Subdivided space
Tax & Accounting18/06/2021 12:00:00 AM

Watch this (subdivided) space!

Contributed by Heidi Maguire, Content Specialist, Wolters Kluwer

Mum and dad subdividers beware. In a decision recently handed down – McCarthy v FC of T 2021 ATC ¶10-573 –  the AAT has held that the profit generated by the purchase and subdivision of a residential property in Perth was assessable as ordinary income under s 6-5 of the Income Tax Assessment Act 1997. While that outcome may well have been correct given the facts at hand, it appears that the scope for what constitutes a profit-making intention and commercial transaction (and thus assessable as ordinary income rather than on capital account) just got that little bit wider.

Many moons ago the Privy Council decreed in McClelland v FC of T 70 ATC 4115 that the proceeds from the mere realisation of an asset are not ordinary income, even if the realisation is carried out in an enterprising way so as to secure the best price. Since then, borderline fact situations have continued to test the judiciary in Australia. Fifty years on, the issue of whether a transaction goes beyond a mere realisation of a capital asset appears as contentious as ever. 

Whether the proceeds of sale of land are assessable as ordinary income or as a capital gain reflects how they are taxed. Sometimes it is more favourable for a taxpayer to account for such proceeds on revenue account (eg in order to carry forward losses). However, most taxpayers (in particular, your average mum and dad) would prefer any profits that arise from property transactions to be on capital account in order to be able to take advantage of the various capital gains tax exemptions and concessions on offer.
  
In McCarthy, the relevant property in Mullaloo had a long-term tenant in residence at the time of purchase. The taxpayer argued that, at the time of acquisition, she and her husband had the intention to rent out the property long term; it was only after that plan proved to be financially unsustainable that the sale of the subdivided lots occurred. In support of her contention that the subsequent proceeds of sale should not be assessed as ordinary income, the taxpayer stressed that the profit did not satisfy Taxation Ruling TR 92/3, as the transaction was not entered into, and the profit was not made, in the course of carrying out a business operation or commercial transaction. 

Taxation Ruling TR 92/3 sets out the Commissioner's views on the application of the Full High Court decision of FC of T v Myer Emporium Ltd 87 ATC 4363. According to that ruling, a profit from an isolated transaction is generally assessable income when: (a) the intention or purpose of the taxpayer in entering into the transaction is to make a profit or gain, and (b) the transaction is entered into, and the profit is made, in the course of carrying on a business or carrying out a business operation or commercial transaction.

The Commissioner contended that the facts of the transaction, including the enquiries as to the property’s subdivision potential at the time of purchase, the amount borrowed being in excess of the purchase price and the subdivisional work undertaken, led to a clear inference that the acquisition of the property was a commercial transaction entered into with the intention or purpose of generating a profit or gain. Even if the taxpayer’s version of events was to be accepted, one of the alternatives at the time of the purchase of the property was the subdivision and sale of the property, which was enough, according to the Commissioner, to evidence the relevant profit-making purpose. 

The AAT agreed with the Commissioner and found the acquisition of the property to be a commercial transaction entered into with the intention or purpose of generating a profit or gain through its subdivision and sale. The AAT said that, whatever the timing of the couple’s appreciation that they could not afford to keep the property as a rental investment property, it was clear that at the time of purchase it was firmly part of their considerations that an option for the property was to subdivide.

Since McClelland, the courts have taken into account various factors to assist them in characterising the proceeds of a transaction, including the taxpayer’s pattern of behaviour, the scale of the activity undertaken and the extent of the costs involved. What has remained key to the characterisation of proceeds is the taxpayer’s intention or purpose at the time of acquisition. What appears to have become less crucial is the requirement that the profit-making occur in the course of carrying out a business operation or commercial transaction.  

Looking at the Australian case examples since McClelland in which proceeds from land development have been found to be ordinary income, what immediately stands out is the prevalence of builders and property developers. The decisions that didn’t involve builders, developers or real estate agents invariably featured large-scale developments and/or multiple lots. 

One notable exception (and perhaps the decision most similar to McCarthy) is McCurry v FC of T 98 ATC 4487, where 2 brothers bought a block of land in 1986 on which they constructed 3 townhouses. When they were unable to sell the townhouses the taxpayers and their families moved into them instead. The townhouses were later sold in December 1988. The taxpayers claimed that any profit-making venture had been abandoned when they moved into the townhouses and that the townhouses were only later sold because of financial difficulties. The Federal Court rejected those arguments, saying that it was the main or dominant purpose of the scheme that was important. In this case, the possibility of reselling the developed property at a profit was found to be the dominant factor. 

Like McCarthy, McCurry appears to have been a borderline situation where the judiciary could have gone either way. What may well have tipped the scales in favour of the finding of profit-making venture rather than mere realisation of a capital asset was the fact that the 2 brothers were known to have undertaken a second development between 1990 and 1994. No such pattern of behaviour was established in McCarthy. Indeed, it is the taxpayer’s distinct lack of commercial prowess (or, as the taxpayer’s counsel put it, “very non-businesslike manner”) that sets this decision apart. 

The taxpayer in McCarthy was employed full-time as a bookkeeper. She had no knowledge of land development, did not take any time off work to be involved in the subdivision process and did not seek any advice regarding the potential tax consequences of the transaction. In response to the “decidedly non-commercial”, “very non-businesslike” claims proffered by the taxpayer’s counsel, the AAT observed that the test is not whether the transaction was carried out in an efficient or business-like manner but whether the transaction is of the sort that a person in business would undertake. According to the AAT, the purchase and subdivision of a block and the sale of the resulting lots are “clearly” the sort of transaction that a person in business would undertake. 

Presumably most individuals acquire a property (be it a main residence, an investment property or an intended combination of the 2) hoping that it will appreciate in value. And many enter into property transactions hoping (if not knowing) that they will have the option to subdivide their land in the future, if and when they need to or choose to. In McCarthy, the blatant upfront existence of that subdivision option was to be the taxpayer’s undoing, even in circumstances where it was accompanied by an equally blatant lack of business acumen. 

The McCarthy decision suggests that the ATO net being cast for profitable property transactions has suddenly widened. Many one-off residential subdivisions may unwittingly get caught up in that net as profit-making ventures. It remains to be seen whether the little fish get thrown back into the sea.