Australia: A stern warning to property "investors"

The recent decision in August v Commissioner of Taxation [2013] FCAFC 85 ('August') is a timely reminder to property investors to not only seek good advice at the time of acquiring a property, but also to be clear about their intentions and keep their house in order if they wish to stay on 'capital account' and within the CGT regime.

This was an interlocutory application to adduce further evidence prior to hearing of a further Appeal to the Full Federal Court following the decision of Nicholas J in August v Commissioner of Taxation [2012] FCA 682. In rejecting the application Siopis, Besanko and Mckerracher JJ have set out in detail the Nicholas J findings and firmly rejected the challenge to the conclusions "of the trial judge" on evidentiary issues.

In short the Full Court effectively confirmed the earlier decision and the ATO view that the sale of the relevant properties were not on capital account and formed part of ordinary income under Section 6-5¹. At stake was the 50% discount that would have been available if it fell under the CGT provisions².

A further step perhaps along the line of what was held by Finn J in R & D Holdings Pty Ltd v FCT [2006] FCA 981 ('R & D Holdings') where the relevant property was found to be trading stock that was held "at the relevant time for the dual profit making purposes of sale or lease of subdivided lots."³

Why is this of concern?

The August judgment, although lengthy makes interesting reading. On the face of it, the facts as set out and the statements of the Applicant/s seem reasonable, and the "capital account" argument perhaps not too far-fetched. The properties were generally rented, if after making significant improvements to improve value or constructed anew on the same site and the Applicant stated that sales only occurred when the price was too good to refuse. All reasonable contentions ordinarily.

Where the arguments seem to have failed is in the detail – detail of original intention, support to that not only in documents and corroborating witnesses, but in the Applicants actions. Also key was the view that the evidence of the Applicant and corroborating witnesses just was not reliable, and evidence sought to be later introduced was not in existence at the relevant time. Serious stuff and an indication of a view not only adopted by the Judge/s but possibly also by the ATO officers involved. Also apparent was a level of "guilt by association" with parties who had a track record of property development.

These issues aside, the facts are perhaps not dissimilar to many investors who may acquire property with the dual intention to lease, perhaps improve and ultimately make a gain. The tricky question along the continuum between "revenue" and "capital" is exactly how far you sit toward one or the other. Who for example buys a residential investment property without some thought of sale for a gain?

Perhaps of more concern would be Property Trusts that have a clear modus operandi of acquisition of commercial buildings, some improvements and/or refit, increases in rent and then sale based on the improved cap rate (in particular, where the property trust does not (or is unable to) make a MIT capital account election). Is that so dissimilar to the circumstances in August? Taking the apparent personalities out of it, this is perhaps just another step along the continuum.

The critical issue to consider here is that, unlike R & D Holdings where the property was held to be trading stock, the properties in August were otherwise ostensibly "investments" that were not trading stock.

A brief note on history

The capital v revenue argument is older than our income tax legislation in Australia, with a history from deep within English law and cases. Many of our cases on property predate the introduction of Capital Gains Tax ('CGT') in 1985 or relate to that earlier period, but the issue has been quietly bubbling along and now seems to be gaining some momentum with the ATO.

On the introduction of CGT the legislated provisions regarding a "profit making undertaking or plan"4 ceased to have operation and were replaced by the much less prescriptive Section 15-15 of ITAA97. In practice many, including the ATO, took the view that the 12-month rule in CGT took care of most gains that would otherwise be "revenue" and the availability of discount CGT provisions (initially indexation, followed by the 50% discount) for gains outside one year, implied that application would be limited to such "short term" gains unless clearly "trading stock".

Whilst R & D Holdings tested that view on "investment" properties, the ATO position has clearly evolved and their sights are firmly set on capturing a wider range of properties on revenue account.

What can be done?

The importance of being clear on intent at the time of purchase cannot be understated. This cannot be simply what you may say later when questioned, but be supported by actions both at the time of purchase and later while you hold the property.

There are a number of factors that the ATO and the courts look to when determining intent and purpose, including what evidence may be available as to intent, how you initially finance the property, the viability if not sold, any level of involvement in improvement/development for sale as well as the extent of that improvement/development.

While there is no reason why you cannot later change your mind and intention, if you intend to hold initially as an investment you should be crystal clear on that and have your advisors assist you in that assessment and perhaps to document this. Your behaviour and actions should remain consistent with that intention.

If you at any point consider taking a different approach to the property, by perhaps undertaking improvements, get some further advice at that time. If indeed there is a change of intention from capital to revenue, with proper advice this can be handled smoothly and some level of "capital" gain preserved for concessional tax treatment.

Footnotes

¹Section 6-5 - Income Tax Assessment Act 1997 ('ITAA97')
²Division 115 Part 3-1 – ITAA97
³R & D Holdings – at para 50
⁴Section 25A – Income Tax Assessment Act 1936 ('ITAA36')

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