Senate

New Business Tax System (Integrity Measures) Bill 2000

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
This Memorandum takes account of amendments made by the House of Representatives to this Bill as introduced.

Chapter 1 - Losses from non-commercial business activities

Outline of Chapter

1.1 This Chapter explains the changes to the taxation treatment of an individual's loss from certain business activities. The changes also cover individuals as partners in a partnership. These changes are contained in Schedule 1 of the Bill which inserts Division 35 into the ITAA 1997. A loss in relation to an activity for an income year, as used throughout the Chapter, means the excess of allowable deductions attributable to that activity over the assessable income from the activity.

1.2 Division 35 will apply to allow a loss from a business activity in an income year to be offset against other income in that year when one of 4 tests is met, or the Commissioner exercises a discretion. Under the change, the deductibility of losses is not being denied, but is deferred when one of the 4 tests cannot be passed and the Commissioner does not exercise the discretion.

1.3 The changes will apply for the 2000-2001 and subsequent income years and will not affect the current treatment of losses incurred in the receipt of passive investment income from activities which do not constitute the carrying on of a business. These activities include the receipt of rent from a negatively geared investment property, dividends from shares or interest on financial investments such as infrastructure bonds.

1.4 Division 35 will also not apply to individual primary producers whose assessable income from non-primary production sources (excluding any net capital gains) in an income year is less than $40,000.

Context of Reform

What is the current treatment of non-commercial business activities?

1.5 Section 8-1 of the ITAA 1997 contains the general deduction rule for determining whether amounts attributable to business activity are deductible against assessable income for income tax purposes. In addition, there are other provisions in both the ITAA 1997 and the ITAA 1936 which allow other specific deductions such as depreciation against assessable income for a particular income year.

1.6 The general deductions rule in section 8-1 allows amounts attributable to a business activity to be deducted from an activity's assessable income when expenditure of the amount is considered as being necessarily incurred in carrying on the business activity to gain or produce assessable income.

Why is the current law being changed?

1.7 In administering the tax law, the concept of what constitutes carrying on a business has been found to be very difficult to administer and resource intensive. Often a case by case approach is the only way to ensure this concept is complied with.

1.8 A broad interpretation of the current law has resulted in significant revenue leakage from individual taxpayers claiming deductions for unprofitable activities. A Tax System Redesigned described many of these activities as hobbies and/or lifestyle choices. Further, even those that have business characteristics (under existing tax law) are often unlikely to ever be profitable.

1.9 The law is being changed following the Government's adoption of recommendation 7.5 in A Tax System Redesigned which was intended to limit the extent to which non-commercial losses in an income year can be used to reduce the tax paid on other income in that year. The change, which is one of a number of integrity measures, will simplify and introduce certainty into the law as it relates to the treatment of allowable deductions attributed to certain business activities.

Summary of new law

1.10 Division 35 does not change the existing income tax concept of what constitutes the carrying on of a business. The Division will apply within that environment to those individuals able to claim business deductions under the existing law on the grounds that they are carrying on a business and meet all existing tests of deductibility.

1.11 Division 35 introduces a framework for determining whether losses from a business activity should be allowed as deductions against other income in a particular income year. Where those losses are not deductible in an income year against other income, they will be deferred and allowed as deductions in a future year against income from the same business activity.

1.12 As discussed at paragraph 1.2, Division 35 will apply to allow a loss from a business activity in an income year to be offset against other income in that year when one of 4 tests is met or a safeguard rule in the form of a Commissioner discretion is exercised.

1.13 Where no test is passed, and the Commissioner's discretion is not exercised, the activity's loss in that year will be deferred and offset against the activity's assessable income, if any, in a future income year. Where one of the tests is met in a future year, any deferred losses can then be offset against any assessable income, including income from the activity, in that year.

1.14 The 4 tests, which cover business income, profitability and asset backing as well as a safeguard provision in the form of a Commissioner discretion, are discussed in detail in paragraphs 1.30 to 1.54.

