Developing and Ordinary Income

This case was mentioned here a while ago. A developer bought two parcels of land, with the initial intention of developing the land with another party in a joint venture. The joint venture dissolved, the taxpayer rented his property and sold it a few years later.

The commissioner declared in a private ruling that the sale was not the 'mere realisation of a capital asset', but the end result of a property development. The AAT agreed.

I thought at the time that the ruling was a bit harsh. The Commissioner seemed to decide it was a development because the taxpayer happened to be involved in other developments, and had a DA on the property.

The Federal Court have now reversed the ruling and the decision of the AAT, and returned it to the AAT to answer question 2.

The FCT found that the correct application of ITAA1997 was that the profit was not ordinary income, but the mere realisation as argued by the taxpayer.

This to me is a good decision. Common sense from the courts!

 

A DA and intention to develop are generally the dead give aways.

I'm kind of surprised that it was overturned. The only reason the development didn't go ahead was the the JV dissolved but it was still being sold as a development site with DA?

It is cases and case law like this that mean it can be quite a financial/legal disadvantage to go get DA for a site to increase the value of it for selling.

 

Nothing contentious here. It does not mean that the Commissioner was wrong.

The task of the AAT was to review the Commissioner's finding that the profits were ordinary income from an isolated commercial profit making scheme.

However, the AAT instead subsituted its own facts that this was ordinary income from the ordinary proceeds of a business. The FCA found that this inference was outside the scope of an administrative review of a private ruling.

So the decision has been referred back to the AAT.

All the AAT needs to do is affirm the Commissioner's original finding of a profit from an isolated commercial transaction and it will still be ordinary income.

This is a whole lot easier to infer from the facts than the AAT inference that a business exists and the profit is an ordinary incident of a business.

Once affirmed by the AAT then there is no avenue of appeal unless another legal technicality arises.

 

What a let down. I thought this would be a thread on how to develop with an ordinary income

 

An example of the possible errors made by some who embark on what is a complex chain of events when they choose to develop and fail to seek guidance at the earliest opportunity and then from time to time as the project completes. Thus it comes back to intention. This then follows through to trading stock etc.

MT 2006/1 also doesn't consider a "business" but adopts the broader GST approach of an enterprise. Reading examples 28-35 are highly recommended discussion points for a tax adviser and developer client. Then reading this together with TR 92/3 is necessary. In summary I like the following as the general premise:

Where a property transaction is neither :
1. Part of a taxpayers normal business; nor
2. Commercial in nature then unless the property was acquired with a view to a profit making intentions, any subsequent disposal (my emphasis here) IS LIKELY to be a mere realisation on capital account under TR 92/3

Taxpayers who fail to seek early advice often fail to consider a deliberate strategy that may encompass both CGT and ordinary income through use of trading stock valuation rules contained in tax law. Too often taxpayers seek to choose the lesser tax - CGT when the truth is they should consider the legal way to incur CGT if it is available. This needs to avoid duty ie disposal to a trading entity. While this event can impose a cashflow burden upfront it can also be well managed so that the 50% tax saving and the deferral through the start of the project is still a win for the taxpayer.

The key issue then is one of when to choose to time trading stock recognition and the value to be used. Care must be taken to avoid a contentious choice of date that merely suits the cashflow problem. There is also the problem of when to recognise a sale...Different rules apply to ordinary income v's CGT event A1.

I take the view that just as you plan a project to build you should plan all of the taxes on these profits. Then build to that budget / project plan. After all you wouldn't budget for materials to be 7% cheaper than reality... so why do that with tax ?

 

Or as I see far too often... "You wouldn't not budget/plan for materials... so why would you not do the same with tax?

I actually think that taxation should be a mandatory high school unit for everyone, the amount of people with absolutely no understanding or, potentially even more dangerous, a fundamentally flawed understanding is just scary.

 

I agree, but its far too big a topic to be covered - especially since it changes regularly too.

