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Are interest costs incurred on borrowings for land acquisition deductible to an entity undertaking a property development as a ‘one-off’ investment?
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The permanency of the permanent: The ‘vacant’ landholding provisions
30 August 2024
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Synopsis
Section 26-102 of the Income Tax Assessment Act 1997 (section 26-102) disallows income tax deductions for outgoings incurred by an entity where land is held by that entity that is ‘vacant’ or where the property held contains a residential premises that is unable to be occupied or is not available for lease or rent with respect to the particular period in question.
In its application to entities undertaking a development project as a ‘one-off’ arrangement, the question arises with regard to whether such projects qualify the entity for deductibility of landholding costs (rates and taxes but more importantly interest) during the course of the development. Further, does the application of the provision now limit the choice of structure to that of a company where such an investment is entered?
Section 26-102
Broadly, effective 1 July 2019, landholding costs are not deductible to an entity holding vacant land or land on which there is a residential premises not available for rent or lease or unable to be lawfully occupied.
There are exceptions, which include the following entities:
- A company.
- A superannuation fund – but not a self-managed superannuation fund.
- An entity carrying on a business in which the land is used for the conduct of that business.
- Land held by primary producers.
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Landholding costs include rates, taxes, and interest incurred in holding the land. Notably, it does not include the cost of borrowing (including interest cost) for the purposes of construction, repairs, or renovations (Taxation Ruling TR 2023/3 – paragraph 26).
Further, the carrying on of a business by a spouse or a person holding the land or an entity that is affiliated or connected with that person will not give rise to the denial of outgoings incurred for landholding costs. This exception does not apply, however, where the land contains a residential premises or under which a residential premises is being constructed.
The one-off development – where are we?
It is a regular question raised by clients or prospective clients, looking to develop property to raise matters with regard to the structure under which the development opportunity should be entered. A further question is whether the gain or profit that may be realised from the development is income subject to ordinary taxation principles or treated as a capital gain and subject to concessional treatment.
That is, by way of example, a client comes to you considering a land development opportunity that is available under which he/she seeks to acquire land and build a residential development. It may be an option that the individual may wish to undertake the opportunity in their name or perhaps through a discretionary family trust or self-managed superannuation fund.
Section 26-102 raises issues with regards to such questions. In particular, the additional complexity with respect to the provisions incorporates the following:
- The challenge with respect to a person entering a one-off development opportunity, which includes that of residential construction, is that such endeavours are unlikely to meet the threshold of ‘carrying on a business’ for the purpose of the provisions. Notwithstanding that the development project will require considerable input and resources to complete, the criteria required to establish the threshold of a ‘business’ for such purposes will likely result in the non-deductibility of landholding costs where the entity holding the land is that of a person, a partnership (other than a partnership of companies), a discretionary family trust, a unit trust, or a self-managed superannuation fund.
- Exempted entities, including that of a company, will not be subject to section 26-102 notwithstanding that the entity is not engaged in the carrying on of a business activity. By adopting the company structure, interest cost on the borrowing for the land and related taxes should be deductible to that entity. This would appear to be the recommended and preferred structure in undertaking one-off development projects. However, the structure may be less beneficial to the flow-on of benefits that may have been otherwise realised by alternative structures (e.g. a discretionary trust).
- A common structure for the purposes of asset protection in an entity group is for one entity within the group to hold or own the land while another entity (usually a company) undertakes the development of the project itself. Cross-charges between the entities result in the bulk of the profit derived being generated by the landholding entity on disposal of the dwellings with the development entity realising a cost-plus margin profit for the development work.
- Where a land developer holds the land in, for instance, a discretionary trust, the entity is not excluded from the application of section 26-102 (where the development project incudes that of residential construction). The question posed by the legislation is whether that landholding entity is carrying on a ‘business’ to avoid the application of the provisions. If its only function is that of landholding then it is unlikely the case that the ‘business’ threshold will be passed, resulting in the non-deductibility of the relevant landholding costs (see paragraph 40 TR 2023/3).
- Landholding costs (including interest and rates and land taxes) denied by section 26-102 should add to the cost base of the asset (section 110-25[4]) as a third element cost. However, all things being otherwise equal, given that the profit derived by the disposal of the residential project will likely exceed the capital gain (in part due to the non-deductibility of the landholding costs), the capital gain should be reduced to nil (section 118-20[2]).
- Is there a ‘clawback’ under the general deductibility provisions in section 8-1 of the ITAA 1997? The short answer is no – provisions that deny the deductibility of an outgoing should not fall within the general deductibility provision. Taxation Ruling TR 2004/4 (paragraph 14A) makes it clear that in the circumstance where interest is denied by section 26-102, there is no ‘clawback’ under section 8-1 as the general deductibility provision.
Summary – the preferred structure
As a result of the introduction of section 26-102, the preferred structure for investment in property development for the isolated project would appear to be that of a company. For land developers conducting the business of such, a company is regularly the preferred structure in any event, more so for the purposes of asset protection and limiting the consequential costs to the group from project failure. An entity structure including that of a discretionary trust as a landholding entity within the group may need to be reviewed.
In the context of a one-off profit-making concern and to overcome some of the disadvantages of a corporate structure in comparison to that of a discretionary family trust, it may be the alternative that the company’s share ownership is simply held by a discretionary trust. This should ensure distribution of the revenue flow from the project will ultimately be similar to, or the same as, that of a discretionary trust holding the primary investment (a family trust election should be made to ensure the franking credits paid in the company are available to beneficiaries). The additional advantage of a company deriving initial profit is that it can be retained in the company over a period of years and distributed accordingly, rather than all be distributed when derived from the project.
To structure otherwise than by way of a company brings the non-deductibility question into sharp focus. And unfortunately, the permanent character of the denied deduction has the potential to materially reduce profits derived and limit the economic benefits a taxpayer may obtain.
Phillip London, senior tax trainer, TaxBanter
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