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PRECEDENT — SANITISED

[Date]

[Addressee]
[Address]

Private and confidential

Dear [Addressee]

Tax consequences of the subdivision and sale of land held by the [Client trust]

1.Introduction

1.1You have requested our tax advice on the consequences of the [Client trust] (the Trust) subdividing land it has held since [acquisition year] into [number] residential lots and selling those lots. In particular, you have asked whether the profit on sale is assessable as ordinary income or as a capital gain, how the land should be reported in the Trust’s financial statements, and what steps the trustee should take before the first lot settles.

1.2This letter sets out the background facts on which our advice is based, a summary of our conclusions, our detailed analysis of the technical issues, and our recommended next steps.

2.Background facts

2.1The Trust is a discretionary trust. The trustee acquired the land in [acquisition year] for [purchase price].

2.2From acquisition until 2024, the land was used for grazing and was leased to a neighbouring farmer. The trustee has advised that there was no intention to develop the land at the time of acquisition.

2.3In [approval year], following a council rezoning, the trustee obtained development approval to subdivide the land into [number] residential lots, as shown in the proposed subdivision plan provided.

2.4Civil works commenced in [commencement date] and are funded by a commercial development loan. The feasibility provided projects total development costs of [development costs] and gross sale proceeds of [gross proceeds].

2.5The trustee has engaged a project manager and a real estate agent to market the lots. The trustee has not previously undertaken any property development.

2.6The trust deed was amended in [amendment year]. The original deed and all amendments have been provided and reviewed. The amended deed permits the trustee to define net income and to stream capital gains to beneficiaries.

2.7The Trust is not currently registered for GST.

3.Executive summary

•On the facts provided, there is a reasonable basis to conclude that the Trust moved from the mere realisation of a capital asset to a profit-making undertaking when it committed to the development in [commencement year].

•The profit from that undertaking is likely to be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (Cth). Value accrued before the undertaking commenced is likely to be treated separately, and a market valuation at that date is critical.

•The Trust is likely to be carrying on an enterprise for GST purposes and will be required to register. The margin scheme may be available but must be agreed in writing with each purchaser before settlement.

•For accounting purposes, the land should be transferred from investment property to inventory from the commencement of development. Differences between the accounting carrying amount and the tax cost should be tracked from that date.

•Trustee resolutions must be made by 30 June in each relevant income year, having regard to the deed’s definition of income and the character of the profit.

4.Tax advice

4.1The issue

4.1.1The central question is whether the profit from the sale of the lots is ordinary income, or whether the lots are capital assets such that the gain is a capital gain under Part 3-1 of the Income Tax Assessment Act 1997 (Cth). The answer affects the amount assessable, the availability of the CGT discount to beneficiaries, and the timing of recognition.

4.2Ordinary income: profit-making undertaking or mere realisation

4.2.1A profit is ordinary income under section 6-5 where it arises from carrying on a business, or from an isolated transaction entered into in the course of a profit-making undertaking or scheme.¹ By contrast, the mere realisation of a capital asset, even in an enterprising way, does not give rise to ordinary income.²

4.2.2In Statham, the taxpayers subdivided land originally acquired for farming and were held to be realising a capital asset.³ In Whitfords Beach, the High Court held that land acquired as a capital asset became the subject of a profit-making undertaking when the shareholding and purpose of the owner changed and an extensive development was undertaken.⁴ More recently, the Full Federal Court in August found that a subdivision undertaken with borrowed funds and professional project management was a profit-making undertaking.⁵

4.2.3The Commissioner’s view is that the relevant factors include the nature of the entity, the scale of the activity, the amount of money involved, whether the transaction is commercial and business-like, and the nature and timing of the steps taken.⁶ Applying those factors to the facts:

(a)the scale of the works and the projected gross proceeds of [gross proceeds] are significant relative to the original cost of the land;

(b)the development is funded by a commercial loan secured over the land, and the trustee has engaged a project manager and selling agent; and

(c)the trustee has not previously developed land, and the land was held for 15 years for grazing, which supports a capital character before 2025.

4.2.4On balance, the facts are closer to Whitfords Beach and August than to Statham. In our view, there is a reasonable basis to conclude that a profit-making undertaking commenced when the trustee committed to the development in [commencement year]. This conclusion is sensitive to the facts in paragraph 2.4 and should be revisited if the scope or funding of the works changes.

4.3Section 15-15

4.3.1Section 15-15 includes in assessable income a profit from a profit-making undertaking or plan, but only where the profit is not otherwise ordinary income and does not arise from the sale of property acquired on or after 20 September 1985.⁷ As the land was acquired in [acquisition year], section 15-15 is unlikely to apply. Any assessable profit will instead arise under section 6-5.

4.4Timing of the change and value of the land

4.4.1Where land held on capital account is later ventured into a profit-making undertaking, only the profit referable to the undertaking is ordinary income. In Whitfords Beach, the profit was measured by reference to the value of the land at the time it was committed to the undertaking.⁸ The increase in value before that time retains its capital character.

