selling.43

It is unclear whether historical cost44 or market value45 at the time the property becomes subject to a profit making scheme is used. The historical cost basis would significantly increase the profit on the transaction and might lead to double taxation.

The concept of cost is arguably includes a wider variety of costs in the profit calculation.46 The fact that a cost has not yet been paid or a liability is contingent at the time of calculating the profit does not preclude such costs being subtracted from the profit.47 The calculation may therefore result in costs not otherwise allowable as a cost of trading stock being subtracted/‘deducted’ under the profit making scheme regime

Where land is sold, the costs applicable to the development must be apportioned to each parcel of land sold. This is done under the method of tax accounting.48 The calculation method will need modification if the project is restructured before development is completed. These issues are variously discussed in the following Taxation Determinations (which in several respects can be criticized):

1. TD 92/126 Income tax: property development: 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, how is a profit on a sale of the land treated for income tax purposes?

2. TD 92/127 Income tax: property development: if land is acquired for development, subdivision and

sale but the development is abandoned and the land sold in a partly developed state, how is a profit

on a sale of the land treated for income tax purposes?

42 FCT v Whitfords Beach P/L [1982] HCA 8 (the decision when remitted to the Federal Court to determine the profit of the transaction). 43 FCT v McClelland (1969) 118 CLR 353, 358. 44 FCT v Myer Emporium Ltd [1987] HCA 18. 45 FCT v Whitfords Beach P/L [1982] HCA 8.

46 FCT v Whitfords Beach P/L [1982] HCA 8; R. Parsons, Income Taxation in Australia, Law Book Company Ltd, 1985, para 12.40 47 R. Parsons, Income Taxation in Australia, Law Book Company Ltd, 1985, para 12.42 & 12.43. 48 FCT v Thorogood (1927) 40 CLR 454


3. TD 92/128 Income tax: property development: if land is acquired for development, subdivision and

sale, but after some initial development the project ceases and is recommenced in a later income

year, how is a profit on a sale of the land treated for income tax purposes?

Capital gains tax

A capital gain or loss may arise upon the occurrence of a CGT event (e.g. a transfer)49 in respect of a CGT asset (e.g. land),50 unless an exemption applies, rollover relief defers the capital gain or a provision denies the loss.

A capital gain arises where the proceeds from the CGT event exceed the adjusted acquisition costs of the CGT asset.51 A capital loss arises where the proceeds from the CGT event are less than the adjusted acquisition costs of the CGT event.52

Capital gains on assets acquired before 20 September 1985 are disregarded.53

A net capital gain is included in the assessable income of the taxpayer.54

An individual or trust that has held a CGT asset for at least 12 months may reduce the capital gain by 50% and a superannuation fund may reduce the capital gain by 33% under the CGT general discount.55 A number of exemptions (e.g. the main residence exemption56) and concessions (e.g. small business concessions57) may also apply in particular circumstances.

Acquiring and retaining land as a capital asset to access these discounts, exemptions and concessions is central to tax planning property projects.

The cost base of acquiring an assets consists of ‘5 elements’:

1. The 1st element of cost base represents amounts of money or property paid or given, or required

to be paid or given, to acquire the asset.

2. The 2nd element of cost base includes incidental costs of acquisition (e.g. advice costs, transfer

costs, stamp duty, advertising costs and valuation fees).

3. The 3rd element of cost base’ includes non-capital costs of ownership (e.g. interest not otherwise

deductible, repairs and insurance costs and rates and land tax).

4. The 4th element of cost base includes capital expenditure increasing the asset's value.

5. The 5th element of cost base includes capital expenditure to preserve title.

Some project expenses may not be included in the cost base. For example, it is unclear whether the 1st element of cost base includes remote third party tender payments58 and whether the 4th element of cost base include compensation payments to obtain Council approvals.