1.15 The overall scheme of the new non-commercial losses provisions is outlined in the following diagram.

For an income year:

Overall scheme of the new non-commercial losses provisions

Comparison of key features of new law and current law
New law Current law
Individual taxpayers 'carrying on a business' activity may only claim the excess of deductions over assessable income from the activity against their other income if one of 4 tests is satisfied, or the Commissioner exercises a discretion. Individual taxpayers 'carrying on a business' may claim the excess of deductions over assessable income from the activity against their other income, such as personal services income, thereby reducing their taxable income and tax payable.

Detailed explanation of new law

1.16 The following concepts, which are necessary in understanding the operation of Division 35, are explained in paragraphs 1.17 to 1.64. Where appropriate, examples are also provided to illustrate the application of the Division. The Commissioner will issue guidelines to further explain the application of Division 35.

Table 1.1
Concept Paragraphs
Business activity and carrying on a business including where a business activity:

·
consists of several components
·
is grouped with another similar activity

1.17 to 1.20
General rule affecting a loss from a business activity 1.21 to 1.29
The 4 tests 1.30 to 1.44
Safeguard rule: Commissioner's discretion 1.45 to 1.53
Application of Division 35 to partnerships 1.55 to 1.57
Application of Division 35 when a taxpayer has exempt income 1.58 to 1.59
Application of Division 35 if a taxpayer becomes bankrupt 1.60
Application and transitional provisions 1.61
Consequential amendments 1.62 to 1.64

Business activity and carrying on a business

1.17 Division 35 only operates in a framework where an individual (including an individual in partnership) is considered to be carrying on a business activity. Business deductions relating to that activity and to which Division 35 will apply, must be otherwise deductible under the ITAA 1936 or the ITAA 1997 before Division 35 can have any application [Schedule 1, item 3, subsection 35-10(1)] . The rules in Division 35 will not apply to the receipt of passive investment income from activities which do not constitute carrying on a business (e.g. the receipt of rent from real property, dividends from shares or interest on financial securities such as infrastructure bonds when the investment activity is not a business).

Example 1.1 Doreen enjoys making handcrafted soft toys. She buys materials from a local craft store, and making the toys consumes most of her spare time. Doreen displays the toys in her house. She sells her toys to family and friends for a nominal price to cover the cost of materials. Occasionally, she charges a little more than a nominal price.Doreen is not carrying on a business for tax purposes and, as such, Division 35 will not apply. Doreen's toy making activities are regarded as a hobby that she enjoys. The money she has received from selling to family and friends is not assessable. Any amounts she has expended on materials or other costs are not deductible.

A business activity consisting of several components

1.18 A business activity may consist of several parts. Where an activity is of a similar kind to another activity undertaken by an individual, it may be treated as being a part of the same business activity. [Schedule 1, item 3, subsection 35-10(3)]

1.19 If the activity is not a part of another business activity it should be viewed in isolation and treated as a separate business activity. Whether or not an activity is simply a part of a particular business activity, or a separate business activity in its own right, will depend on the circumstances of each case.

Example 1.2 Annette conducts a business activity as an olive farmer producing olive oil. She has had great success manufacturing high-grade oil and selling it both locally and to exporters.Recently, Annette started producing bottled olives, in an attempt to expand her business. This new activity is sustained independently from the olive oil market activity.Division 35 will treat Annette's bottling activity as a part of her primary business activity of producing olive oil. Both her olive oil activity and her bottling activity are similar, and may therefore be looked at in aggregate against the 4 tests to determine whether her losses, if any, from those activities can be deducted from her other income.Annette is also a keen amateur scientist. In her home laboratory Annette has developed a new chemical insecticide for olives. She has patented its composition and is now receiving royalties from a chemical manufacturer. Annette has also written a research paper on insecticides, which is available for purchase.Annette's research activities are not of an inherently similar nature to her olive oil production and bottling activity and will be considered as a separate business activity under Division 35.

General rule affecting a loss from a business activity

Deferral of losses under Division 35 to a future year

1.20 Where an individual is carrying on a business activity that fails to satisfy one of the 4 tests for a particular income year and the Commissioner does not exercise the discretion:

·
the loss for the business activity for the income year will be deemed, for the purposes of that individual, not to have been incurred in that year [Schedule 1, item3, paragraph 35-10(2)(a)] ; and
·
these losses are instead treated, for the purposes of that individual, as an amount attributable to the business activity that can be deducted in the next income year that the business activity is carried on [Schedule 1, item 3, paragraph 35-10(2)(b)] .

