Calculation Of Net Capital Gain/Loss And Assessability Of Sale Of Constructed Premises

Background Information

Rainsmart Pty Ltd (‘Rainsmart’) is an Australian resident company that manufactures and sells weatherproof clothing to the Australian and international market. Rainsmart purchases raw materials from Indonesia and New Zealand and manufactures at their production facility and head office in Sydney. An administration office is located in each of the Australian capital cities, to support sales and customer service. Rainsmart’s turnover is just over $20 million,net assets $12 million and permanent staff total 150 Australia wide as at 30 June 2017.

On 2 February 2017, Rainsmart entered a contact for the sale of its administration office in Melbourne for $4.5 million, as the office staff had moved to leased premises 2 months earlier. Rainsmart acquired the Melbourne office in January 2000 for $1.8 million (GST exclusive), and spent $430,000 (GST exclusive) in replacing the external windows and doors as well as painting the building, prior to the first use of the premises for its operations.

Rainsmart also acquired a strip of land adjacent to the Melbourne office for $360,000 (GST exclusive) in March 2010, with a view to constructing an access road and a parking lot for staff at the back of the premises. There had been some dispute with the neighbours as to the ownership of the relevant strip of land however after legal negotiations Rainsmart’s ownership was upheld in June 2013. Legal costs incurred with respect to the ownership dispute totalled $25,000 (GST exclusive). The incidental costs of acquisition and disposal of the Melbourne office that was paid to the relevant real estate agent totalled $34,000 (GST exclusive). Rainsmart claimed an interest deduction of $22,000 in the relevant years in respect of a loan it had obtained to purchase the Melbourne office.

On 20 June 2017 Rainsmart also sold its shares in Hailsafe Pty Ltd (‘Hailsafe’) for $800,000. The decision to sell the shareholding in Hailsafe was made because Hailsafe had produced an income tax loss of $150,000 in 2016. The management of Rainsmart were of the view that without a substantial injection of additional capital, something they were not prepared to do,Hai lsafe would continue to make losses. Rainsmart had acquired 100% of the shares in Hailsafe in 2012 for $2.2 million and incurred legal fees of $38,000 (GST exclusive) on acquisition and $18,000 (GST exclusive) on the disposal of the shares. Rainsmart also received a payment from Hailsafe (after the sale of the shares) of $280,000 (GST exclusive) for agreeing not to set up a similar business to Hailsafe for the next 6 years.

Also in June 2017 two paintings that hung in the foyer of the head office of Rainsmart were stolen. Although the stolen paintings were never recovered Rainsmart received a compensation payment from its insurers of $110,000 for one painting, originally acquired by Rainsmart for $100,000 in 2001 and $50,000 for the second painting, originally acquired by Rainsmart for $70,000 in 2006.

a) Based on the information provided calculate the net capital gain or loss derived by Rainsmart for the year ended 30 June 2017. Please show all workings and cite relevant legislation. You must cite relevant legislation and cases where relevant and
explain your answers. 

b) Rainsmart is considering the possibility of using the proceeds of the sale of shares in Hailsafe to purchase vacant land. The land would be subdivided into 20 individual lots and premises constructed on each lot. Rainsmart seeks your advice on whether
the sale of each of the constructed premises would be assessable as ordinary income or as a capital transaction subject to the capital gains tax provisions in the ITAA 1997. You are required to explain why the sale would or would not be ordinary income or
a capital gain and reach a conclusion, making assumptions if required.

You are required to apply a critical thinking approach to answering this part, in that you must explain why the sale would or would not constitute ordinary income or a capital gain or loss. Please refer to the video explaining the steps to critical thinking on ilearn in the section with this assessment as well as the recording of how critical thinking (and problem solving) is used in tax advising in practice.

