Draft legislation to disallow certain deductions in relation to vacant land – unless used in carrying on a business or incurred by a company etc (unintended consequences for ‘residential premises?)

On Monday 15.10. 2018, Treasury released draft legislation to give effect to its 2018-19 Federal Budget measure to disallow deductions for expenses associated with holding vacant land, except in specified circumstances.

Treasury’s explanation for the measure is [para 1.6 of the Draft EM] is:

It is designed as an ‘integrity measure’ – but I’ll let you be the judge, after seeing what it doesn’t cover.

The Draft Bill would insert a new s25-105 into the ITAA97.

The primary prohibition is in ss(1), and this is to deny deductions incurred to derive assessable income, unless the taxpayer was using the vacant land to carry on a business. Subsection (1) provides as follows.

My observations about this primary prohibition are as follows.

• This prohibition primarily applies to individuals and SMSFs (having regard to the corporate and other entities excluded entities in ss(4) – see below).
• The prohibition will have teeth for, say, individuals who acquire vacant land to build commercial premises (such as a factory), for the purposes of leasing the improved land, as an investment. The deductions normally available (principally holding costs) during the time of construction, would no longer be deductible until the building is ‘ready for use’ (see ss(1)(b)).
• This compares with the treatment for the development of ‘residential premises’ where costs are not deductible until the premises are not only ‘ready for use’ but also: leased or available for lease (see ss(3)).
• These non-deductible expenses, may be allowed in the CGT ‘cost base’, for this building, if they are the kind of holding costs allowed in the ‘third element’ of a cost base, under s110-25(4) of the ITAA97.
• If there other types of disallowed expenses, they might be written off over 5 years under s40-880 of the ITAA97 (writing off ‘blackhole’ expenditure).
• Presumably, these rules would not apply if the developer bought a property, that was not vacant, to demolish the building and construct another (even though there would probably be a time when the land did not have any ‘permanent structure’ on it).
• It is easier for a company to ‘carry on business’ than an individual, but that doesn’t matter as companies are excluded from this rule (see ss(4)).
• One might have thought that there would be a problem for individuals, carrying on a ‘profit making undertaking or scheme’, which falls short of carrying on a business. This is probably illusory, in that the outlays are costs used in calculating the net profit as it is only the ‘profit’ component, that is assessable income. The expenses are not ‘deductions’ against gross income.

The prohibition is narrowed, in that it is enough for ‘affiliates’ and ‘connected entities’ to use the land in carrying on their business.

1. This is because ss(1) does not operate to disallow deductions, only were the taxpayer uses the land to carry on business, but also where the taxpayer’s spouse, child (over 18), ‘affiliate’ or ‘connected entity’ uses the land to carry on a business (see ss(2) for this list).
2. For the expenses to have been deductible, to the landholder/taxpayer, in the first place, the taxpayer must have been earning some assessable income from holding the land. This is probably in the form of rent, paid by the business entity, to the taxpayer (which is a common enough form of asset protection).

‘Residential premises’ come in for special mention. On its face, ss(3) has a nasty and hopefully unintended operation.

1. It’s operation is to deny deductions, for newly constructed residential premises for potentially longer than other ‘permanent structures’ (that might signal the end of the land being vacant). The residential premises must not only be ‘ready to use’ but also legally able to be occupied (maybe the same thing) and also ‘leased’ or ‘available for lease’ (or, likewise, ‘hired’ or ‘licensed’).
2. But it achieves this by saying that, in determining whether land is vacant, or not, it is necessary to ‘disregard’ residential premises that have been ‘constructed or substantially renovated, while you [the taxpayer] hold the land’.
3. This means that the land does not have to actually vacant, before the residential premises are constructed. It means that knocking down one building, to construct residential premises, will deny holding cost deductions on the new construction, until it is leased.
4. Further, and worse, it means that a taxpayer, who was demolishing a house they previously built, would have all deductions disallowed, over the period the previous house was rented out, even if that were for a long period (say 30 years).
5. The deductions disallowed (over the period the previous rental premises were let out) would not be limited to holding costs, but would extend to repairs, depreciation and building write-off.
6. It is difficult to conceive of this being the indented effect of ss(3), given the rationale of it being only an integrity measure, because it is difficult to determine a taxpayer’s use, of vacant land, other than by potentially self-serving statements from the taxpayer.
7. And if this was intended, it seriously requires revision, as it appears markedly out of step, from the operation of the rest of the provision.

Various entities are excluded from the operation of the measure (see ss(4)).

1. Importantly, ‘corporate entities’ are excluded – and this is not limited to companies but other entities that are taxed like companies.
2. Superannuation funds are excluded from the measure – but the is a ‘carve-out’ for Self Managed Superannuation Funds, that leaves them subject to the ss(1) prohibition on deductions).
3. ‘Managed investment trust’s are excluded.
4. ‘Public unit trusts’ are excluded.
5. And ‘unit trusts’ and partnerships of the above kinds of entities are also excluded.

DATE OF EFFECT: The amendments will apply to losses and outgoing incurred on or after 1 July 2019, regardless of whether the land was first held prior to that date.

SUBMISSIONS are due by 31 October 2018.

[Treasury website: Minister’s Media Release, Consultation Page, Draft Bill, Draft EM; LTN 198, 15/10/18; Tax Month – October 2018]

CPD questions (answers available)

1. Is this a measure to deny deductions otherwise available, in relation to vacant land?
2. Can the land have ‘residential premises’ on it and still be vacant?
3. Would the prohibition apply to individuals?
4. Would the prohibition apply to companies?
5. Would the prohibition apply to SMSFs?
6. Is the prohibition primarily focussed on holding costs, until the ‘permanent structure’ is ‘ready for use’?
7. Is the prohibition for ‘Residential Premises’ the same?
8. Is the prohibition limited to ‘holding costs’.
9. Does the prohibition apply if the taxpayer is using the vacant land to carry on a business?
10. Does the prohibition apply if an ‘affiliate’ of the taxpayer is using the vacant land, to carry on a business (and pays rent to the taxpayer)?