Are you a developer or investor?
- certain taxpayers can access the 50% CGT discount on capital assets;
- if you have a history of development (directly or indirectly through interposed entities), other things being equal there is a higher evidentiary burden in seeking to hold property on capital account;
- holding revenue and capital assets in separate entities may assist, however, ultimately it depends on all the relevant facts and circumstances of the case, that is:
- what you told your financiers, surveyors, real estate agents, local council authorities etc;
- whether you subsequent actions objectively support your previously stated intention;
- whether any specific event(s) gave arise to a change of intention and if so, was that change appropriately reflected for, income tax purposes, CGT and/or GST purposes in the relevant income year?
Subject to meeting various conditions, most notably holding an asset for at least 12 months prior to its disposal, individuals and trusts (but not companies) are eligible for the 50% CGT discount. That is, they can halve the capital gain before including it in their assessable income – the other half is completely tax-free!
This significant benefit creates a tax bias or distortion in favour of holding assets on capital account compared ordinary business assets (trading stock) or otherwise on revenue account – taxpayers would be prefer to pay 50% less tax.
However, the classification of an asset as either trading stock or revenue assets on the one hand, or capital assets on the other, can be a very grey area of the law.Think of it as a spectrum with “Trading stock/revenue asset” on one side and “Capital asset” on the other. Where the particular facts clearly support one conclusion or the other, it is very straightforward, however, as you head towards the middle, it becomes more a matter of arguing by way of analogy based on common factors with the decided cases as to where the relevant taxpayer sits and why.
In recent years, certain taxpayers have pushed the boundaries to create vehicles purportedly limited to holding assets on capital account yet all other facts and circumstances pointing towards the opposite end of the spectrum.
This paper is not intended to canvass the relevant case law as to the revenue /capital distinction. Rather, it is intended to provide some practical guidance as to the Commissioner’s current compliance activity and practical evidentiary issues required in order satisfy the Commissioner that an property was held on capital account.
Ultimately, the practical reality is that taxpayers generally have the burden of proving that a tax assessment is excessive, therefore, the taxpayer’s intention with regard to the relevant assets will be determined based on myriad factors including:
- the taxpayers history of development (if any);
- how long the assets were held;and
- whether what the taxpayer says to the Commissioner as to their/its intention accords with what the taxpayer told their financiers, real estate agents, the local council etc at the outset.
The reality is, in the face of the Commissioner’s compliance activity and recent case law in this area, those taxpayers with a history of property development (whether directly or indirectly through interposed entities) will face a higher evidentiary burden in satisfying the Commissioner of its intention to hold assets on capital account and this must be kept in mind from the very beginning so as to ensure that contemporaneous documentation is maintained and activities are strictly referable to same.
The Commissioner’s views
The Commissioner released Taxpayer Alert TA 2014/1, ‘Trusts mischaracterising property development receipts as capital gains’ (“Alert”) on 28 July 2014. However, the Alert does little more than mirror the recent Full Court of the Federal Court decision in August v Commissioner of Taxation  FCAFC 85 (“August”) insofar as the critical importance of:
- objective evidence of the taxpayer’s intention; and
- activity referable to, and in accordance with, that intention,
in seeking to satisfy the Commissioner that an asset was held on capital account.
Neither the contents of the Alert, nor the observations (and outcome) of the court in August should come as a surprise to practitioners. Taxpayers always have the onus of proving that an assessment is excessive and therefore, in advising clients on the structure of a property transaction, great care should be taken to stress that the Commissioner (and a court for that matter), will gauge subjective intention from objective material and subsequent actions. Further, the evidentiary requirement will be especially important for those taxpayers with a history of development and/or hold the property for ‘dual purposes’, that is, for sale or lease.
The Alert focuses on a particular set of facts broadly described as follows:
- an entity with experience in developing/selling property or otherwise involved in the property or construction industry establishes a new trust to acquire property for development and sale;
- the trust deed may or may not state that the purpose of the trust is to hold the developed property as a capital asset;
- activity is undertaken at odds with the stated purpose of treating the property on capital account, for example:
- financing documents refer to sales and repayment within a specified timeframe;
- correspondence with planning authorities refer to development for sale;
- correspondence with and/or engagement of real estate agents early in the development process (i.e. off-the-plan sales).
- the property is sold soon after completion (as little as 13 months after), with the trustee claiming the 50% CGT discount in relation to the disposal.
The ATO’s concerns include whether the underlying property constitutes trading stock (see Division 70 of the Income Tax Assessment Act 1997 [“ITAA 1997”]) or the proceeds of sale constitute ordinary income under section 6-5 of the ITAA 1997.
The decision in August
In the recent decision in August, at issue was the character of the profit derived from the sale of various parcels of land, that is, on income or capital account.
Mr August met and befriended a property developer whose modus operandi was to develop industrial/commercial property, lease it up and sell it off. Mr August was advised that there was a good opportunity to make some profit by acquiring various contingent lots, spending some money renovating/developing, leasing it up and selling.
Mr August established a unit trust and began acquiring various contingent lots in November 1997. The unit trust continued to acquire lots and develop some of those lots.
In or about mid-2005, fully developed and leased up, the court found that Mr August had commenced discussions with real estate agents with a view to sale (a finding of fact based on the court’s assessment of the available evidence).
In early 2007, the properties were sold in one line.
The unit trust returned the profit as a capital gain. The ATO argued that it was on revenue account. On appeal, the court found that Mr August’s evidence was unreliable and that his purpose was to emulate the business model of his developer friend, that is, to acquire a run-down shopping centre, rejuvenate and develop the complex, leased it up and sell for a substantial profit.
Separate to the above, Mr August’s unit trust was also a party to a 50/50 joint venture with his developer friend in relation to another property. The joint venture agreement provided for maximum flexibility in terms of the relevant investment strategy and said nothing at all in terms of holding assets for long-term investment.
