MLC703 Principles of Income Tax Law :Policy Based
Part -1 Problem Question 1A
Kristie is 42 and decided to buy an investment property with a view to selling the land in the future to fund her retirement. She considered between buying an inner suburban house on a small piece of land or an outer suburban house on a larger piece of land. She eventually decided on the larger outer suburban house. Although her primary intention was to hold the house and sell it at her retirement, one of the factors that made her decide to buy the outer suburban house is that she wanted to be open to the possibility of developing the land in the future.
As it turned out, 12 months later Kristie got lucky in that her investment property was rezoned by her council, which meant that she was able to build a 5 storey apartment on its land (subject to local council approval). She went to a lot of work to get local council approval, which involved getting a professional planner to draft sketches and plans as to what the proposed apartments would look like. This cost her around $15,000. After gaining council approval, she decided that she did not want to be actively involved in the building process, and so paid a professional builder $7m to construct the apartment block (and demolish the existing house). When the apartments were complete rather than sell each unit individually, she sold the whole block herself to a rich investor for $12m.
Required: Ignoring Capital Gains Tax, discuss whether the sale of the apartment block generates ordinary income.
Where appropriate, support your answer with legislative and case authority.
Problem Question 1B
Dave, on 1 February 2013, entered in a contract to purchase:
- A premises with a factory that manufactures doors, for $900 000; and
- Goodwill relating to the door business for $100
Dave after the purchase ran this door manufacturing business, and did so as a sole trader.
Dave’s sole customer of the doors was a retail outlet called DoorsRUs, which sold doors to the general public. Initially Dave did not have any long-term contract with DoorsRUs. However, this changed on 1 July 2016, at which time, Dave and DoorsRUs entered into an 8 year contract for DoorsRUs to purchase doors from Dave’s business at a set price.
During 2017, Dave suffered from ill health, and so looked at selling the door manufacturing business. At first he could not find any buyers and considered closing the business down. However, as DoorsRUs still wanted a supply of doors, it decided to purchase the business from Dave and continue to run it themselves. As a result, on 10 January 2018, DoorsRUs and Dave (who was 53 at the time) entered into the following agreement:
- DoorsRUs would purchase the factory premises from Dave for $2 000 000.
- DoorsRUs would purchase the goodwill from Dave for $400
- The balance of the 8 year agreement between Dave and DoorsRUs was to be cancelled. As compensation for this, DoorsRUs was to give Dave $80 000 as a lump sum.
- DoorsRUs would pay Dave 3 lump-sum annual payments of $10 000 each in exchange for Dave not competing with them in the door manufacturing business.
Dave estimates that for the time he owned and ran the business, annual revenue was between $3-$3.5 million.
Dave owned the following assets at the time of entering the January 2018 agreement:
- A house he lived in (located in Burwood). This was worth $1.1 million, and had a $500 000 mortgage on
- A rental property (located in Coburg) worth $650 000 (referred to below). This property had a $200 000 mortgage on
- A superannuation account with a balance of $400
- A life insurance policy worth $200
- A 20 per cent interest in a company called Invest Pty Ltd which Dave has owned for the last 5 years. This company owned various shares in publicly listed companies. This company had a market value of $800
- A 60 per cent interest in a company called Property Pty Ltd, which is a property developer. The company had a total market value of $550,000.
Dave had previously, on 20 January 2013, purchased an apartment in Coburg as his main residence (for $380 000), and had paid stamp duty of $20 000 at the time. He had immediately moved into it and treated it as his main residence. However, on 20 January 2015 Dave bought the abovementioned house in Burwood to live in, moved into it immediately, and treated it as his main residence. At the time the Coburg apartment was worth $600 000. Dave entered into a contract to sell the Coburg apartment on 20 January 2018 for $650 000.
Required: Advise Dave on the Capital Gains Tax implications regarding the above transactions for the 2017/18 tax year – please ensure that your discussion includes advice on whether he can take advantage of the CGT Small Business Concessions to reduce the amount of tax payable on his Capital Gains.
Part 2: Policy Based Question:
Negative gearing is a feature of the Australian tax system where losses (including interest expenses) on investments can be used to reduce the tax payable on the taxpayer’s other income, such as their salary income.
Some have advocated for the removal of negative gearing. Discuss the arguments for and against the removal of negative gearing. In your discussion, please consider this in the context of fairness, efficiency, protection of government revenue and any other relevant considerations.
