Assessable income: instalment sales contracts - default profits - carrying on a business

Are the deposit and instalments retained when a purchaser defaults under an instalment sales contract included in the assessable income of the vendor (the taxpayer) under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), in the year in which the purchaser defaults under the contract?

Yes. The forfeited deposit and instalments are assessable as ordinary income under subsection 6-5(1) of the ITAA 1997 in the year in which the purchaser defaulted under the contract.

The taxpayer carries on a business of buying and selling residential properties. The properties are sold under instalment sales contracts with vendor finance.

The instalment sales contract has the following features: • the sale price represents a profit over the investor's purchase price • the purchaser will pay the investor a deposit • vendor finance is provided to the purchaser with interest charged at a premium above the rate of interest paid by the investor on their mortgage on the property • payment of the balance of the price, plus interest, is by instalments over a substantial period such as 25 years • the deposit and instalments are not refundable • the purchaser is licensed to occupy and entitled to possession of the property during the term of the instalment contract • the contract states that this occupation or possession is not by way of lease • the purchaser is required to reimburse the investor for the rates and taxes on the property • the purchaser is required to keep the property in good condition and repair • the investor retains title to the property until the final instalment is paid and the contract is completed • the purchaser defaults on the contract the deposit and instalments paid are forfeited to the investor

It is common ground that the interest is included in assessable income in the year it is received.

The taxpayer did not use the properties for any other purpose prior to sale. The properties were sold for an amount that was in excess of the amount paid by the taxpayer to acquire the property. Each property was sold within six months of it being acquired by the taxpayer.

The properties are trading stock for the purposes of subdivision 70-C of the ITAA 1997.

During the year, a purchaser defaulted under an instalment sales contract. The purchaser had paid a deposit and made a number of instalment payments. At the time of receiving the instalment payments, the taxpayer divided them into their 'price' and interest components. The interest component was brought to account as assessable income. The taxpayer retained the deposit and all instalments paid.

Subsection 6-5(1) of the ITAA 1997 includes income according to ordinary concepts (ordinary income) in assessable income. Subsection 6-5(2) of the ITAA 1997 includes in assessable income the ordinary income derived during an income year.

Taxation Ruling TR 92/3 at paragraphs 15 and 32 provides that if a taxpayer carrying on a business makes a profit from a transaction, that profit is income if the transaction is in the ordinary course of the taxpayer's business, provided that the gross receipts from the transaction lack the character of income.

The comments of McGarvie J in L'Estrange v. Federal Commissioner of Taxation (1978) 9 ATR 410; 78 ATC 4744 whilst considering 'recision or default profits' in the context of paragraph 26(a) of the Income Tax Assessment Act 1936 , are relevant to this case. McGarvie J at ATR 430, ATC 4763 said:

The amounts in question were moneys paid under the contract. On the discharge of the contract they became profits because the taxpayer had acquired a right under a term of the contract that, although the taxpayer was no longer obliged to transfer the land to the purchaser, he was not obliged to refund equivalent amounts of money to the purchaser. In my opinion the 'recision' profits were profits arising from the sale by the taxpayer of the property. In this case the taxpayer received under the contract the moneys which subsequently became profits and was protected by a right acquired under the contract from having to refund equivalent amounts.

The monies retained by the taxpayer where the purchaser has defaulted on the contract are considered to be 'profit' made in the ordinary course of carrying on the business of buying and selling residential properties, and are therefore ordinary income for the purposes of subsection 6-5(1) of the ITAA 1997.

In Gasparin v. Federal Commissioner Taxation (1994) 50 FCR 73; (1994) 28 ATR 130; 94 ATC 4280, where the residential properties were trading stock (as in this case), it was considered that when a contract of sale came to an end, the forfeited deposit payment became a receipt of the business at that time.

The monies retained by the taxpayer will be derived for the purpose of subsection 6-5(2) of the ITAA 1997 at the time the purchaser defaults under the contract. This is the point at which the taxpayer has done everything necessary to earn the amount.

Accordingly, the deposit and instalments retained will be included in the taxpayer's assessable income under subsection 6-5(2) of the ITAA 1997 in the year of income in which the purchaser defaults on the contract.