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Regular pattern of building and selling houses catches up with trustees

In a recent Taxation Review Authority case[1], Sinclair DJ has found that the trustees of a trust failed to prove on the balance of probabilities, that they were not liable for income tax, GST and shortfall penalties in relation to various property transactions undertaken.  This case perhaps sits at the obvious end of the scale in terms of what is a taxable event from carrying out land transactions.  However it also highlights several interesting points and misconceptions about the rules that apply and the need to take tax advice at an early stage.

By way of background, the taxpayers were three trustees in a family trust (the trust) which over a nine year period, established a pattern of buying a vacant section, building a house and on selling that house within a short time.  One of the trustees, Ms X was in fact a solicitor and independent trustee who could be described as a passive trustee who was not involved in the specifics of implementation.  The other two trustees were husband and wife (Mr and Mrs B), who were also primary beneficiaries of the trust together with their children. 

The trust entered into 11 transactions during the nine year period, with the family only living in each property, on average, for seven months.  While not every sale resulted in a profit, the trust built up considerable equity over this period.  The issues for determination in this case were:

  • Whether the amounts received on the sale of the properties were taxable as income on the basis that:
    • The properties were acquired with the intention of resale;
    • The trust was in the business of erecting buildings;
    • Or whether the residential exemption applied to certain properties.
  • Whether the trust was liable to account for GST output tax.
  • Whether the trust was liable for shortfall penalties for gross carelessness or alternatively for not taking reasonable care.

Acquisition of land with the intention of resale

If a person acquires land for a purpose or intention of selling it, an amount derived from the sale will be income.  The trust had the onus of proof to show on the balance of probabilities that it did not acquire the land with a purpose or intention of sale.  Ascertaining this purpose involves questions of fact and degree.  The reasons for selling in this case make interesting reading.  For example, property 2 was sold because there was a “creepy guy” next door, property 3 was sold because the woollen carpets installed caused asthma, property 4 was sold because there was concern that the home might be leaky, property 5 was sold because they wanted to move closer to their daughter’s school and so forth.  Overall Sinclair DJ did not consider Mr and Mrs B to be credible witnesses.  The explanations provided for the respective sales and purchases were not supported by contemporaneous documentation or other evidence and in each case the Judge felt that a reasonable person would take steps to mitigate or remedy the problems rather than making a decision to sell having only been in each house for a matter of a few months.  Accordingly, it could be reasonably inferred that at the time each property was purchased, there was an intention on the part of the Trust to on sell it.  

Was the trust in the business of erecting buildings?

The law states that an amount derived from the sale of land is income if at the time the land was acquired, the person carried on a business of erecting buildings, the person made improvements to the land, and either the land was acquired for the purposes of that business or it was sold within 10 years of the improvements being made.

The trust employed the same draftsman and builder to construct the houses on the sections purchased by the trust.  In each building contract, the work was completed to the gib-stopping stage.  Mr B obtained the building consents on most occasions, and both Mr and Mrs B played an active role in project management.  Mr B was responsible for organising sub-trades and for completing the finishing work post gib stopping.   Each project involved a considerable financial and time commitment by Mr and Mrs B on behalf of the trust.  Other factors taken into account were:

  • That the period between each purchase was short.  In some cases the Trust had purchased the next section before the last one was sold.
  • The sections were all located in three streets in three separate subdivisions.  In some cases, the properties were adjoining.  The houses were all of a similar size and construction, built on a fixed fee basis to the same stage.
  • The houses were only lived in for about 7 months on average, but the time between occupying and listing each property was less.  

It was held that, on examination of the evidence, by the time of the fourth property purchase, the trust was engaged in the business of erecting buildings.

Did the residential land exemption apply?

The trustees argued that as Mr and Mrs B occupied each house primarily and principally as their family home that the residential land exemption should apply.  The Commissioner contended that each property was only occupied incidentally to the more significant purpose of sale and as such the properties were not occupied “primarily or principally” as a residence.   Sinclair DJ agreed, holding that Mr and Mrs B only moved into the property to enable finishing work to be completed before the property was marketed and the process repeated. 

Liability for GST

To be liable for GST, there must be a taxable activity and the total value of supplies made in a 12 month period must exceed the relevant threshold.  The Judge had already found that the trust was engaged in the business of erecting dwelling houses by the time property 4 was purchased in 1999.  Accordingly it was not difficult to find that the trust was deemed to have been registered for GST from 1 February 1999 when the threshold at that time of $30,000 was exceeded.  It was held that the trust was liable to account for GST output tax on the sales of properties for 6 monthly GST periods ending 31 March 1999 to 20 September 2005.

Shortfall penalties for gross carelessness

To be liable for a shortfall penalty for gross carelessness, the taxpayer must have taken a tax position that suggests or implies a complete or high level of disregard for the consequences.  In the view of Sinclair DJ, the scale and duration of the activities undertaken by the trust meant that the tax risk was obvious and serious, and that a reasonable person in the circumstances would have foreseen this risk.  In addition the independent trustee, Ms X gave evidence that she was aware of the possibility of a tax liability and that she had advised Mrs B on two occasions to obtain tax advice.  Mrs B denies that Ms X said this.  In any event the fact remains that the risk of a tax liability had been identified by Ms X who was a trustee and despite this, no tax advice was obtained.  An accountant was actually only consulted following the commencement of the Commissioner’s investigation. Accordingly, Sinclair DJ reached the view that a shortfall penalty for gross carelessness should be imposed.

The independent trustee

This case really highlights the need for lawyers and accountants acting as independent trustees to take extreme care before agreeing to such appointments.  Ms X, the independent trustee, was not consulted prior to entering any of the transactions and Mr and Mrs B never gave any explanations as to why they were selling a particular property.  Ms X would prepare and execute resolutions for every transaction, but took no active role in the trust’s affairs and left the day to day running of the trust to Mr and Mrs B.  Ratification occurred formally by way of resolution and informally by way of sanction and approval.  As a consequence, all the trustees are bound by the decision and actions of each other. 

Accordingly Ms X has been held to be jointly and severally liable along with Mr and Mrs B for the income tax, GST and penalties arising for the period until she was replaced by an independent trustee company on 14 September 2005.

[1] TRA 019/11 [2013] NZTRA 05


Tax Alert November 2013 contents:


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