Differences in expense treatment

It is unclear whether development costs such as:

1. informal ‘compensation payments’ to residents objecting to the development;

49 Sec. 104-10 ITAA 1997 - Disposal of a CGT Asset: CGT event A1. 50 Sec. 108-5 ITAA 1997. 51 Sec. 102-5 ITAA 1997. 52 Sec. 102-10 ITAA 1997. 53 Sec. 104-10(5) ITAA 1997 - Disposal of a CGT Asset: CGT event A1; Determination TD 7.

54 Sec. 102-5 ITAA 1997. 55 Sec. 115-25 ITAA 1997; Determination TD 2002/10. 56 Div. 118-B ITAA 1997. 57 Div. 152 ITAA 1997. 58 The provision would appear to be sufficiently widely worded.


2. the notional value of personal services in managing the development;

3. ‘opportunity payments’,59 ‘tender administration payments’60 and ‘transferable floor area’

payments61

will be a cost of trading stock, subtracted in calculating profit under the profit making scheme regime or an element of cost base under the CGT regime or whether such costs will be wasted (i.e. black hole expenditure).

The entitlement to these expenses can be inconsistent across the regimes, so tax planning may require structuring so a particular regime applies which will include the particular expenses.

Mere realisation

Where the trading stock, profit making scheme or capital gains tax regimes do not apply (e.g. pre-CGT assets), the proceeds of the project are not taxed.

Post-CGT buildings and intangible improvements to pre-CGT Assets are separate post-CGT Assets. These improvements are subject to the CGT regime, requiring capital proceeds to be apportioned.

A post-CGT building or structure is a separate asset to the pre-CGT land.62 Accordingly, the building component of a property development on pre-CGT land, is taxable. The Commissioner considers that the increase in land value attributable to Council approval for rezoning and development will be a separate post- CGT Asset and separately taxable under the CGT regime.63

Tax planning to retain the pre-CGT status of land usually involves appointing a separate development entity to undertake any development so that the landowner remains very passive so that the property project does not become a profit making scheme.

Introduction to structuring

Tax planning

Tax planning is the professional art of balancing different legal and tax entities’ relative tax and non-tax characteristics including:64

1. tax treatments (degree of transparency, working capital retention, distribution splitting/streaming,

entitlement to CGT discounts and concessions);

2. progressive marginal and corporate tax rates;

3. investment flexibility (capitalisation and financing);

4. asset protection robustness (personal, corporate and intra-entity insolvency);

5. business succession flexibility (third party or intergenerational transmissions);

6. governance regulation (degree of contractual, statutory and governmental and professional

supervision); and

7. administrative and compliance complexity and cost.

59 A payment to a person to assume that person’s right to tender for land in a restricted tender arrangement. 60 A payment to a tender offeror to permit the taxpayer to tender or to defray administration costs of the offeror in considering the tender. 61 The ability for the owner of a conservation site to transfer developer ‘floor area’ to another site to increase the maximum permissible floor

area for development purposes of the other site; see the Naval Military & Airforce Club of South Australia Case (1994) 28 ATR 161. 62 Section 108-55(2) of the 1997 Act. 63 CGT Determination No. 5; sec. 108-70(2) ITAA 1997. 64 B. Freudenberg, ‘Tax on my mind: Advisors’ recommendations for choice of business form’, (2013) AT Rev 33.


Legitimate tax planning uses tax policy distinctions/disconformities to reduce the overall effective tax rate.

Tax planning opportunities are dictated principally by whether the landowner intends to sell the subdivided land to produce a profit or retain the land for income producing purposes (e.g. to use in a business or for leasing). This will determine whether the profit is potentially taxable on revenue account (e.g. as ordinary income) or on capital account (e.g. as a taxable capital gain) respectively.

Choosing the correct business structure is an art rather than a scientific application of principles. The choice of structure will vary depending upon (amongst other matters) the insolvency protection, liquidity and financing requirements and priorities of each participant.

There is a significant benefit of classifying a transaction on capital account on the odd occasion where the ‘mere realisation’ principle will apply. Also, there is arguably a bias towards classifying a transaction on capital account where the taxpayer has carried forward capital losses or there is the opportunity to use the CGT general discount65 or the small business concessions.66

This paper does not discuss the State taxes consequences of structuring including stamp duty and land tax.

