On 28 July 2014, the ATO released its taxpayer alert TA 2014/1: Trusts mischaracterising property development receipts as capital gains.
The ATO warns against property developers using trusts to undertake property development activities. The ATO’s concern is that the trustee then returns the sales proceeds on capital account, allowing the beneficiaries to access the general 50% capital gains tax discount, when the full profit from the development should be reported as ordinary income without any tax discount.
In the taxpayer alert, the ATO has indicated it will continue audit activity in this area and is targeting arrangements that display the following characteristics.
- The taxpayer has experience in either developing or selling property – or in the property and construction industry – and establishes a new trust to acquire property for development and sale.
- The circumstances surrounding the arrangement are inconsistent with the stated intention of purpose of developing the property as a long term investment. This may be evident in the documents prepared when obtaining finance, communications with local government authorities or the early engagement of real estate agents.
- The development is advertised as available to purchase before completion or is sold soon after completion.
- The trustee claims the 50% capital gains tax discount on the sale of the property.
While there will no doubt be circumstances where the position taken by the ATO is correct, we have also seen audit activity where the ATO has incorrectly assumed that, because the clients have a history in property development, each and every property connected to them is trading stock.
For example, a commercial property purchased for use as the office premises for a related business, and with no intention to resell in the foreseeable future, is likely to be on capital account. This is regardless of whether it is held in a separate trust.
The capital/revenue distinction continues to produce disputes and litigation. Given the taxpayer alert, we expect more ATO audit activity in this area.
Taxpayers who want to qualify a development property as a long term investment (and therefore a capital asset rather than trading stock) need to ensure that all documentation in relation to the project is consistent with the stated intention. In particular, finance applications and similar documents must support this intention, as the ATO will almost always access these documents if they consider a development was undertaken to generate a short term profit rather than acquire a long term investment.
Also, if a taxpayer does develop a property as a long term investment and then changes their mind and sells in the short term, it is important that the reasons for this change of heart are clearly documented (e.g. because of change in financial situation or ‘an offer too good to refuse’).