The issues and difficulties with the ‘capital v revenue’ characterisation stretch back to around the time income taxes were introduced. Since that time it has been left to the courts to resolve these issues and lay down the principles of capital vs revenue.
However, despite the long line of authorities and well-established principles, the area is still a perennial issue for tax authorities, taxpayers and their tax advisers. This is evidenced by the regular disputes between the Australian Taxation Office (ATO) and taxpayers in this area.
In our October 2018 Tax Flash, we discussed the recent decision in Greig v FCT  FCA 1084 where the Federal Court held that the taxpayer did not acquire the shares in Nexus Energy Ltd (Nexus) as part of a “business operation or commercial transaction” within the Myer principle, even though the taxpayer had the requisite profit-making intention.
In our December 2018 Tax Flash, we also discussed a more recent case, Ransley and FCT  AATA 4359, where the taxpayer also lost her case, although this time the taxpayer unsuccessfully argued that the gains made on the sale of her shares were on capital account. Therefore, the Commissioner of Taxation has successfully argued that losses on the sale of shares were capital losses in one case and then gains on the sale of shares were income in another case.
The development is not just limited to the disposal of shares. Earlier in 2018, the ATO released a paper titled ‘Draft Property and Construction Website Guidance’ (the Guidance) providing the ATO’s view on the capital v revenue characterisation in the context of property development.
The ATO Draft Consultation Paper
The ‘Guidance’ is actually a consultation paper and consists of two parts. The first part of the Guidance provides the factors that the ATO takes into account in making a decision on the capital v revenue characterisation. In particular, the ATO provides a list of relevant indicia that they will take into account when determining whether a sale of property is on capital or revenue account. Some of the factors include the length of time the property is held, the prior activities (if any) conducted on the land or prior use of the land, the property development history of the taxpayer, and the level of involvement of the taxpayer in the rezoning, subdivision and development of the land.
The second part of the Guidance provides 12 examples to illustrate how the ATO applies the above factors to common scenarios involved in the subdivision of land and/or developing the land.
One particular aspect of the Guidance that stands out is the ATO’s view on certain arrangements made between landowners and developers under Property Development Agreements (PDA). In particular, the ATO’s key focus is on the “profit-sharing” arrangement (e.g. the basis on which the developer is compensated pursuant to the PDA) and the exposure of the respective parties to the risks and rewards associated with the development. Specifically, the greater the extent to which the mechanism(s) in the PDA for compensating the developer results in the landowner sharing in the risks and rewards of making improvements to the land with the developer, the stronger the inference that the land is no longer held on capital account by the landowner in the ATO’s view.
The ATO further illustrates this view in Example 1 and 2 in the Guidance. The examples have similar facts involving a “Mr. Farmer” attempting to sell his farmland by way of developing the property into 1,100 vacant residential lots over a 7-year period. In Example 1, the developer offered Mr Farmer $80 million (intended to represent the market value of the property, increased to reflect the delayed receipt of funds from the sale of subdivided lots) plus 10% of any profit on sale of the lots. On the other hand, in Example 2, the developer requested an 11% margin on the gross cost of construction/development, plus 22% of the development profit. The developer’s receipt of its fee (i.e. development costs plus an 11% margin, together with 22% of the development profit) was to occur progressively, as those amounts are disbursed from Mr Farmer’s proceeds from lot sales.
The ATO states in Example 1 that, taking into account all of the facts, while this is a very large development, the landholder did not adopt any risk or participate actively in the development. That is, the risk of the project was effectively borne by the developer, with Mr Farmer guaranteed a minimum return of $80 million, which is reflective of the approximate market value of the property. Accordingly, the ATO considers the sale of the developed lots to be a mere realisation and on capital account and the proceeds are not subject to tax as the land was a pre-CGT asset.
On the other hand, in Example 2, while the ATO recognises that Mr Farmer’s original intention for acquiring the land was for farming, taking into account a wide survey of facts, the ATO considers that Mr Farmer has entered into the carrying on of a business dealing in land at the point where he formed the intention to commence the property development project. A key factor which separates this case from Example 1 is that Mr Farmer is taking on a significantly greater proportion of the risk of the development, in particular being required to pay the developer the costs of the development, plus an 11% margin.
Arguably, this particular aspect of the ATO’s view is not supported by the case law. In fact, this view appears to be inconsistent with the comment made by Gibbs J in FCT v Williams (1972) 3 ATR 283; 72 ATC 4188 that the proceeds resulting from the mere realisation of a capital asset are not ordinary income even though the realisation is carried out in an enterprising way so as to secure the best price.
Similarly, the other examples also shed light on the ATO’s position on various scenarios of property development activities. Although many of the points raised in the Guidance are in accordance with our current understanding on how the law operates, there are a few points that have attracted criticism from commentators.
MKT has assisted clients, as well as our PAN members’ clients in dealing with the ATO in this area. If you require any tax advice, the preparation of an application for a Private Binding Ruling, submission of an objection or any other assistance in dealing with the ATO in this area, please contact Sean Pearce or Peter Hong.
These recent developments in the area will be discussed in more details in our Tax Case Study – The Capital v Revenue Argument – New Developments.