Capital v Income

Author: Peter Gell
Publish Date: October 28, 2006

Topic one: Capital v Income; the general concept and relevance to property development.

Relevance
In a small to medium sized legal practice a common issue which arises with regularity and which has specific relevance to the property industry is whether an asset has been purchased on income account or on capital account.

The issue is of fundamental importance for the following reasons:

Capital is now, in certain circumstances, concessionally taxed when compared to income. This arises from a combination of the operation of Divisions 115 and 152 ITAA 1997 which can operate in tandem, in certain circumstances, to reduce tax on a capital gain to an amount equal to 25% of the real gain (that is, disregarding indexation which is available as an election up to gains calculated up to 21 September 1999). (A short discussion will take place on these reliefs).
It is important in determining whether an entity is an entity making taxable supplies and has to register for GST purposes. Note the Commissioner takes the view in GSTR 2001/7 that a taxpayer who is not otherwise registered for GST but undertakes a one off property development will be required to register and pay GST on the proceeds of that transaction - where an entity engages in acquiring a single asset for resale at a profit the activity, for GST purposes, is considered an "enterprise" as an activity in the form of an adventure in the nature of trade. The issue of Mum and Dad owning a farm or a second property long term and then deciding to sub divide and whether this requires GST registration and accounting is one which is ripe for litigation.
Capital v income is an issue which has plagued the courts since about 1890 commencing with a decision emanating from the United States of Eisner v Macomber where the court referred to "the tree and the fruit" analogy (this will be explained orally).

In determining whether an asset has been purchased on income account or on capital account the courts have looked at the subjective intention of the taxpayer objectively ascertained by the facts surrounding the purchase.

With the purchase, development and sale of real property, a number of different income and capital tax consequences are possible;

Section 15 -15 ITAA 1997. This will assess net profit arising out of a profit making undertaking or plan as income except where the tax payer acquired the property post capital gains tax. The section simply says that "your assessable income includes profits arising from the carrying on or carrying out of a profit making, undertaking or plan". It expressly excludes profit arising in respect of the sale of property acquired on or after 20 September 1985.
Alternatively section 25A ITAA 1936 will assess the net profit from the transaction as income if the tax payer acquired the property pre-CGT for the purpose of profit making by sale.
If the tax payer acquired the property post 19 September 1985 the sale proceeds may be capital in nature if they flow from the mere realisation of a capital asset acquired without any subjective intention on the part of the tax payer to make a profit by resale. In such as case sale proceeds are received on capital account and assessed to capital gains tax if the capital proceeds exceed the cost base of the asset.
The sale proceeds may be capital in nature but the property was acquired pre GST and the proceeds are therefore tax free.

Normally where profit made from a sale is in the ordinary course of the tax payers business such as the business of property development, the land will be treated as trading stock. If the trading stock provisions apply then the gross proceeds from the sale are included in the tax payers assessable income under section 6-5 ITAA 1997 and all expenses relating to the development are deductible under section 8-1. This is different from assessing liability to tax on a "net profit" basis.

When the transaction is not part of the tax payers ordinary business activities yet a profit is made on the isolated transaction the amount received is treated as ordinary income not capital. This will be the case where it is established that the tax payers intention to enter into that transaction was to make a profit. In this event the land is not treated as trading stock and only the "net profit" from the sale is included in the gross income of the tax payer.

If the transaction relates neither to a sale in the ordinary course of business or profit from an isolated transaction, then the sale process, to the extent that capital proceeds exceed cost base, will be treated as a capital gain.

Land is trading stock under section 70-10 ITAA 1997 when it is held for the purpose of sale or exchange in the tax payers ordinary course of business.

In Taxation Determination 92/124 the Commissioner expresses the view that the land will be trading stock where it is acquired for the purpose of resale and a business activity which involves dealing in the land has commenced. The Commissioner also expresses the view in that determination that the purchase, subdivision, and sale of the land can still be considered trading stock even if it part of a one-off development - there need not be repetition to evidence a business.

The cost of acquiring trading stock is deductible under section 8-1 ITAA as an ordinary revenue expense so that with the value of stock on hand at the end of the year exceeds the opening value of stock the difference is included in assessable income - if less, the difference is an allowable deduction.

Section 70-45 ITAA 1997 states that when trading stock is held at year end by a tax payer it is valued at either cost market value, or replacement cost.

A number of different determinations and rulings apply to the elements that can be included in the cost price of land for trading stock purposes. Basically these can include infrastructure costs, material costs, direct labour costs, and direct production overhead costs. Further detailed information on these costs and different methods can be given if required in table format.

A series of cases have highlighted the practical difficulty with properly characterising a transaction of being either that of conducting a business, a profit making scheme or capital gain.

The main authorities are:

FCT v Whitfords Beach Pty Ltd 82 ATC 4031 - this is a central authority on expanding the scope for isolated and one off transactions to be treated as ordinary income.
FCT v Myer Emporium 87 ATC 4363 - an isolated transaction being part of a profit making scheme and treated as ordinary income. This involved a parent company lending to a subsidiary and assigning the right to receive the interest under the loan to another company for a lump sum.
Stevenson v FCT 91 ATC 4476 - a farmer decided to scale back his farming activates. He obtained finance and engaged in extensive activities to redevelop his land and subdivide part of it - eventually he subdivided 220 blocks. Federal court held that the tax payer was carrying on a business of subdividing, developing and selling on land. Profits made on land sales where assessed as ordinary income under what is now section 6-5 ITAA 1997.
Casimaty v FCT 97 ATC 5135 - tax payer was given his father's farm. Could not make a living out of the farm. For a period of 20 years tax payer slowly disposed of separate subdivisions of the property completing minor work during that period. He continued to farm as much as possible. Court held there was no profit making motive or business like methodology - the subdivision was completed in a disjointed matter. Proceeds were not received on income account.

Relevant factors which can form a check list include:

Amount of actual work completed in developing the land.
Amount of borrowing to finance the development. Any attempt to sell the land broad acres before subdivision - this will indicated that development was not driven by profit motive.
Tax payers previous history in relation to property development.
Book keeping and recording of transactions particularly whether the transactions are recorded on a revenue account and interest borrowings are treated as a tax deduction.
How the lots where released on to the market and the speed.
Involvement of tax payer in actual sale of lots.
Magnitude of the development.
Manner in which the lots are sold particularly if multiple real estate agents are used with concerted advertising campaigns.
The nature of the entity undertaking the development.
The number of contractors engaged by the tax payer.
The number of stages in the development.
The overall nature, scale and complexity of the development.
Profitability and a profit motive.
The purpose for which the tax payer originally acquired the land.
The reason for the sale of land.
The location of the site office or other building erected on the land will indicate a business venture.
Subsequent land developments by the tax payer.
The tax payer's involvement in the actual development.
The occupation of the tax payer.
The whole business organisation of the tax payer.

Another paper can be the subject of the calculation of assessable income for a profit making scheme - the costs of the land and development costs and the ascertainment of "net profit".

For further information or assistance please contact Rockliffs on 02 9299 4912 or email us at lawyers@rockliffs.com.au

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