1.21 Usually the loss will be simply attributable to the very next income year. However, if the business activity ceases for a year or number of years, the loss will be carried forward and become deductible in the income year when the activity is next conducted. [Schedule 1, item 3, subsection 35-10(2)]

1.22 The rule in subsection 35-10(2) applies only to business activities which fail all the tests [Subsection 35-10] . Therefore, if a business activity passes any of the tests any loss will not be deferred under paragraph 35-10(2)(a). Accordingly, the total deductions attributable to an individual's business activity will be able to be offset against any assessable income of that individual. The deductions that may be offset thus include any brought forward losses that have been deemed to be attributable to the individual's business activity for that income year under paragraph 35-10(2)(b). In effect, these losses are no longer quarantined. [Schedule 1, item3, subsection 35-10(1)]

Losses that have been deferred

1.23 Losses that have been deferred under subsection 35-10(2) will be able to be offset against:

·
any profits of the relevant business activity in a future year (refer to paragraphs 1.25 to 1.26); and
·
the other income of the individual carrying on the relevant activity if the business activity meets at least one of the 5 objective tests including a Commissioner's discretion (refer to paragraphs 1.27 to 1.28).

1.24 The ability of an individual to offset a non-commercial loss that has been deferred under subsection 35-10(2) is modified if that individual has exempt income or becomes bankrupt. These rules are discussed at paragraphs 1.56 to 1.58.

Offsetting a deferred loss to the extent of profits from the relevant business activity where one of the tests is not met in an income year

1.25 In an income year that a business activity has a profit but does not pass a test, losses deferred from prior years may be offset to the extent of this profit. Here, profit is taken to be the excess of the business activity's assessable income over the deductions attributable to that business activity (excluding deferred losses). [Schedule 1, item 3, section 35-10]

1.26 Where a deferred loss exceeds the profit of a business activity in an income year, that loss will be reduced to the extent of that profit. The balance (or unused amount of loss) will then become the loss under Division 35 for that income year, which in turn will be deferred under subsection 35-10(2).

Offsetting a deferred loss against other income of the individual

1.27 If a business activity meets a test, or the Commissioner exercises the discretion, any deferred loss from an earlier income year will not again be deferred. Accordingly, the total deductions, including losses deferred, attributable to an individual's business activity will be able to be offset against any assessable income of that individual. In effect, the deferred loss and any loss for the current income year are no longer quarantined. [Schedule 1, item 3, section 35-10]

1.28 Where an individual's other income is insufficient to absorb all of the deductions relating to their business activity, any remaining Division 35losses will then become normal carry forward tax losses. These losses will be treated in the same way as any other carry forward loss under Division 36 of the ITAA 1997.

Exception for small primary producers

Exception for losses from primary production business activity if taxpayer has other assessable income less than $40,000

1.29 A specific exception from the loss deferral rule in section 35-10 is provided for losses from primary production business activities where, in that income year, a taxpayer's assessable income (except any net capital gains) from sources that are not primary production businesses is less than $40,000. These taxpayers will be able to claim their losses from the primary production activity without regard to other rules. The exception is to be considered separately for each individual carrying on the primary production business activity. [Schedule 1, item 3, subsection 35-10(4)]

The 4 tests

1.30 The 4 tests about an activity, one of which needs to be passed to enable an individual's loss from a business activity in a year to be deducted against the individual's other assessable income, are summarised in Table 1.2.

Table 1.2: Four tests contained in Division 35 of the ITAA 1997
Test Description
1 Assessable income from a business activity is at least $20,000.
2 The business activity produces profit (for tax purposes) in at least 3 out of the last 5 years including the current year.
3 Value of real property used in carrying on a business is at least $500,000.
4 Value of other assets used in carrying on a business is at least $100,000.