Landowner entities

Selecting the landowner structure for a property project is not always possible.67

A comparison of some of the relevant attributes of the above structures are summarised on the next page:

Individual Partn’ship Family Trust

Unit Trust Company Joint Venture

Administrative complexity

Low Medium Medium Medium High High

External regulation _ Partnership Acts

Trustee Acts Trustee Acts Corporations Act

_

Insolvency risk to participants

High High Low Low Low Medium

Family dispute risk to participants

High High Low High High High

Access to development losses

Yes Yes No68 No No Yes

Access to negative gearing at participant level

Yes Yes No Yes69 Yes70 Yes

Access to 50% CGT Discount

Yes Yes Yes Yes No Yes

Access to equity Yes Yes71 Yes possible CGT Event E4

Dividend Division 7A

Yes

Distribution flexibility Low Low High Low Low Low

65 Div. 115 ITAA 1997. 66 Div. 152 ITAA 1997. 67 e.g. the land was acquired under a will or by a particular entity for commercial and other reasons without regard to the taxation and commercial issues for future development.

68 The trust loss rules in Schedule 2F of the 1936 Act may permit injection activities in limited circumstances. 69 If borrowed at participant level and used to capitalise the unit trust. 70 If borrowed at participant level and used to capitalise the company. 71 FCT v Roberts & Smith 92 ATC 4380; (1992) 23 ATR 494; Ruling TR 95/25.


A company provides a high degree of insolvency protection and has a well-defined corporate governance process, which is ideal for unrelated business parties. A company may be suitable for a trading stock or profit making scheme project landowner. However, legislative restrictions on dividend policies;72 the inability to distribute current year losses,73 and ineligibility for the CGT discount;74 means that a company is not the most appropriate tax structure for a capital gains project landholder.

A trust (particularly a discretionary trust or a hybrid unit trust) provides a high degree of flexibility in profit distribution policy. Again, the inability to distribute current year losses and restrictions on transferring losses without making a family trust election75 means that a trust is not the most appropriate structure for landownership between unrelated parties. Negative gearing discretionary and hybrid trusts is also problematic.76

A partnership permits the distribution of current year losses and has a reasonably well-defined governance process. However, the agency and fiduciary relationships of the partners and the joint and several liabilities of the partners generally outweigh the advantage of using current year losses, making a partnership an unattractive structure.

An ‘unincorporated joint venture’ or a ‘non-entity joint venture’ provides separate taxation treatment of landowners.77 The Commissioner limits a joint venture operation to circumstances where the participants are compensated by a share of the output rather than joint or collective profits.78 An improperly established joint venture structure may not achieve the desired business,79 financing80 and taxation81 requirements, because it is in fact a general law partnership82 or a taxation partnership.83

Various forms of unincorporated joint ventures of companies and trusts are frequently used to achieve a satisfactory mix of the above requirements.

Restructuring

Care needs to be exercised when the structuring of a property development is intended to be on capital account, because changes to the taxpayer structure (e.g. a change of shareholding or a change of purposes in a Constitution) may transform a capital account development into a property development business. The admission of new equity parties to fund the property development may be the catalyst that transforms a capital account development into a property development business. Such changes were considered critical in FCT v Whitfords Beach Co P/L84 where beach front land held in a company and used as a right of way to fishing shacks on the beach was acquired and restructured to permit subdivision and development.85

The practice of establishing separate development entities to argue that each entity does not have a history of property development may be of little effect. The members’ extensive history of property development was a significant factor in FCT v Whitfords Beach Co P/L86 in concluding that the company was carrying on a property development business.87 This reasoning suggests that the Courts may look

