Investors that have ever divided or developed their investment property – or even investigated this – will probably have had to come to grips with section CB12 of the Income Tax Act.
Section CB12 is one of the commonly sited land taxing provisions. It states that any disposal gains from land that is developed or divided within ten years of acquisition can be taxed, where the work associated with the undertaking is ‘more than minor’.
The section has four exclusions:
- schemes that result in residential occupation by the taxpayer,
- the creation of business premises,
- farming and agricultural businesses,
- developments that are completed to enable the taxpayer to derive investment income such as rent.
So, what’s an example of development work that might be subject to tax under CB12?
Imagine Joe purchases a rental property for the purpose of deriving rental income. It sits on a nice large site that allows the land to be subdivided without a zoning change. Within 10 years of his purchase, Joe decides to undertake a subdivision of the land and, in doing so, creates a new section. Rather than retain the section and add another rental property to the land, he decides to sell the section and reduce his overall debt.
Because his scheme of division was commenced within 10 years and does not meet any of the exclusions to the taxing provisions, Joe stands to be taxed on his gain. That is, unless his scheme falls below the bar of being considered ‘minor’ in nature.
The question of how to determine whether a scheme is minor or not is therefore critical to the taxing outcome.
The IRD’s approach to this has been to consider the matter in both absolute terms (ie, is the total cost significant in and of itself?) and in relative terms (ie, is the cost significant relative to the value of the original land – prior to it being developed or divided).
While these criteria are useful, they don’t offer guidance on exactly where the all-important limits lie.
For many years, the bar was considered to be extremely low due to common law decisions on the question that went in favour of the IRD.
For example, in the case of Costello vs the Commissioner of Inland Revenue, the taxpayer spent $1,700 on legal fees associated with a unit titling scheme to separate flats in a block onto their own title. Despite involving no physical work and being minor in absolute terms, the court of appeal ruled in favour of the Commissioner on the basis that the works were still ‘more than minor’ in relative terms.
Following this judgement, tax practitioners often feel that relying on the argument that works were minor should be the last resort.
Recently, the IRD have released Interpretation Statement IS 20/08. This seeks to offer better guidance around assessing whether work is more than minor.
It introduces for the first time ‘safe harbour’ thresholds for assessing the cost of work both in an absolute and relative sense:
- Absolute costs – $50,000 or below.
- Relative costs – less than 5% of the value of the land at the start of the scheme.
Both measures of cost must be considered, as it’s possible for cost to be low in absolute terms but high in relative terms and vice versa.
Development work typically includes fencing, demolishing buildings, site clearing, earthmoving, installation of services, creating driveways, legal work, zoning applications, drafting engineering plans, and entering contracts for physical development work. It excludes the erecting of buildings.
Divisional work includes planning and preparation of formal plans, survey work, obtaining of consents and permits, legal work including the deposit of subdivisional plans and the issuing of separate titles.
Interestingly, boundary adjustments are considered to fall within the scope of CB12 and are considered to be divisional work – even though new titles are not created.
Overall, the introduction of these safe harbour thresholds brings a degree of certainty to the assessment of the question of whether a scheme is minor in nature.
Because of the need to look at the question in both absolute and relative terms, taxpayers seeking to argue that their schemes are minor will need to seek valuations of their land, prior to the schemes being commenced. This is so that costs can be measured against the value of land in order to satisfy the relative safe harbour test.
If you’re interested in more detail on how these safe harbour thresholds will work in practice, you should read the examples cited in the back of the interpretation statement.
And remember, taxpayers should always seek professional tax advice when considering any tax issues associated with developing and subdividing land.