Test 1: Assessable income test

1.31 The amount of assessable income from the activity for the income year in question is used when applying test 1. If an activity commences or ceases during an income year, paragraph 35-30(b) allows a reasonable estimate to be made of what the assessable income would have been if the activity had been carried on for the whole year. The use of an estimate rather than a pro-rating will be appropriate where taxpayers need to take into account seasonal variations in determining their assessable income for the income year. [Schedule 1, item 3, section 35-30]

Example 1.3 Dario carries on a business of writing articles for various running magazines. He ceased the activity at the end of September in the current year to undertake full time marathon training. Up to the time of cessation of activity, assessable income of $6,600 had been produced and allowable deductions of $8,000 had been incurred.Paragraph 35-30(b) allows Dario to make a reasonable estimate of the assessable income that the activity would have produced if he had carried it out for the whole of the income year. In the immediately preceding income year, the activity generated assessable income of $22,000. Dario estimates that the activity would have produced $24,000 assessable income had he not ceased the activity.Based on Dario's estimate, the activity satisfies the assessable income test and Dario can deduct the $1,400 loss against his other income because the rule in section 35-10 to defer the activity loss to a future income year does not apply.

1.32 Where the activity is carried on by a partnership, there is a special rule for determining what portion of the assessable income is attributable to each individual taxpayer. A taxpayer may include that part of the partnership's assessable income attributable to other partners who are individuals, including the taxpayer's own share. This is in addition to that which the taxpayer may incur and derive of his or her own accord from the activity outside the partnership. [Schedule 1, item 3, paragraphs 35-25(a) and (b)]

Test 2: Profits test

1.33 Test 2 involves determining whether an activity has produced taxable income in 3 out of the last 5 years. The 5 year period includes the current year in which the loss has arisen. [Schedule 1, item 3, subsection 35-35(1)]

1.34 Taxable income arises for the activity where the sum of the deductions attributable to the activity for the year is less than the amount of assessable income from the activity in that year. In order that the result is determined based on the amounts which actually arise in a particular year, the rule specifically excludes any deferred losses which are deemed to be attributable to the activity for a particular income year by paragraph 35-10(2)(b). [Schedule 1, item 3, subsection 35-35(1)]

1.35 Where an individual carries on a business activity with one or more other persons in partnership at general law, the share of the deductions and assessable income attributable to the taxpayer's interest in the partnership is to be used for the profits test, in addition to their own assessable income and allowable deductions from the activity outside the partnership. [Schedule 1, item 3, subsection 35-35(2)]

1.36 Table 1.3 illustrates the application of Test 2.

Table 1.3
Yr Taxable profit or loss from activity in current year Loss deferred from prior year Result in current year with excess deductions including loss deferred Other taxable income Test for profit in 3 out of the last 5 years (excluding prior year loss deferred) Loss for current year Taxable income
1 Profit $5,000 Nil Profit $5,000 $40,000 Profit from activity returned. Nil $45,000
2 Profit $5,000 Nil Profit $5,000 $45,000 Profit from activity returned. Nil $50,000
3 Loss $10,000 Nil Loss $10,000 $50,000 Test not satisfied. Excess deduction may not be offset, but deemed a deduction for the following year. $10,000 $50,000
4 Profit $8,000 $10,000 Loss $2,000 $55,000 Test satisfied, excess deductions offset against other income. Nil $53,000

Example 1.4 Just over 4 years ago Gavin, a full time journalist, started producing real estate guides in his spare time. He publishes these guides, called 'Gavin's Guides' at his home using his advanced computer equipment.'Gavin's Guides' have proved to be rather successful, and in all but his second year, where Gavin failed to secure adequate advertising income, 'Gavin's Guides' have made a profit.There is no requirement in the profits test that the business activity be actually carried on for 5 consecutive years. As Gavin has made profits in 3 years over the past 5 years (including the current year), he will pass the profits test.