72 Div. 7A ITAA 1936 (deemed dividends); sec. 109 ITAA 1936 (excessive remuneration); Div. 202 - 207 ITAA 1997 (imputation credits); sec. 160APHC-160APHU ITAA 1936 (45-day holding period rules); Division 197 ITAA 1997 (share tainting rules) 73 Div. 36 ITAA 1936 (prior year losses); Div. 165 ITAA 1997 (current year losses and bad debt deductions); Div. 175 (current year deductions); Div. 170 ITAA 1997 (intercompany loss transfers) 74 Sec. 115-10 ITAA 1997. 75 Sch. 2F ITAA 1936. 76 Income Tax Ruling IT 2385 & ATOID 2003/546. 77 Ruling GSTR 2004/2. 78 Ruling GSTR 2004/2. 79 The Laws of Australia, The Law Book Company Limited, Part 4.8, Chapter 4. 80 The Laws of Australia, The Law Book Company Limited, Part 4.8, Chapter 4. 81 Discussed in M. Walsh, ‘Partnerships – joint ventures and taxation (1978-79) 13 Taxation in Australia, 478; G. Ryan, ‘Joint venture

agreements’, (1982) 4 AMPLJ, 101; H. Speath, ‘Joint ventures & GST’, (2001) 4(3) Tax Specialist, 162. 82 A general law partnership is defined as the relationship that subsists between persons carrying on a business in common with a view to profit (Section 5(1) of the Partnership Act). 83 A partnership for tax purposes includes a general law partnership and an association of persons in receipt of income jointly (Section 995-1 of the 1997 Act). For the purpose of this paper, ‘general law partnership’ will refer to a partnership satisfying the Partnership Acts, a ‘taxation partnership’ will be used to refer to persons in receipt of income jointly and ‘partnership’ will refer to both types. 84 FCT v Whitfords Beach P/L [1982] HCA 8. 85 FCT v Whitfords Beach P/L [1982] HCA 8, Gibbs CJ; Wilson J; cf Mason J. 86 FCT v Whitfords Beach P/L [1982] HCA 8. 87 FCT v Whitfords Beach P/L [1982] HCA 8 Gibbs CJ; Mason J cf Wilson J.


beyond the separate legal entity to the history of members and possibly other key associates such as directors and managers.88

Development entity

Since the indicia of carrying on a property development business includes the extent of involvement of the landowner, the appointment of a development entity to manage the development and contract with service providers may permit the landowners to remain very passive to assist in establishing that the landowner is not carrying on a business.

The developer entity can be a company or trust. Depending on how the development contract is structured, derivation of income and incurring of expenses can be managed so avoid liquidity problems.

Builder entity

The Proposed Structure

The obligation to incur and carry building costs may be transferred by the building contract to Builder P/L.

A ‘turn-key’ or ‘modified turn-key’ building contract may require Builder P/L to incur and carry development costs and to render an account only upon achieving a milestone (e.g. at lock up or practical completion stages) or upon sale of the development (respectively).

Builder P/L deducts all these outgoings on a current year basis and returns income in the later years when the milestones are met or the development is sold (as applicable). The landowner only brings into account the increase in value of the land resulting from the building at the later years when the milestones are met or the development is sold. As a group, the group has effectively accelerated the deduction for the building costs.

88 compare Determination TD 92/124 where the Commissioner takes a broad view of when land will be trading stock.


Tax Effect for the Builder

Builder P/L will derive income when entitled to bill for the work (being the time Builder P/L has a present and non-contingent right to receive payment).89 This will be when Builder P/L achieves the milestone or the development is sold (as applicable). The Commissioner appears to have accepted this proposition in respect of arm’s length contracts.90

The Commissioner requires Builder P/L to apply normal accounting methods.91

The ‘basic method’ and ‘estimated profit basis’ are alternate accounting methods available to Builder P/L to return income in respect of a ‘long term construction contract’. A long-term construction contract is a building contract that extends over two income years.92 The basic method returns income (e.g. all progress and final payments) derived in an income year less all outgoing deductions incurred in carrying on the building business in an income year.93 The estimated profit basis returns the ultimate profit or loss over the duration of the contract on a reasonable basis in accordance with accepted accounting standards.