Provisions:

Section 100 to 149 of ITAA97 specifies the regulation regarding general rules for ascertaining capital gain tax liability and special topics. Capital gains are assessable as statutory income and are part of assessable income as per section 102 -5(1) of ITAA 97. Section 104-10 CGT event A applies in case the asset is purchased after 19/9/85 and must have been sold to other entity. In case asset is not sold, though ownership is change even than provision of CGT will be applied. A capital gain is assessed in case capital proceeds exceed the cost of asset; on the contrary capital loss is assessed in case it is less in comparison to cost of asset (Australian Tax Office. Working out your capital gain or loss, 2016.).

Section 108.5 (1) specifies that any kind of property or legal right which is not a property will be considered as asset for CGT purpose. Further, rights relating to personal service and right to bring action for personal service injuries are not deemed to be asset for CGT purpose.

Applicability

In present case as Rain smart has purchase land after 19/09/85 i.e. in Jan 2000 and disposal of asset (office building) has been made to another entity; the provision of CGT will be applied in present scenario. Building is an asset in accordance with provision of section 108 -5 (1) of ITAA 97 thus the same will be taxed in accordance with specified provision (Australian Taxation Office. Capital gains tax, 2016). Elements which are been required to be included in cost have been specified in section 110-25; section 110-35, section 110-38; section 110-40; section 110-45 of ITAA 97. Thus incidental cost relating to disposal of asset and capital expenditure relating to asset for maintaining or increasing the value of asset is treated as part of cost (Yinger, Bloom and Boersch-Supan, 2016). Thus, in present case all relevant cost of office building has been treated as part of cost of office building.

Computation of capital gain

Capital gain relating to sale of Melbourne office

Selling price of asset $4500000

Cost of asset (Working note -1) $2649000

Calculation of Net Capital Gain/Loss

Capital gain $1851000

(Selling price – total cost of asset)

Three method of calculating capital gain have been specified in ITAA97. In first method which is known as discounting method in which if asset held for more than twelve month than 50% of taxation gain is taxable for individual and trust. However, discounting method is not applied in case company disposes an capital gain tax asset (Jones, 2016). Thus, in present case as it is a company capital gain will be computed in accordance with other method i.e. (Selling price – Cost of asset).

Cost of Melbourne office

AASB 116 specifies the provision relating to Property, plant and equipment. Para 11 to 14 specifies explanation relating to initial and subsequent cost of asset which is to be recognized in books of accounts. As per the specified provision all expenditure made on an asset with are required to prepare the asset for its intended use are included in cost of asset (Vernimmen and et.al; 2014).

Purchase cost     $1800000

Cost relating to painting and other expenditure necessarily required $430000

Strip of land   $360000

Legal cost $25000

Incidental cost of acquisition and sale of office $34000

Total $2649000

Capital Gain on Sale of Shares

Selling price $800000

Cost of shares $12000000

Sale of shares generally triggers capital gain tax; and the same is calculated by reducing cost from selling price (Jacob, 2016). Further, an exemption has been provided that no CGT provision applies on sale of shares between members of same group; whether the shares relate to company outside the group. Thus, in present case of capital gain tax provision will be applied as the company is selling its own shares. Similar description is provided under case of FCT v. Lamesa Holdings BV.

Section 24 of ITAA97 specifies the provision regarding situation when asset are lost or destroyed. It has been provided in sub-section 1 that in case the entire asset is lost or destructed it will deemed as disposal of asset whether or not any sum has been received as compensation. Thus, computation of capital loss in present case will be done in following manner:

Assessability of Sale of Constructed Premises

Sellin100000g Price Nil

Cost of acquisition

1^st Painting $100000

2^nd Painting $70000

Total $170000

However, as compensation has been received than loss will be

reduced to same extent; thus compensation in present case is $160000

$110000 and $50000 for second painting

Capital loss $10000

Capital gain from sale of office building $1851000

Capital gain from sale of own shares               0.00

Capital gain from sale of painting -$10000

Total capital gain $1841000

(As capital loss from one asset can be set off against capital gain of another

asset in same year. (Harding, 2013))

