Is it on Capital or Revenue Account?

Many people would assume that a gain made on the sale of a rental property held for nearly 10 years would be a capital gain eligible for the 50% general discount.

However, in a recent decision by the Full Federal Court, the length of time an investment property had been owned was judged not as significant than other factors in deciding the tax outcomes.

Rather, the court looked at the original intent of the taxpayer and determined the gain on sale to be ordinary income (not a capital gain) to which no capital gains tax discounts could be applied.

Capital gains vs Ordinary income

An asset will generally fall into one of 3 categories:

  • Capital (on account of capital)

A capital asset is generally acquired for the purpose of deriving an ongoing stream of income from the use of the asset (even though a gain may be made on the eventual sale of the asset, a mere realisation).

The disposal of the asset by a ‘mere realisation’ will give rise to a capital gain or capital loss.

  • Trading stock

The term trading stock applies to any asset(s) traded in the ordinary course of business. Proceeds from the sale of trading stock will be assessable on account of revenue.

  • An asset used for the dominant purpose of enterprise or profit making

These assets are generally acquired with the intention of making a profit from the sale of the asset.

Gains or losses on disposal will be assessed on account of revenue.

The distinction between each of these categories is crucial in determining the tax outcomes arising on sale.

A capital asset may be eligible for discounts or access to many concessions which reduce the assessable amount of any gain on the eventual sale.

Where a resident individual or trust has held a capital asset for greater than 12 months, they will generally be eligible to reduce the assessable amount of any gain on disposal by 50% (assuming it is a mere realisation)

Conversely, the sale of trading stock or an asset used in a profit making venture will be on revenue account as the intention is to derive income or profit from the sale of the asset.

Generally the entire amount of a revenue gain will be assessable.

The August case – Why intent is important

The recent August case1 highlights the importance of the taxpayer’s intent in determining the categorisation of assets and their tax treatment.

In the August case, a small strip of shops was acquired in the late 1990’s.

Shortly after acquiring the properties some of the shops were leased to a supermarket operator, a hairdresser and a butcher on five year leases with options to extend the lease. Prior to leasing the properties some renovations and extensions to the properties were required.

During the early 2000’s, surrounding land including land previously used for car-parking, was acquired by the taxpayer.

Additional shops were constructed on these properties and were leased to restaurants on five year leases (with options to extend the lease).

Shortly after the last of the shops was tenanted, the taxpayer entered into discussions with a real estate agent regarding the best way to dispose of the properties. After a lengthy process, the properties were finally sold in early 2007.

Although the shops had been held for a significant period of time, the Commissioner of Taxation (and ultimately the judges in the Full Federal Court) was not satisfied that the shops had been acquired as long term capital assets.

Instead, they found that it was more likely that the properties had been acquired as part of a profit-making scheme with the principal intention being to develop, tenant and sell them for a profit.

Accordingly the sale was not deemed to give rise to a capital gain and therefore not eligible for a 50% discount.

In coming to their conclusion, the judges considered two factors as being crucial:

  • Prior to acquiring the properties the taxpayer had sought considerable advice and assistance from a friend who was a successful property developer. The friend explained in detail how he had been successful in buying, developing, leasing and then selling property. The court believed that the taxpayer was looking to emulate this approach; and
  • The value and sale of the shops was investigated in detail once the last of the shops was tenanted. The judges felt the most plausible explanation for this was that it was part of a profit making scheme of purchasing, developing, securing long term tenants and then selling the property.

How does this case impact on taxpayers?

The August case provides an important reminder to advisors and their clients that care needs to be taken when classifying an asset as being on capital account or revenue account.

Ultimately, the taxpayer has the burden of proof in demonstrating their position is correct. Where possible, detailed advice on the likely tax treatment should be sought prior to acquiring an asset.

While holding an asset for a considerable period of time may seem to indicate that it is a long term capital asset, the intention of the taxpayer at the time of acquisition (and throughout the ownership period) is the more crucial aspect.

Documenting the intent and purpose prior to the acquisition and throughout the holding period is important if the matter is challenged by the Commissioner of Taxation.

Factors to address include:

  • How is revenue or profit to be generated from the asset?
  • What is the likely holding period and do the surrounding facts support this intention?
  • What does the loan documentation say? Arguing that an asset is held on capital account if your mortgage documentation suggests that the property is being held for a shorter term property development is likely to be a challenge.
  • How much development or redevelopment of the property is required and how close to the time of sale will this occur?
  • Consistency of accounting treatment. Where a taxpayer changes the treatment of an asset from being on revenue account to capital account in the years leading up to sale, the change would need to be consistent with the surrounding factors and intentions.

Should you require assistance in determining the tax treatment of an asset sale, please contact your CTBS – (07) 3267 2111 or tim@ctbs.net.au.