When a public accountant is uncertain about a tax matter one of the first ports of call is, inevitably, rulings and determinations made by the Australian Taxation Office. I recently reviewed a client’s tax returns prepared by one of our accountants who had unfortunately too slavishly followed the ATO’s stated interpretation of tax legislation.

The facts in this situation were that two clients had formed a partnership to buy a property, the existing house was rented for a period, the house was then demolished and two townhouses built and sold. After this successful venture a unit trust was formed for future property investments.

The young accountant, after checking the relevant ruling by the ATO, decided that as the future intention was to buy, develop and sell properties for a profit, all of the gain on the first investment was assessable as business income and the general 50 per cent capital gains tax discount did not apply.

Realising that the ATO is not always right with their interpretations of the Tax Act, I contacted their media unit, as I thought it would be an interesting subject for a future article. Their reply provides an insight into how the ATO considers the subdivision of a property should be treated for income tax purposes.

“While a property may have been used privately or as an investment, once a taxpayer decides to use it in a way that might be the same as a property developer, then it can become a ‘commercial transaction’ made with a view to realise a profit from sale, rather than simply a realisation of a property that is no longer needed”.

Interpretation could be challenged

I believe this interpretation by the ATO could be challenged. I remember a case (but unfortunately not the case details) in which the vibe of the decision by the court was that a taxpayer could maximise their gain on an asset and not have it treated as business income.

It is hard to generalise, as the facts of each case play a major role in determining how the gain on the subdivided property is treated, but where a taxpayer only maximises their gain from a property that had previously been held as an investment or a residence, I believe it should be treated as a capital gain and challenged if the ATO believe it is business income.

Unfortunately, the young accountant who had thought the first transaction should be treated as normal income did not have all of the facts surrounding the original purchase and development.

When the partnership was formed to buy the original property the intention had been for it to be a one-off venture with one of the partners renting out their townhouse for investment purposes, while the other intended to live in their townhouse.

As a result of a change in the personal circumstances of one of the partners it was decided that both townhouses would be sold. Based on these facts, I made the decision to class the profit made by the partnership as a capital gain which resulted in a major reduction in tax for both clients.

The lesson to learn

The lesson to learn from this story is that public accountants should clearly take account of the ATO’s determinations and pronouncements but, as there have been numerous cases of where the ATO have been proven to be wrong in their interpretation of tax legislation, they should not slavishly follow what the ATO says should be done.

A perfect example is the change in attitude that the ATO had towards requiring two bank accounts when segregation of investments in an SMSF was used as a strategy. But that is a story for another time.

 

Max Newnham has worked in public accounting for almost 40 years. He is a financial planning specialist with the Institute of Chartered Accountants and a specialist adviser with the SMSF Association of Australia.
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