Mr August argued that there was an Addendum to the joint venture agreement which stated that:
- the strategy was to create a long-term investment portfolio of commercial and industrial properties;
- use the income and equity generated from investments to reinvest and build assets; and
- restrict the sale of assets unless absolutely necessary.
However, the court found that the objective evidence showed:
- the surveyors report in relation to the proposed development of the property stated that it was to be subdivided into 6 smaller lots to be sold individually (which was the topic of discussion at various meetings with the relevant Territory Government Authority);
- signs were erected on the property advertising subdivided lots “For Sale or Lease”; and
- neither Mr August or his other joint venture participant’s evidence was reliable and that there had been highly improper collusion between them with regard to the existence of the Addendum after the fact.
On this basis, the property was taken to be held by the joint venture participants on revenue account.
As can be seen from both R&D Holdings and August, contemporaneous objective evidence as to intention is critical, and all activities should be consistent with that intention. The bar is be higher in terms of the evidentiary burden applicable to those with a history of development, but it is not the case that just because an entity (or its directing mind) has developed in the past, and continues to do so, that it is not capable of holding assets on capital account under any circumstances.
Trading stock and dual purposes?
It is clear from the decision in August (relying on the decision of Finn J in R & D Holdings Pty Ltd v FCT  FCA 981 [“R&D Holdings”]) that in circumstances where a client is “keeping their options open” with regard to the sale or lease of a property, it will be trading stock. That is, where a dual purpose exists, the decisions in August and R&D Holdings appear to introduce a judicial gloss inserting a tie-breaker test in favour of trading stock (as opposed to capital account) akin to that under the debt/equity rules in Division 974 of the ITAA 1997.
Whether this is correct, that is, where even the slightest intention to sell triggers this de facto tie-breaker or a dominant purpose test is more appropriate in seeking to characterise the relevant assets as either trading stock or capital assets at any particular time, is beyond the scope of this paper. However, the practical reality is that in almost every instance, even taxpayers who clearly hold an asset on capital account are “open” to the prospect of a sale and this, of itself, cannot be sufficient to render the asset trading stock (or otherwise on revenue account).
Strangely, Finn J himself in R&D Holdings accepted on the evidence that the relevant entity’s dominant purpose was the sale of strata lots, even though, in relying the authority of John v FCT (1989) 166 CLR 417, the trading stock regime did not employ a sole or dominant purpose test. Similarly, the Commissioner himself in TR 93/26 (partially withdrawn) referred to a dominant purpose requirement in a trading stock context (specifically, the circumstances in which horses would be live-stock, and therefore trading stock, rather than plant – see paragraph 18 of TR 93/26).
Further, there is UK case law authority for the proposition that assets can change their character (as between trading stock and capital assets), but cannot have a dual character at the same time (see Simmons (as liquidator of Lionel Simmons properties) v Inland Revenue Commissioners  2 All ER 798, as cited by the Commissioner in MT 2006/1 in the context of carrying on a business and obtaining an ABN). This is not binding authority in Australia, but should be persuasive.
Practical observations and conclusions
For those practitioners advising clients on property transactions, it is necessary to carefully consider the following:
- what are the client’s stated intentions?
- does the client, or the directing mind of the client (i.e. directors, trustees or directors of corporate trustees) have a history of property development or sales?
- on what basis has the client obtained bank finance? For example:
- is it a construction/development loan?
- is it an ordinary residential loan?
- if it is a construction/development loan, is it to be repaid from:
- sales; or
- refinanced on completion and replaced by an ordinary residential loan?
- what has the client told various stakeholders as to its plans, including:
- the financier?
- real estate agents?
- the local council?
- is the client ‘keeping their options open’? If so, there is considerable risk based on the above that the underlying assets will be treated as trading stock (and although this may not be technically correct, the Commissioner’s views do present a clear compliance risk in this regard);
- if the client’s intention changes, ensure it is properly reflected both in the accounts and for tax purposes (e.g. from capital account to trading stock – section 70-30 of the ITAA 1997; TD 92/124; section 104-220 of the ITAA 1997 [CGT event K4]; from trading stock to capital account – section 70-100 of the ITAA 1997).
Finally, in many cases practitioners are required to advise on joint ventures between multiple parties. Further, it is often the case that joint venture participants wish to sell some end-product and retain others.
Clearly, issues arise as to ‘dual purpose’, however, provided that the evidence clearly supports the disposal of particular properties and the retention of others, there is no dual purpose with regard to a single property and therefore, a clear distinction could be maintained between those that are trading stock, and those on capital account.
For example, A Co and B Trust enter into a joint venture to develop and partition 8 apartments. A Co is to take away 6 apartments and sell them for its exclusive benefit. B Trust is to take away 2 apartments and wishes to sell one (“Apartment 7”) and retain one (“Apartment 8”).
If the evidence clearly supports, from the outset and throughout the entire development process, B Trust’s intention to retain Apartment 8, then the issues outlined above should not arise, despite the fact that Apartment 7 is clearly trading stock.
Of course, any taxpayer, particularly those with a history of development or property sales, who maintain a property was held on capital account which is sold very soon after the expiration of the 12 month holding period (facilitating access to the 50% CGT discount) will come under particular scrutiny.
Broadly, in the absence of special circumstances, such as a rapid decline in the taxpayer’s financial circumstances forcing a sale, it would increasingly difficult to discharge the taxpayer’s burden of proof in seeking to prevent the Commissioner from treating it as trading stock (or otherwise on revenue account) the shorter the holding period.
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Note – this article was published in the August 2013 edition of inTax Magazine.
Disclaimer – this article does not constitute specific advice and cannot be relied upon as such.