Answer
Part I:
1 A: Issues:
The issue here is based on determining whether the taxpayer will be considered taxable relating to the profits derived from the sale of apartment under “section 6-5 of the ITAA 1997”?
Rule:
Income obtained upon the sale of property is viewed as ordinary income based on circumstances that the taxpayer improves and develops the property for deriving profit from property development activities. Taxpayers engaged in developmental activities are generally treated as property developers. When the sale of property happens in the ordinary business, income obtained through property sale is held as assessable income in terms of gross proceeds basis under “section 6-5 of the ITAA 1997”.
As defined under the “taxation ruling of TR 92/3” any profits attained from isolated transaction is treated as income based on the ordinary concepts of the circumstances. Taxpayers that makes the profit from the isolated transaction must consider those profits as ordinary income if the objective of the taxpayer was to enter the transaction for the purpose of making profit.
Selling of revenue assets give rise to ordinary income for an individual taxpayer. The commissioner judgement in “Whitfords Beach Pty Ltdv FCT (1982)”states that an individual taxpayer is assessable under “section 25 (1)” for proceeds that are obtained from the sale of land as the activities is termed as the land development business. The commissioner of taxation held that the profits obtained from isolated transactions is considered as income based on the ordinary concepts of “section 6-5 of the ITAA 1997”since the profits derived from execution of business transaction was commercial.
Application:
In the current study of Kristie, the investment property was bought with the objective of producing profit. The services of professional property planner were sought by Kristie for drafting the sketches and proposed plans of apartment. This signifies that investment property was developed by Kristie with the intention of producing income from property development activity. Denoting the judgement in “Whitfords Beach Pty Ltd v FCT (1982)” the activities of Kristie should be treated as property developer with the sales proceeds of property reflects carrying on of land development business. The objective of Kristie was to make profit from such transaction.
Conclusion:
On a conclusive note, profits obtained from the sale of block of apartment should be treated as ordinary income based on “section 6-5 of the ITAA 1997”.
1 B: The current issue is related to the determination of whether the taxpayer will be liable for capital gains tax that is made from the selling of assets under the “ITAA 1997”
Capital gains is applied on the taxpayers that acquire the assets or any other events that happens on or after 20th September 1985. A person can generate capital gains or losses if the sell the assets, or. through gifts or transfer. A business asset may consist of premises, goodwill, licences or rights. A person is under the obligation of including the amount of capital gains which is earned during the income year while filing tax return.
As stated by the Australian Taxation Office a person that owns the commercial property are most probable to generate capital gains or losses. An individual taxpayer is in the probable situation of making capital gains or capital losses at the time of selling the commercial. On noticing that an individual taxpayer generates capital gains during the relevant income year, the taxpayer would be required to pay capital gains tax. Any form of capital loss or gains that is made by the taxpayer represents the difference between the costs that is obtained by a person and what is received by the taxpayer at the time of disposing the property. Any amount which a person claims as deductions for lowering the tax liability are left out from the property cost base.
The present case study of Dave introduces that he bought the business premises for $900,000 as well as a business goodwill for a sum of $100,000. Because of the poor health conditions of the taxpayer he eventually sold the business to Doors RUs for $2,000,000. Doors Ru further bought the goodwill of Dave by additionally paying him with $400,000. As an added sales stipulation, a premature end to the contract between the Doors RUs and Dave resulted in yielding a sum of $80,000 as the lump sum receipt in the form of compensation fee to Dave.
As defined under the “section 102-5 of the ITAA 1997” Dave would be required to pay the capital gains tax for the relevant income year ended because selling of commercial premises and goodwill gave rise to capital gains and attracts tax liability relating to the amount of gains derived during the income year. The capital gains that is made by Dave constitute the difference between the purchase price and the selling price.
As defined under the “Section 104-25 of the ITAA 1997” CGT event 2 takes place when a person obtains the compensation relating to the termination of the CGT assets of intangible nature. Evidences from the case study obtained suggest that Dave obtained a lump sum payment of $80,000 for termination of contract. Citing the explanation of “section 104-25 of the ITAA 1997” the termination of contract gave rise to CGT assets of intangible in nature. The amount of $80,000 should be treated as CGT event C2 because it constituted dissolution of intangible CGT assets.