The Commissioner has attempted unsuccessfully to require Builder P/L to use the estimated profit basis where derivation of income for Builder P/L is deferred under the building contract.94

Tax Effect for the Landowner

The landowner is obliged to include in the cost of trading stock expenditure incurred in the course of the landowner’s material purchasing and manufacturing activities to bring the article to the state in which it became trading stock held. The building expenditure under the turn-key and modified turn-key building contracts are not incurred until Builder P/L achieves the milestone or the development is sold. This is because the landowner does not have a non-contingent liability to pay those amounts until that time. Accordingly, the landowner does not have an obligation to increase the cost value of trading stock by the value of the building improvements.

Reduced Building Margin

There is no requirement for a captive builder to charge a captive landowner full margins on services. Where the landowner’s development is on capital account Builder P/L might forgo the builder’s margin, which would otherwise be taxable to Builder P/L as ordinary income. As the value of the building vest in the landowner, Builder P/L’s notional profit may be shifted to the landowner and converted to capital.95 This value shift may have value shifting consequences where Builder P/L is incorporated.96

Part IVA

The general anti-avoidance provisions in Part IVA ITAA 1936 need to be carefully considered.

Practical Examples

Main residence projects

The purpose of this example is to demonstrate the technical considerations that must be considered in selling a 2 lot main residence subdivision.

89 Henderson v FCT 70 ATC 4016; (1970) 1 ATR 596; Barratt v FCT 92 ATC 42745; (1992) 23 ATR 339. 90 Determination TD 94/39. 91 Ruling IT 2450. 92 Ruling IT 2450.

93 This represents the simple application of the statutory provisions; Grollo Nominees P/L v FCT 97 ATC 4585; (1997) 36 ATR 424. 94 Grollo Nominees P/L v FCT 97 ATC 4585; (1997) 36 ATR 424. 95 Grollo Nominees P/L v FCT 97 ATC 4585; (1997) 36 ATR 424 96 Div. 727 ITAA 1997.


Jack purchased 2 hectares (5 acres) in July 1997 on the outskirts of St Helens township. Jack completed building a main residence on the property by December 2008. The property has tripled in value. Jack wants to subdivide into 2 x 2.5 acres blocks, to retain one block as a main residence and to sell the other block.

The property was acquired to be used as a main residence and is on capital account. The property is within the 2 hectare main residence limitation.97

The main residence exemption will apply to the block and subsequent dwelling from date of acquisition, if the dwelling is built within 4 years from the date the land was acquired. The main residence must be moved into as soon as practicable after the work is finished and cannot be sold within 3 months of completion.98

The subdivision of the property is not a CGT event and the cost base is apportioned between the new split blocks.99 The Commissioner will accept an apportionment between the new split blocks on an area basis or a relative market value basis.100

The main residence exemption attaches to the land with the dwelling. Accordingly, the main residence exemption will not apply to the sale of the vacant land.101 Therefore, to preserve the main residence exemption, the current dwelling and land should be sold and the taxpayer should retain and build upon the vacant land.

The taxpayer can build on the vacant block, assume occupation of the new main residence and sell the old main residence, provided the concurrent ownership periods do not exceed 6 months.102 A modified method of calculating the ownership period would then apply.103 The taxpayer’s ownership interest in the old main residence only ends at settlement of the sale.104 Care is required to ensure the 6 months period is not exceeded. Long settlement dates can, therefore, be hazardous.

Alternatively, the taxpayer can sell the old main residence and then build a new main residence on the vacant land. The main residence exemption may be retained in the new main residence for up to 4 years from the date the land is acquired (not applicable in this example). Otherwise the 4 year period applied for the period immediately before the land became the new main residence. The new main residence must be moved into as soon as practicable after the work is finished and cannot be sold within 3 months of completion.105

The ownership period of the new main residence does not include the period of the old main residence (if more than 4 years from the date of acquisition of the land). Accordingly, tax will be payable on the subsequent disposal of the new main residence on a proportionate basis. The alternate scenarios need to be compared for tax efficiency.

