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Profit While Subdividing Building Houses

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Question:

Discuss About The Profit While Subdividing Building Houses?

 

Answer:

Introducation

On the basis of the given facts, various alternative ways of tax accounting for the proceeds from the sale of the three houses need to be highlighted with reference to the existing statute.

Relevant Rule

The primary source for assessable income is ordinary income which is defined as per s. 6(5) ITAA 1997. The given statute does not highlight which incomes to include within the purview of ordinary income and hence the relevant information is obtained from applicable court decisions and tax rulings. A particular contribution to ordinary income is for income derived from business and also employment. However, in case of terming any proceeds as business income, it becomes imperative to separate the business from hobby in line with the Evans v. F.C. of T(1989) 20 ATR 922 verdict (Barkoczy, 2017).

It is imperative that employment or activities related to business must be of continuous nature to be categorised under ordinary income under s.6(5) ITAA 1997. However, certain isolated transactions are entered into by the concerned taxpayer for profit motive which would lead to assessable income as per s. 15(15) ITAA 1997. The essential element is profit and also the transaction not being regular. The assessable income would comprise of the profits derived from such transaction (Sadiq et. al., 2016).

Assessable income could also potentially result as statutory income. A common type of statutory income is capital gains on which CGT (Capital Tax Gains) would be applied. These may arise when there is a disposal of a particular capital asset. The proceeds derived from capital asset realisation would be considered as capital proceeds and hence outside the realm of taxation (CCH, 2013). Thus, capital gains need to be computed and taxed as per s. 104-8 ITAA 1997 (Gilders et. al., 2016).

 

Application

The facts outlined do not highlight profession of taxation Penny and hence it is assumed that she is engaged in the contracting business or deals with real estate dwellings. Hence, as per her business, she took money on interest and subdivided the land purchased to construct four homes.  From these four, three houses were sold and the proceeds derived through sale of these are classified as assessable income as per s. 6(5).

An assumption is made about the taxpayer’s profession that Penny does not deal with real estate contracting or selling.  Hence, with the motive of profit, Penny decided to sub-divide the land for constructing houses which were then liquidated. In order to maximise the profits, Penny also used marketed services so that the houses can be sold at the maximum possible prices. Thus, both the conditions i.e. profit motive presence and nature of transaction as isolated is fulfilled and hence s. 15(15) is applicable.

The main assumption in this case is that profit motive was lacking on the taxpayer part. Hence, Penny thorough sub-dividing of land and consequent selling of house amounted to realisation of the capital asset. Hence, the sale proceeds would be capital in nature and thus non-taxable. However, CGT would apply on the capital gains that Penny would derive owing to the realisation of the capital asset.

Conclusion

The discussion above clearly highlights that income for the given sale of house is possible through three alternative statutes (s. 6(5), s15(15) & s. 108(10)).

Assessable income computation in the above listed approaches is carried out below.

Sales proceeds obtained from three houses sale = $ 3 million

Construction cost (four houses) = $ 1 million

Hence, on proportional basis construction cost (three houses) = (3/4)*1 million = $ 0.75 million

Also, vacant land cost = $ 1million

Hence, on proportional basis land cost (three houses) = (3/4)*1 million = $ 0.75 million

Considering the above deductions under s.8(1), the taxable income from the above can be calculated  (Deutsch et. al., 2017).

Sales proceeds obtained from three houses sale = $ 3 million

Construction cost (four houses) = $ 1 million

Hence, on proportional basis construction cost (three houses) = (3/4)*1 million = $ 0.75 million

Also, vacant land cost = $ 1million

Hence, on proportional basis land cost (three houses) = (3/4)*1 million = $ 0.75 million

Thus, net profit = $ 3 million – (0.75 million + 0.75 million) = $ 1.5 million

Hence, the assessable income derived would be $ 1,5 million (Woellner, 2014).

Property cost base = Land cost + Construction Cost = $1 mn + $1mn = $ 2 million

But on the basis of the given fact, the given property has in total four houses, thus the proportional cost for three houses = (3/4)*2 million = $ 1,5 million

Sale proceeds obtained from the liquidation of the houses = 1 million *3 = $ 3 million

Thus, realised capital gains = 3 million – 1.5 million = $ 1.5 million

No discount would be available on the above capital gains under s. 115-25, ITAA 1997 as discount method of capital gain computation is applicable only for long term capital gains which arise when the holding period is in excess of 1 year (CCH, 2013). A key aspect in the above computation is that cost of marketing for house sale is assumed to be zero or else it would also contribute to cost base and hence reduce the applicable capital gains.

Based on the given information, assuming a specific profession for Penny would be incorrect and hence application of s. 6(5) seems inappropriate. For application of capital gains, a key assumption was the absence of profit while subdividing and building houses. This seems unlikely considering that she used borrowed money and also marketed the finished houses for profit maximisation. In case of absence of profit motive, Penny would have constructed only one house for her use and would not take debt for construction. The presence of profit motive is confirmed and hence application of s. 15(15) to the given transaction would be most suitable (Barkoczy, 2017).

 

References

Barkoczy, S. (2017), Foundation of Taxation Law 2017, 9thed.,North Ryde: CCH Publications

CCH (2013), Australian Master Tax Guide 2013, 51st ed., Sydney: Wolters Kluwer

Deutsch, R., Freizer, M., Fullerton, I., Hanley, P., and Snape, T. (2016), Australian tax handbook 8th ed., Pymont: Thomson Reuters,

Gilders, F., Taylor, J., Walpole, M., Burton, M. and Ciro, T. (2016), Understanding taxation law 2016, 9th ed., Sydney: LexisNexis/Butterworths.

Sadiq, K, Coleman, C, Hanegbi, R, Jogarajan, S, Krever, R, Obst, management, and Ting, A (2016) , Principles of Taxation Law 2016, 8th ed., Pymont:Thomson Reuters

Woellner, R (2014), Australian taxation law 2014, 7th ed., North Ryde: CCH Australia

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