In the later part of the case study Doors RUs is found to be paying a lump sum amount of $10,000 to Dave for not competing directly in the manufacturing of door for a period of three years. A CGT event D1 arises when a taxpayer establishes a contractual right or any other legal equitable rights in alternative entity. Denoting the judgement made in the event of “Higgs v Oliver (1951)”a lump sum amount was paid to an actor for not acting in any other direction, films and production for a minimum 18 months. The court held that the amount cannot be treated as income since it constituted CGT event D1. Referring to the above decision the lump sum amount of $10,000 that would be paid to Dave for not competing in the door manufacturing business gave rise to CGT event D1. The reason for this is that the sum of $10,000 constitutes the making of contractual rights in favour of Doors RUs.
As stated by the Australian Taxation Office the main residence of an individual taxpayer is generally exempted from capital gains tax. For a taxpayer to obtain the exemption on the main residence, there must be dwelling on the property and a taxpayer must have living on it. A taxpayer can gain the full exemption from the CGT on dwelling when it forms the base for the taxpayer till the period it owned the property is owned by them. An individual taxpayer is permitted to obtain complete main residence exemption only when the dwelling is owned for a particular time period.
Referring to the present circumstances of Dave he bought a property in Coburg to use as his main residence. A partial main residence exemptioncan be claimed by him because the property was earlier used as the main residence from the period beginning from 20 January 2013 to 20 January 2015. Later in 2018, the Coburg property was disposed for a sum of $650,000. The property would be regarded for exemption because Dave has lived in the property from the time when he acquired. The amount of time spend by Dave is held significant and gains that is derived from the disposal of the property would be eligible for partial main residence exemption from the capital gains tax.
As stated by the Australian taxation office an individual taxpayer that hold the property for a minimum time period of 12 months it would held as eligible for 50% discount on the capital gains that is made. Evidently, a small business entity can reduce the capital gains tax liability through small business CGT concession upon selling the business premises. The current case study provides that Dave is eligible to claim a retirement exemption. The Australian taxation office capital gains that are made upon the sale of active assets are exempted till the lifetime limit of $500,000.
An individual tax payer who is under the age of 55 years can obtain exemption from the amount that is mandatorily required to be paid while complying the super fund or the retirement savings account.The disposal of business premises and gains made from thereon is eligible for CGT concession. The capital gains that is made by Dave upon the disposal of premises is eligiblefor exemption till the lifetime limit of $500,000. Furthermore, Dave ages below 55 years and exemption amount should be paid in the retirement savings and super funds.
On a conclusive note, Dave is eligible for claiming CGT concession originating from the disposal of the commercial premises and would be entitled for claiming a partial main residence exemption because Dave used the property partly until he undertook the decision of shifting to another property in 2015.
Part 2: Policy Based Question:
Introduction:
Negative gearing is regarded as the untouchable taxation policy of Australia. Negative gearing continues because of the insistent myth that it assist in enhancing the availability of housing and reduces the rent. Recently, negative gearing has attracted widespread attention from the media. Generally, there are only two sides of a story however only one attains success. The recent prime minister announcement stated that changes in negative gearing off the table has been successful in settling few nerves but also swept away few naps as well. Nevertheless, negative gearing has turned out to be costly, ineffective, and inequitable and has led to ownership of housing. Negative gearing creates severe pressure in budgets for government and it is kept on the top priority list of reformations.
Negative gearing helps the taxpayer in reducing the losses which is incurred by them during investment from a taxpayer’s taxable income. The strategy can be viewed as the attractive element for the taxpayers as they can subtract the entire amount of interest and can pay taxes only for the half-sum of capital gains. The present study would provide aargumentative analysis of negative gearing based on the fairness, efficiency and government measures as revenue protection.
Argument against the negative gearing:
Alike most of tax concession regimes on investment, negative gearing has been partial towards wealthy persons. Persons with negatively geared residential property falls in the top 40% bracket of revenue recipients. An important argument against the negative gearing is that it raises the housing prices and raises the after-tax returns of housing investors. Negative gearing makes the prices greater than it would have been or else. This helps the present housing owners in speeding up the falling rate of residential owners amid the younger age group.