97 Sec. 118-120 ITAA 1997; Determination TD 1999/67. 98 Sec. 118-150 ITAA 1997. 99 Sec. 112-25 ITAA 1997; Determination TD 7. 100 Determination TD 97/3. 101 Sec. 118-165 ITAA 1997.

102 Sec. 118-140 ITAA 1997. 103 Sec. 118-130 ITAA 1997; Determination TD 2000/13. 104 Gasparin v FCT 94 ATC 4280, 4288; (1994 ) 28 ATR 130. 105 Sec 118-150 ITAA 1997.


The subdivision and sale of a main residence is unlikely to be an enterprise for GST purposes.106 The subdivision and issue of new titles will, therefore, have no GST consequences.107

Mixed investment and sale projects

The purpose of this example is to demonstrate the effect of mixed investment & development purpose projects.

Jack acquired a property for the purpose of subdivision, building 1 shop, 3 terrace houses and 48 townhouses for lease. To repay the bank, it is estimated that the shop, terrace houses and 15 townhouses would be sold (i.e. 36% of the project). In fact only the shop, 3 terrace houses and 13 townhouses were sold (32% of the project).

ARM Construction P/L v FCT has stated that:108

The decisive factor in determining whether or not the units…became trading stock at any time…was the primary or substantial intent or purpose of the parties, which intention or purpose was carried into execution. The fact that they may have had a secondary or subsidiary purpose in selling the units if that became necessary in order to discharge their subsequent borrowing…did not stamp upon the units the character of trading stock…

…[So] far as the unsold town houses are concerned, the situation is the same…I am of the opinion that the town houses in fact retained… as well as the 13 sold, could not be characterised a “trading stock”, a conclusion which extends to the shop and the terrace houses. But I consider that the profits arising on the sale of the…properties in fact sold is assessable under the provisions of sec. 26(a). So far as the shop and the two terrace houses are concerned, I find that it wa the intention of the appellants from the outset o sell them in order to assist funding the development, an intention which related with greater certainty to the ship than to the terrace houses.

Accordingly, the properties intended to be sold and in fact sold would be a profit making scheme. The balance would retain their capital status. Although the taxpayer thought he would have to sell an additional 2 townhouses, that expectation does not appear to make those 2 townhouses part of the profit making scheme.

106 Determination GSTD 2000/8; Miscellaneous Taxation Ruling MT 2000/1, example 11.

107 Ruling GSTR 2003/3. 108 ARM Construction P/L v FCT 87 ATC 4790, 4806; (1987) 19 ATR 337.


Private property syndicate projects

The purpose of this example is to demonstrate that a unit trust property syndicate is generally tax inefficient, unless a specially modified unit trust is used.

Jack and seven unrelated people acquired a property in a unit trust for the purpose of subdivision, building a house on each block and distributing the block in specie (in kind) to each unitholder.

The mixed purpose of the participants creates a problem identifying the purpose of the project. To reconcile the mixed purposes, the property should be subdivided and each block distributed in kind to the relevant unit holder.109 This will ensure the property is not trading stock and is not a profit making scheme. This will permit the various unit holders to have different intentions.

The terms of the unit trust will also be vital. The unit holders of a traditional unit trust hold a tenants-in-common interest in all of the property (not any identifiable part of the property).110 After subdivision, each unit holder owns a proportionate interest in each block. The partition and exchange of interests so that each unit holder owns one block absolutely represents a proportionate disposal of an interest in all other blocks. The disposal of the various interests will, therefore, have income tax consequences.111

If a special purpose unit trust is used where each unit in the trust grants a beneficial interest in the particular block of land, then the unitholder will have an absolute entitlement to the land and there is no partition and exchange.112

The unit holder exemption exempts an in-kind transfer of land by the principal unit trust to a unit holder who was a unit holder at the time the land was acquired.