Test 3: Real property test

1.37 Test 3 uses the value of real property at the end of an income year which is used on a continuing basis in carrying on the business activity. The value to be used is the greater of market value or the reduced cost base. Market value and the reduced cost base of real property are concepts which are currently used under the CGT provisions of the ITAA 1997. Taxpayers will have records of these cost base amounts as they must be kept for CGT purposes. [Schedule 1, item 3, section 35-40)]

1.38 Dwellings, and adjacent land used in association with the dwelling, that is used primarily for private purposes are excluded from the test. This rule will ensure that only that part of real property that is used mainly in the business activity is counted. Real property includes fixtures (whether depreciable or not). Tenant's fixtures are specifically excluded from this test and included under the other assets test if they are depreciable. [Schedule 1, item 3, subsection 35-40(4)]

Test 4: Other assets test

1.39 Test 4 has regard to those assets used in the activity which are not real property assets. The assets, the values of which are to be included for test 4, are those that are used on a continuing basis in carrying on the activity. Generally the value of assets used for a short time, such as assets that are leased or hired on a short time basis for a specific task, are excluded from test 4 on the grounds that they are not used on a continuing basis. [Schedule 1, item 3, section 35-45]

1.40 There are a number of specific categories of assets, the values of which are to be excluded from this test. Real property assets or interests in real property assets would be excluded from this test due to their inclusion for the real property asset test (other than tenant's fixtures). [Schedule 1, item 3, paragraph 35-45(4)(a)]

1.41 Test 4 contains a specific exclusion for cars, motorcycles and similar vehicles. This exclusion is directed towards excluding high value motor vehicles used in carrying on particular activities from being claimed towards meeting the other assets test. Taxpayers using these assets in their business activities may still count their other assets towards this test. [Schedule 1, item 3, paragraph 35-45(4)(b)]

1.42 The specific assets and the values to be attributed to them for inclusion in this test are described by the items in the Table in subsection 35-45(2). For leased assets, specifying the value as shown in this Table (future lease payments less an interest component) will produce a result for the value of leased assets that is similar to that which arises where an asset is owned and depreciated. It is also consistent with the general principles of Australian Accounting Standard AAS 17. [Schedule 1, item 3, subsection 35-45(2), table item 3]

Both assets tests

1.43 Generally the value of assets under tests 3 and 4 is to be determined at the end of the income year. However, if the individual ceased to carry on the business activity during the year, the value of the asset at the time of cessation of the business activity is to be used. [Schedule 1, item 3, paragraphs 35-40(3)(a) and (b), and 35-45(3)(a) and (b)]

1.44 For the purposes of tests 3 and 4 an apportionment rule is provided to address situations where assets are used only partly in carrying on the business activity to which the tests are being applied. Only that part of the reduced cost base, market value or other value that is attributable to the use of the asset in carrying on the business activity is to be taken into account. [Schedule 1, item 3, section 35-50]

Aggregation for partnerships under assets tests

1.45 Where the activity is carried on by a partnership, there is a special rule for determining what portion of the assets may be counted for each of the assets test for an activity. A taxpayer may include the share of the value of the partnership's assets attributable to individual partners as well as the value of assets which the taxpayer may use on an ongoing basis in the activity of his or her own accord outside of the partnership. [Schedule 1, item 3, paragraphs 35-25(c) and (d)]

Safeguard rule: Commissioner's discretion

1.46 Where certain conditions exist, the Commissioner may exercise a discretion to allow a taxpayer to offset amounts which are deductible against their other income if the business activity does not satisfy any of tests 1 to 4. [Schedule 1, item 3, section 35-55]

1.47 The discretion may be exercised for one or more income years if the Commissioner is satisfied that it would be unreasonable not to allow the losses to be offset because either:

·
special circumstances are applicable to the business activity; or
·
the business activity has started to be carried on, and because of its nature it has not yet satisfied one of tests 1 to 4, and there is an objective expectation that it will either pass a test or produce profit within a reasonable time. [Schedule 1, item 3, subsection 35-55(1)]

1.48 The discretion is provided to ensure that certain individuals who carry on genuine commercial business activities are not disadvantaged due to particular circumstances which prevent them from satisfying tests 1 to 4 are discussed in paragraph 1.30 to 1.45.