4.4.2If the Trust is instead carrying on a business of land development such that the lots are trading stock, section 70-30 allows the trustee to elect to treat the land as having been sold and reacquired at either cost or market value when it became trading stock.⁹ An election at market value would give rise to a CGT event, with any capital gain potentially eligible for the CGT discount.¹⁰

4.4.3In either case, a contemporaneous market valuation as at [commencement date] is essential to support the split between capital and revenue amounts.

4.5Interaction with the CGT provisions

4.5.1A capital gain made on the sale of the lots is reduced by any amount included in assessable income under another provision.¹¹ This prevents the same gain from being taxed twice. The CGT discount will only be available for any capital gain referable to the period before the profit-making undertaking commenced.

4.6GST

4.6.1An entity carrying on an enterprise, including an adventure or concern in the nature of trade, must register for GST once its projected GST turnover reaches $75,000.¹² The sale of the lots is likely to be in the course of an enterprise, and registration is likely to be required before the first sale.

4.6.2The margin scheme may be used to calculate GST on the sale of the lots, but only where the trustee and each purchaser agree in writing on or before the making of the supply.¹³ As the land was acquired after 1 July 2000, the margin will generally be based on the consideration for acquisition, unless a valuation method is available.

4.7Trust distributions

4.7.1Beneficiaries presently entitled to a share of the income of the Trust are assessed on that share of the Trust’s net income.¹⁴ If the profit is ordinary income, it cannot be streamed as a capital gain. Any capital gain referable to the pre-undertaking period may be streamed where the deed and resolutions allow.¹⁵

4.7.2We have reviewed the [amendment year] amendment and confirm that it permits the trustee to determine the income of the Trust and to stream capital gains. Resolutions must be made by 30 June of each income year in which lots settle.

4.8Accounting treatment

4.8.1Investment property is transferred to inventory when there is a change in use, evidenced by the commencement of development with a view to sale.¹⁶ From that date the land is measured at the lower of cost and net realisable value.¹⁷ Borrowing costs directly attributable to the development may be capitalised to the cost of the inventory.¹⁸

4.8.2The accounting carrying amount of the lots is unlikely to equal their tax cost, particularly where capitalised interest is deducted for tax purposes as incurred. These differences should be reconciled in each year’s tax workpapers.

4.9Alternative view and risk

4.9.1The Commissioner may contend that the profit-making undertaking commenced earlier, for example when the rezoning application was lodged in [approval year]. If so, a greater share of the profit would be ordinary income. In our view, the better position is that the undertaking commenced with the commitment to the works in [commencement year], but this should be supported by contemporaneous documents.

4.10Recommended next steps

•Obtain a market valuation of the land as at [commencement date] from a registered valuer.

•Register the Trust for GST and include margin scheme clauses in each contract of sale.

•Retain board minutes, loan documents and correspondence that evidence the timing of the decision to develop.

•Prepare trustee resolutions before 30 June in each income year in which lots settle.

5.Disclaimer

5.1This advice is based on the facts and documents provided to us and the law as at the date of this letter. It is a draft prepared for review and must not be relied on until it has been reviewed and issued by a registered tax agent. If any of the facts set out above are incorrect or incomplete, please let us know, as our advice may change.

Yours faithfully

Director
Calloway Reid Tax & Advisory

1. ¹Income Tax Assessment Act 1997 (Cth), s 6-5; Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199.
2. ²Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation (1950) 81 CLR 188; Californian Copper Syndicate v Harris (1904) 5 TC 159.
3. ³Statham v Federal Commissioner of Taxation (1989) 20 ATR 228.
4. ⁴Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355.
5. ⁵August v Commissioner of Taxation [2013] FCAFC 85.
6. ⁶Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income, [13].
7. ⁷Income Tax Assessment Act 1997 (Cth), s 15-15(2).
8. ⁸Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355 at 376–377 (Mason J).
9. ⁹Income Tax Assessment Act 1997 (Cth), s 70-30. Land may be trading stock: Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (1978) 138 CLR 210.
10. ¹⁰Income Tax Assessment Act 1997 (Cth), s 104-10 and Div 115.
11. ¹¹Income Tax Assessment Act 1997 (Cth), s 118-20.
12. ¹²A New Tax System (Goods and Services Tax) Act 1999 (Cth), ss 9-20 and 23-5; Miscellaneous Taxation Ruling MT 2006/1.
13. ¹³A New Tax System (Goods and Services Tax) Act 1999 (Cth), s 75-5(1A); Goods and Services Tax Ruling GSTR 2006/8.
14. ¹⁴Income Tax Assessment Act 1936 (Cth), s 97; Federal Commissioner of Taxation v Bamford (2010) 240 CLR 481.
15. ¹⁵Income Tax Assessment Act 1997 (Cth), Subdiv 115-C.
16. ¹⁶AASB 140 Investment Property, para 57(b).
17. ¹⁷AASB 102 Inventories, para 9.
18. ¹⁸AASB 123 Borrowing Costs, para 8.