In respect of the exemption:

1. only unit holders at the time the land was acquired can obtain an exempt transfer and other unit

holders are subject to duty;

2. the exemption is only applicable in the same proportion as the unit holder’s proportionate unit

holding; and

3. the value of the unit holder in the unit trust must decrease by a redemption of unit or by the overall

value.

109 ARM Construction P/L v FCT 87 ATC 4790, 4806; (1987) 19 ATR 337. 110 CSR (Vic) v Karingal 2 Holdings P/L [2003] VSCA 214. 111 Determination TD 92/148.

112 Sec. 116-30 ITAA 1997; cf TR 2004/D25; CSR (Vic) v Victoria Gardens Developments P/L [2000] VSCA 233.


The transfer must be a transfer in the capacity of beneficiary and not on sale. There must not be any collateral consideration.

The beneficiary must receive the property in its capacity that it owned the units. Where the unit holder was a company there must be no change in ownership control or as a trustee there must be no change in the relevant beneficiary from the date the land was acquired by the principal unit trust.

The unit trust is treated as a separate entity for GST purposes.113 Accordingly, the in kind distribution of property will have GST consequences.114

Partition and exchange and in-specie distribution projects

The purpose of this example is to demonstrate how a partition and exchange occurs.

Jack and Jill inherited a property at tenants-in-common. Jack and Jill wish to subdivide the land so each owns their own block.

A partition of land occurs when W and B as co-owners of both ‘white acre’ and ‘black acre’ exchange their interests so that W solely owns white acre and B solely owns black acre.115

In Maybelina Investments P/L v CSR (Vic),116 M, A and I acquired property as co-owners to develop and partition 6 lots. Prior to partition 2 lots were sold to third parties. The partition of the balance land was effected by sale contracts for a specified monetary amount. The SRO argued that since the transaction was effected as a sale, it was not a partition and it was subject to transfer duty. Further, since some land was removed from the pool of land, a partition could not occur in respect of any of the property because there was not a community of ownership of the original acquired property.

VCAT held that a partition occurred in respect of the land interests exchanged despite being effected by a sale. However, no partition occurred in respect of the lots sold to third parties accordingly, duty was payable on the value of that land.

Ruling DA.017 provides the following worked example:

Example

X and Y own land in Victoria valued at $100,000 with a respective 30% and 70% interests in the land. The land is partitioned under an agreement such that after the partition, each has an interest of $50,000 in the land.

No duty would be charged on the transfer of Y's interest in the land because the value of Y’s interest in the land prior to the partition (ie $70,000) exceeds the value after the partition (ie $50,000). Duty would be

113 Sec 23-5 & 184-1 GSTA 1999. 114 By analogy with partnerships see Rulings GSTR 2003/13 & GSTR 2003/D5.

115 Sec. 27 DAV 2000; CSR (Vic) v Christian [1991] 2 VR 129. 116 Maybelina Investments P/L v CSR (Vic) [2004] VCAT 549.


charged on the transfer of X's interest in the land because the value after the partition (ie $50,000) is greater than that before the partition (ie $30,000). Duty would therefore be charged on the transfer of the interest in land to X and calculated on a value of $20,000.

Provided each block is of equivalent value to the value of the tenants-in-common interest, no duty should be paid.

GST residential development classifications

This example discusses the differences between different types of residential premises for GST purposes.

Jack owned a terrace and significantly renovated the interior, including moving walls, altering the location of the bathroom, refurbishing the kitchen and building a second story on the rear of the terrace. Jack used the terrace as a dental surgery. Jack listed the property for sale and the purchaser wanted to use the property as medical treatment rooms.