The specified asset is CGT as per provision of section 108-5 (1) of ITAA 97. If a block of land is subdivided, each part land will be registered with a separate title. For the purpose of capital gain, the original piece of land is divided into separate assets (Australian Taxation Office. Subdividing land, 2016). Mere sub division of land does not in itself result into capital gain, if the ownership is retained by the original owner. No capital gain or capital loss arises at the time of subdividing land. For this purpose case study of Scottish Australian Mining Co Ltd v FC of T (1950) 81 CLR 188 can be considered. Capital gain arises only when there is a clear intention by the owner of selling the subdivided land (Gitman,  Juchau and Flanagan 2015). For calculating the capital gain or capital loss, the date on which a person acquires the land and further sub divided it is to be considered. The cost of original land is sub divided into the number of sub divisions on reasonable basis.

The profit which arises from the sale of subdivided land may be treated as capital gain or ordinary income, depending upon the situation. If a block of land is subdivided and sell the blocks which are newly created than the profit is treated as a capital gain and is subjected to the tax provisions. Same is cited under provisions of Federal Commissioner of Taxation v. Whitfords Beach Pty. Ltd. However, as per views of Faccio and Xu, (2015) if the sole intention of subdividing the land is to create profit or gain in the normal course of business than the profit will be treated as ordinary income.

Conclusion

According to the taxation ruling, TR 92/3, Rain smart’s sale of constructed premises of 20 subdivided lands will be treated as capital gain. Since, the land was not acquired for the sole intention of making profit and the profit does not arises in the normal course of business; the gain will not be treated as ordinary income. Moreover, as far is capital gain is concerned, it will only arise when the subdivided land is sold and a transaction arises on the part of Rain smart (Clark, 2014).  Distinction between income and capital receipts have been specified in Sec26 (a) and section 25A of ITAA36; thus in accordance with provision of specified section the receipts which will be received on sale will be treated as capital receipts. Thus the difference between the cost of acquiring the land and the proceeds from its sale will be considered as the capital gain (Nicola, 2016). The cost at which the land was acquired will be divided rationally amongst the 20 sub divided land.

The assumption on which the above conclusion is drawn is that since the purchase of the land by Rain smart is for the use of proceeds from sale of shares, the purchase will be treated as an investment.

Conclusion

In accordance with above provision it can be concluded that capital gain provision will be applied when blocks of land will be sold as the activity is not in ordinary course of business for Rain smart Ltd.

References

Clark, J. (2014). Capital gains tax: historical trends and forecasting frameworks. Economic Round-up.  (2), P.35.

Faccio, M. & Xu, J. (2015). Taxes and capital structure. Journal of Financial and Quantitative Analysis. 50(3). Pp.277-300.

Gitman, L.J., Juchau, R. & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.

Harding, M. (2013). Taxation of dividend, interest, and capital gain income.

Jacob, M. (2016). Tax regimes and capital gains realizations. European Accounting Review. Pp.1-21.

Jones, D. (2016). Capital gains tax: The rise of market value?. Taxation in Australia. 51(2), P67. 

Vernimmen, P. & et.al.  (2014). Corporate finance: theory and practice. John Wiley & Sons.

Yinger, J. Bloom, H.S. and Boersch-Supan, A. (2016). Property taxes and house values: The theory and estimation of intrajurisdictional property tax capitalization. Elsevier.

Online

Australian Tax Office. Capital gains tax. (2016) [PDF]. Available through < https://www.ato.gov.au/General/Capital-gains-tax>. [Accessed on 8th October 2017].

Australian Tax Office. Subdividing land. (2016) [PDF]. Available through < https://www.ato.gov.au/General/Property/Land---vacant-land-and-subdividing/Subdividing-land/> [Accessed on 8th October 2017].

Australian Tax Office. Working out your capital gain or loss. (2016) [PDF]. Available through < https://www.ato.gov.au/General/Capital-gains-tax/Working-out-your-capital-gain-or-loss/>. [Accessed on 8th October 2017].

Nicola Webber. Real Commercial, Commercial News. (2016) [Online].Available through < https://www.realcommercial.com.au/news/capital-gains-tax-means-commercial-property>. [Accessed on 8th October 2017].