Special circumstances outside the control of the taxpayer

1.49 The first of these rules operates where there are special circumstances outside the control of the business operators that demonstrate it would be unreasonable not to recognise the loss in an income year. The special circumstances include drought, flood, bushfire or some other natural disaster. Special circumstances are not limited only to natural disasters, but may also include other circumstances of a special nature. The list is merely indicative to enable the Commissioner to consider circumstances outside the control of the taxpayer which may arise in specific cases. [Schedule 1, item 3, paragraph 35-55(1)(a)]

Example 1.5 Peter is a senior partner of a change management consulting firm. He also carries on a business growing pumpkins in Northern Queensland. In the first 2 years the activity has produced profits. However, in the third year flooding caused by severe storms destroys his entire pumpkin crop. Peter received no assessable income from the pumpkin growing activity but incurred deductible expenditure of $41,350. None of the objective tests were satisfied for the activity. His other assessable income is $108,000.The natural disaster which resulted in Peter's pumpkin losses would satisfy the first arm of the safeguard rule, being special circumstances outside the control of the taxpayer. Therefore the Commissioner may exercise the discretion to allow Peter to offset his $41,350 loss from the pumpkin growing activity against his other income.

Business activity started to be carried on

1.50 The safeguard rule incorporates a second arm whereby the Commissioner may allow a taxpayer to offset losses from a business activity that does not satisfy any of the objective tests where there is an objective expectation that it will either pass a test or produce assessable income within a reasonable time. The taxpayer would need to establish the objective expectation based on information from industry bodies or scientific research, for example, if such information is available. [Schedule 1, item 3, paragraph 35-55(1)(b)]

1.51 This arm of the safeguard discretion will ensure that the loss deferral rule in section 35-10 does not adversely impact on taxpayers who have commenced to carry on activities which by their nature require a number of years to produce assessable income. Examples of activities which could fall into this category are forestry, viticulture and certain horticultural activities.

1.52 Under this aspect of the safeguard, the taxpayer must have commenced to carry on the activity. The rule will thereby exclude from the scope of the discretion expenditure incurred during the period preceding commencement of the business activity, for example, expenditure on feasibility studies. [Schedule 1, item 3, paragraph 35-55(1)(b)]

1.53 The Commissioner must not exercise this arm of the discretion after the time that it is reasonable to expect the activity to first produce a profit or pass one of the tests. [Schedule 1, item 3, paragraphs 35-55(2)(b)]

Example 1.6 John has commenced to carry on a business activity cultivating macadamia nuts. John had carried out extensive research before commencing the activity, has established a commercially viable operation and expects the venture to be highly profitable.The standard time period for macadamia farming to become profitable at the time John commenced the activity was 5 years.The Commissioner may exercise the discretion to allow John to offset the losses from the macadamia production activity as John can demonstrate that he has commenced an activity which, because of its nature, is yet to meet a test. In addition, there is an objective expectation that the activity will pass an objective test within 5 years, which is a commercially viable period for the macadamia nut industry.

Application of Division 35 to partnerships

1.54 Division 35 must be considered for every business activity carried on by an individual taxpayer. This includes business activities carried on by that individual in partnership with other individuals or entities. Therefore any partnership that carries on a business activity and consists of at least one individual as partner, will fall within the ambit of Division 35. [Schedule 1, item 3, subsection 35-10(1)]

1.55 Where a business activity is carried on by an individual in partnership with an entity, only that part which is attributable to the interests of the individuals in the partnership is taken into account for the purpose of the assessable income test, real property test and other assets test. In addition, assessable income and assets of an individual partner on their own account, if any, are also taken into account by that partner in considering these tests. [Schedule 1, item 3, subsection 35-10(1) and section 35-25]

Example 1.7 Jennifer and Francis are partners in a jewellery manufacturing business activity. A third partner is Jennifer's family trust. All partners have an equal entitlement to partnership distributions and partnership capital. Francis owns an expensive polishing machine which he allows the partnership to use in its jewellery manufacturing business. However, the polishing machine at no stage becomes a partnership asset.On an individual basis, Jennifer has a one third interest in the partnership's income, real property, assets and profit. However, she is able to count two thirds of the partnership's assessable income, and assets for the purpose of the assessable income test and the assets tests. This is because these tests allow her to include the value of any interests in the partnership attributable individuals. For Jennifer, the interests attributable to individuals in the partnership would include both her and Francis' interests.Jennifer cannot include the value of Francis' polishing machine for the purposes of any of the objective tests. This is because it is not an asset that is either attributable to Jennifer herself, or to an individual's interest in partnership assets. (The polishing machine is not a partnership asset, and so cannot be attributable to the interest of individuals in the partnership.) When Francis is assessing his business activity against the tests, he will be able to include the value of the polishing machine in the other assets test.Jennifer cannot count the one third interest of her family trust for the purpose of any of the tests.