10% GST is levied on the value (or deemed value) of taxable supplies of goods, services, rights and things connected with Australia made in the course or furtherance of an enterprise that is registered or required to be registered but does not include GST-free, financial or input taxed supplies.117

Such an enterprise is entitled to an input tax credit or reduced input tax credit in respect of creditable acquisitions of goods, services, rights and things obtained in the course or furtherance of the enterprise that are not referable to GST-free, financial or input taxed supplies.118

The supply of new residential premises is a taxable supply. The supply of residential premises is an input taxed supply. The supply of commercial residential premises is a taxable supply.119

‘Residential premises’ means land or a building that is occupied or is intended to be occupied and is capable of being occupied as a residence or for residential accommodation (regardless of the term of the occupation or intended occupation).120

The character of the premises is determined by the physical characteristics of the premises test121 without reference to the supplier’s use of the premises122 or the recipients intend use of the premises.123

Jack’s terrace demonstrates all the objective characteristics of residential premises. Jack’s use of the premises and the recipient’s intended use of the premises is irrelevant and does not convert the premises into commercial premises.

The premises will be new residential premises where the premises are substantially renovated.124

The Commissioner considers substantial renovation includes:

1. the renovation needs to affect the building as a whole and result in the removal or replacement of all or substantially all of the building;125

2. substantial renovations can be the structural or non-structural components of the building;126

3. the removal and replacement of a kitchen and bathroom will not of itself be substantial renovation;127

117 Sec. 9-5 GSTA 1999. 118 Sec. 11-20 GSTA 1999. 119 Sec. 40-65 GSTA 1999 120 Section 195-5 GSTA 1999. 121 Sunchen P/L v FCT [2010] FCAFC 138 122 Ruling GSTR 2000/20 at [19] and [22] does not apply.

123 Toyama P/L v Landmark Building Developments P/L 2006 ATC 4160; Decision Impact Statement (4541/02). 124 Sec. 40-75 GSTA 1999; GSTR 2003/3. 125 GSTR 2003/3 at [61]. 126 GSTR 2003/3 at [69]. 127 GSTR 2003/3 at [76].


4. the additional story to the building was not substantial renovations;128

Reasonable practitioners can differ on what constitutes substantial renovation and whether substantial renovations has occurred to Jack’s terrace.

Reasonable practitioners can differ on whether the sale is the input taxed supply of residential premises or the taxable supply of new residential premises.

GST going concern project disposals

This example discusses whether the supply of an incomplete property development can constitute a GST free supply of a going concern.

Jack owned 50 hectares of land and carried on a property development business of subdividing the land into residential blocks over 3 stages. At the end of stage 1, Jack sells the land to a new developer and agrees to continue construction of stages 2 and 3. Up until settlement Jack continued to the development in accordance with the development timetable.

The supply of a going concern is GST-free if for consideration, the recipient is GST registered or required to be GST registered, all things necessary for the continued operation of the enterprise are supplied and the supplier and recipient agree in writing that the supply is of a going concern.129

In Aurora Developments P/L v FCT130 the supply was not a going concern because the supplier had abandoned the development activities before settlement. Theoretically it should be possible to continue the development activities up until the date of settlement. There are some practical difficulties in how to contractually manage this - e.g. adjustments for the materials and expenses up until settlement since it is not defrayed from trading income.

Any hiatus between the completion of stage 1 and the continuation of work on stage 2 by Jack may result in the property development enterprise not being carried on up to the date of the supply.

20 October 2015

Ron Jorgensen Partner Rigby Cooke Lawyers Chartered Tax Advisor Accredited Specialist in Tax Law

128 GSTA TPP 068. 129 Sec. 38-325 GSTA 1999.

130 Aurora Developments P/L v FCT [2011] FCA 232.

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Glossary

DAV 2000 Duties Act 2000 (Vic)

GSTA 1999 A New Tax System (Goods and Services Tax) Act 1999 (Cth)

ITAA 1936 Income Tax Assessment Act 1936 (Cth)

ITAA 1997 Income Tax Assessment Act 1997 (Cth)

Disclaimer

This publication contains commentary of a general nature only and does not constitute taxation advice. Rigby Cooke Lawyers recommend that you obtain professional advice regarding your specific circumstances. No liability is accepted for any loss occasioned as a result of any material in this publication.

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