The most recommended method of improving the distortion in the housing market and reduced cost of budget from negative gearing would be by eradicating the capital gains tax discount. The government would be benefited as the revenue would increase by $5 billion in the next income year which may simultaneously abolish the speculative incentive in housing prices. Nevertheless, if the policy creators are unwilling to bring reformations in the capital gains tax, reforming the negative gearing form a better alternative. In short-run abolishing capital gains would help in protecting the revenues for the government. This would enable the government in collecting greater than $4 billion over the year with taxpayer may start accumulating losses to reduce the tax liability that may be paid on capital gains.
With respect to the definition of negative gearing, negatively geared property costs higher than the revenue it derives through rent. Losses can be set off against alternative types of income. Consequently, this leads more affordable property purchase since investors can obtain long term capital gains even though the property is not producing short-term profit. Australian council of social services explains that taxes relief altogether with the discount on capital gains tax has increased the speculative purchase of housing in Australia. This contributes to higher prices for regular home buyers.
Providing tax relief on negative gearing and capital gains fails to provide assistance in enhancement of the housing affordability as they even make it worse when there is a constant rise in the price of houses, similar to the present situation that is prevalent in Sydney. A minimum of one-tenth of negative gearing housing investment are directed towards the new properties whereas the remaining nine-tenth shoots-up the present price of the house.
Mythologies and taxpayer’s popularity cannot be considered as the better reasons for maintaining the costly, ineffective and insufficient arrangement of tax that shoots up the housing ownership by far out of the younger population reach. Therefore, negatively can be considered as the tool which should be abolished sooner rather than later.
Argument for the Negative Gearing:
A large number of studies have been carried out by the researchers regarding the current changes in policy setting for residential gearing. The policy setting are directed to eventually lower the housing affordability and would lower the living standards for Australia. The purchase of new residential housing is viewed as one of the highly tax environment currently in the economy however abolishing the negative gearing would result in reduced investment and may eventually worsen the housing market. There may be short supply of houses in the market and may lead to increase in rents costs.
According to the statement made by Property Council of Australia negative gearing cannot be only considered as the useful tool for rich persons but also forms an important feature for a large number Australians for their long-term plans of monetary security. The statistics can be viewed as decisive in Australia since the tool of negative gearing is used by the average workers group that mainly owns the single investment property. Empirical evidences have suggested that, abolishing the negative gearing would not only cause an effect on the regular investors but would lead to confounding effect on the private tenants. Most of the populations that are living on the accommodations could be negatively impacted due to shortage in the supply of houses.
According to the opinion of the tax practitioners negative gearing helps in enhancing the supply of houses by promoting investment. Negative gearing provides assistance in lowering down the costs of rent due to the better accessibility of the rental property. Tax practitioners have argued that negative gearing could be viewed as the tool that helps the Australian in creating wealth for themselves, for their retirement and for family. Abolishing the negative gearing may result in adverse impact as the cost of rents would increase and there would be reduced supply of houses with intense competition in market of housing property. The investors are expected to generate profit in two ways, firstly, when the net amount of rental income increases over the period and goes further than the interest expenses. Secondly, when the capital gains originating from the disposal of the property.
After the disposal of property is made, the system of taxation is such that it favours the treatment of capital gains with only half portion of the capital gains is charged as the taxable earnings if the investment property is held for no less than a period of twelve months. The system of taxation is such that only lower value of capital gains is considered for taxation. With respect to such perspective, distortions only happens from the 50% CGT discount for the income that is generated from the capital gains for the assessment purpose and not due to the negative gearing. As a result of this, abolishing negative gearing would lead to rise in the price of houses and would also result in loss of investment for the investors as well as the owners of the house. The effect of negative gearing is such that the investors may remain ahead based on economic terms and would yet be able to reduce the taxation liability.
Conclusion:
Conclusively, currently the prime minister of Australia has ruled out any further transformation in the negative gearing which ultimately contributes more in the direction of housing industry relief. Recent examples includes a notable increase in the real rents when the negative gearing was abolished in Sydney and Perth. This not only contributed to higher price but also led to greater number of rental vacancies.
The argument cannot be regarded as consistent that negative gearing formed the significant factor since negative gearing was viewed to introduce negative effect on the rental properties in all parts of the city. A rise in rental costs in two cities though matched up with the provisional abolition of negative gearing tax deductions, however it is not probable presently that negative gearing abolition would result in significant impact on the rents in any key capital city in Australia.
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