 

Don't agree. You don't study medicine expecting to become ill and mechanical eng when you buy a car.. What most need to do is find a great team around them and when a issue pops up use them. ie GP, electrician, mechanic. town planner, lawyer, tax adviser.

Many client questions are answered in under 10mins and not charged. When they take longer I may but by then they know there is a issue and its good value advice.

 

Financial literacy will be a good foundation for kids and asking questions from the right person, not next door neighbour, cab driver or gardener when it is tax. Australian Tax laws are huge and complicated.

 

It's more so they have a basic understanding to know when to ask for advice. Everyone does study physics, human biology, systems technology/IT, legal studies and the like to have a basic understanding of when they need to seek advice and what potential issues there are that could cause that. They're all mandatory subjects, I'm just saying tax should be one of those, imo, as it's a vitally important topic (it should fall under a general "financial intelligence" topic that everyone should have, imo.

A basic understanding of the difference between capital account/trading account would have people knowing, "I'm not sure, I better ask my accountant" instead of the more normal approach of not knowing there is even an issue.

 

My reading is the FCT overturned the AAT's decision on question one, and returned the case to the AAT because they hadn't addressed question two.

From the Tax Institute: It followed that the Tribunal ought to have held that the Commissioner's ruling, as confirmed by the objection decision, was in error, at least in respect of the answer given to question 1. The correct conclusion as to the application of the ITAA 1997 to the arrangement was that the profit was not ordinary income. On the basis of the description in the arrangement, what occurred was the mere realisation of a capital asset, taxable under the CGT regime. The first of the questions posed for the ruling ought to have been answered, “Yes".

 

I concur.

However, see paragraph 30.

The only reason that the court was given the power to substitute their finding for question 1 was because there was a question of law regarding question 2.

The two questions were under the one notice.

Once a single question of law arises, the court has jurisdiction to review the other part of the notice since it was not merely a finding of fact. The peculiarity of a review of a private ruling is that no dispute of facts arises.

All the AAT had to do was affirm the Commissioner's original reasoning about a profit making scheme and it would have been unlikely that an appeal from the AAT decision would have been allowed.

The Commissioner could make any future decision more "judge proof" by firstly ascertaining more detail of the facts and then being consistent with his explanation.

Whether this has caused a shift in the blurred boundary between income and capital remains to be seen.

 

Whatever the ultimate result for this taxpayer, the reality is that no precedent has been created on whether or not this "profit" was ordinary income or not.

 

Thanks to Dan for the post though.

In spite of no precedent being set for mere realisations, the rationale for overturning question 1 is interesting.

Implication from the FC decision is that a taxpayer in similar circumstances could directly appeal to the Federal Court and test whether abandonment of a profit making scheme prior to sale could be a mere realisation of a capital asset.

It seems that the court made the distinction (on only the facts as accepted) that where disposal by a sale with just planning permits was not originally contemplated, then the latter outcome is not part of a profit making scheme.

The sale transaction as part of the scheme is significant, if property is kept for another purpose for a significant period prior to sale then perhaps the nexus with a scheme is broken.

However, a scheme could be abandoned at any stage during its implementation and the issue would then be one of degree.

There was still a considerable sum spent on the planning permits, and the block was originally intended to be sold with further development.

I was more interested in the technicalities of the administrative law in this case.

 

Yes it is very broad and complicated. But basic understanding of what tax is and why it is required may help future generations. No need to cover the come stuff. I did Basic Accounting in high school and I believe it really helped me understand real life principles today. Of course we will always need professionals for specific advice but it wouldn't hurt to have some basic understanding as we start our adult life.

 

Paul,

An isolated profit making scheme would not usually be subject to trading stock provisions, profit & loss accounting as ordinary income would apply.

If subject to the trading stock provisions as a business then the market value is included as assessable income at the time it ceases to be treated as trading stock and used for another purpose.

You could have a large tax bill on an unrealised gain since purchase (market value - cost) and no discount is available.