Taxing sale proceeds: income or capital? That is the question

Taxpayers and the ATO often grapple with whether proceeds from the sale of property are on capital account or revenue account. The issue continues to generate disputes and litigation. This is often because there are concessions available for sales of property on capital account. But sometimes it is about whether revenue losses can be used to offset other income.

Sales of shares and property have recently been put under the microscope. In both cases, the distinction is whether the sale of the asset is either:

• a mere realisation of a capital asset – and therefore on capital account; or
• part of the taxpayer operating a business or profit-making undertaking – and therefore on revenue account.

The Federal Court recently considered the issue in the context of a sale of shares in Greig v Commissioner of Taxation [2018] FCA 1084.

The ATO has also published a draft ‘property and construction website guidance’ that details cases and decisions the ATO is making in property development cases. The ATO is seeking industry consultation, which closes on 17 August 2018. The final report is due at the end of August 2018.

What is the test for a profit-making undertaking?

The law on whether a sale of property is part of a profit-making undertaking (and on revenue account) is relatively settled. It requires that:

1. the taxpayer’s intention or purpose in entering into the transaction was to make a profit or gain; and
2.  the transaction was entered into in carrying out a ‘business operation or commercial transaction’.

What happened in Greig?

In Greig, the taxpayer claimed deductions for losses he incurred in relation to certain Nexus shares. He had bought the Nexus shares with a hope that the share price would rise. However, Nexus was subsequently placed into voluntary administration and the taxpayer’s shares were compulsorily acquired for no value. The taxpayer argued that:

•  the losses were on revenue account because he incurred them in a ‘business operation or commercial transaction’ entered into as part of a profit-making undertaking; or
• the losses were necessarily incurred in the carrying on of a business dealing in the Nexus shares.

On the first issue, the Court proceeded on the basis that:

Where assets are acquired with a sufficient profit-making purpose, in a ‘business operation or commercial transaction’, then absent any other reasons supporting a contrary conclusion, the profit on disposal is ordinary income…irrespective of whether the acquisition occurred in the course of an existing business …

The Court’s view was that, although Mr Greig had the necessary profit-making intention, he did not acquire the shares in a ‘business operation or commercial transaction’. This was because purchasing the shares hoping to profit from dividends or an increase in the share price did not amount to a ‘business operation or commercial transaction’.

The decision in Greig needs to be read in light of its very specific facts.

1. First, the taxpayer described having a ‘Profit Target Strategy’ for his Nexus shares, but his dealings in shares up until that time had all been returned on capital account.
2. Second, the Court noted that, where the taxpayer had a substantial interest in any company, he had never sold those shares. The taxpayer had acquired a substantial interest in the Nexus shares. The Court considered it was difficult to predict whether the Nexus shares would have been sold for a profit if the share price rose.

While the Court concluded that the transactions were not ‘commercial dealings’, it also appears that there were some reservations as to whether the Court accepted the taxpayer intended to sell the shares for a profit.

The Court accepted that an isolated transaction could be a ‘commercial dealing’ but indicated that the taxpayer’s activities did not meet that threshold.

How does the ATO’s draft guidance in real property transactions fit in?

The ATO’s draft guidance is targeted at transactions involving the sale of real property.

The draft guidance addresses a number of different issues. It includes a list of 21 ‘indicia’ that the ATO look at when applying their ultimate test, which is verbosely described as ‘whether, on the balance of probabilities, it is more likely than not that the relevant tax provisions apply to the facts of the particular case’.

Some of the indicia are:

• whether the landowner has held the land for a considerable period prior to the development and sale
• whether the landowner has conducted farming, or other non-development business activities, on the land prior to beginning the process of developing and selling the land
• whether the landowner has changed its use of the land from one activity to another (e.g. farming to property development)
• the level of active involvement of the landowner in any development activities.

Why is this important for taxpayers and advisers?

It is important that this checklist of indicia does not replace the test.

Take, for example, a farming property that is owned for a number of years and is later subdivided. The subdivided lots are then sold. The owner has minimal involvement in the subdivision work, delegating that to third parties. In that case, the landowner has conducted farming on the land and has held the land for considerable time. These factors would often lead to the conclusion that the sale of the subdivided lots is a mere realisation of a capital asset.

However, in this example, the landowner will have also applied to have the land rezoned to maximise the value of the subdivided lots. The profits may be substantial. These factors, according to the ATO, point to a profit-making undertaking.

How do I manage these issues?

There are a number of options for managing the income tax position. It is important that this is done at the outset, as the options taken can significantly affect the tax and therefore net proceeds from the sale. The income tax position will also directly affect the GST position. This will also need to be dealt with early in the process, as the GST issues will be complicated by the GST withholding provisions.

We anticipate that the ATO’s final guidance will change from the current draft, so watch this space – we will hopefully know the final position at the end of August 2018.

Please contact a team member if you would like to discuss.