1.56 When considering whether or not a business activity is carried on by individuals as partners, the general law notion of 'partnership' is to be used. Where an individual is merely in receipt of income jointly with another person, they will not be taken to be in partnership for the purposes of Division 35.

Example 1.8 Ross is a primary producer who grazes sheep. His friend Neil, a stock farmer based in Northern Queensland has requested a large quantity of sheep from him. However, although Ross is carrying on a business of sheep grazing he does so in a small way and cannot meet the order from his own stock.Ross has a neighbour, Tim, who also grazes sheep on a small scale. Ross approaches Tim to help him supply enough sheep to meet Neil's request. Together they have enough to meet Neil's needs.On sale, the sheep sold to Neil are not separately identified. Neil pays them in one cash sum. Ross and Tim then split this amount according to the number of sheep that each contributed.While Ross and Tim are in receipt of income jointly, and thus may be considered as partners for tax law, they will not be partners under general law. The indicators of carrying on a partnership under general law, such as the ability for one partner to legally bind others and joint ownership are lacking. Rather, Ross and Tim each carry on their own separate businesses. As such they are not considered to be in partnership for the purposes of this measure. [Schedule 1, item 3, subsection 35-5(10) (note)]

Application of Division 35 when a taxpayer has exempt income

1.57 The rule in section 35-10 for the deferral of deductions will be modified for a taxpayer who derives exempt income. These modifications are modelled on the rules for the carry forward and offset of normal tax losses under Division 36 of the ITAA 1936. The rules ensure that losses deferred under Division 35 are treated in a similar way to normal losses. This will prevent the potential inequities which may arise if the 2 types of losses were treated differently.

1.58 A Division 35 loss that is to be carried forward to a future income year under paragraph 35-10(2)(b) is to be reduced by the amount of any exempt income derived in the current year or subsequent years that has not already been offset against normal Division 36 tax losses in those years. If in an income year, there is a Division 35 deferred loss, exempt income and a profit arising from an activity, then the exempt income would reduce the Division 35 deferred loss before that loss can be used to reduce the profit for tax purposes. [Schedule 1, item 3, section 35-15]

Example 1.9 Emma incurs a loss from a business activity in a particular income year of $35,000 and derives exempt income of $5,000. She does not pass any of the tests or come within the discretion. Emma did not have any Division 36 tax losses from earlier income years The Division 35 amount which is deductible in a later year is $30,000 after taking the exempt income into account.Emma continues the activity in the next year and derives exempt income of $3,000. The Division 35 amount which will be brought forward and is attributable to the activity for that year will be $27,000. That is, $3,000 of the non-commercial loss must be offset against the exempt income derived in that year.

Application of Division 35 if a taxpayer becomes bankrupt

1.59 Rules are included in Division 35 to address situations where taxpayers have losses (including deferred losses) from an activity and become bankrupt. As with the rules for offsetting losses from a business activity against exempt income, these rules are modelled on those in Division 36 of the ITAA 1997. A Division 35 loss incurred prior to the date of bankruptcy, cannot be deducted after the date of bankruptcy. This rule will ensure that Division 35 losses are treated a similar way as normal carry forward losses where a taxpayer becomes bankrupt. [Schedule 1, item 3, section 35-20]

Application and transitional provisions

1.60 The amendments apply to assessments for the 2000-2001 income year and later income years. [Schedule 1, item 4]

Consequential amendments

1.61 Two specific consequential amendments to the ITAA 1997arise from the introduction of the new rules for the deferral of losses from non-commercial activities.

1.62 Item 1 of Schedule 1 adds a note at the end of the general deduction provision in subsection 8-1(1) of the ITAA 1997. The note acts as a signpost to alert taxpayers claiming deductions under the general deduction provision that Division 35 prevents losses from non-commercial business activities being offset against other income. [Schedule 1, item 1]

1.63 Section 12-5 of the ITAA 1997 lists the provisions of the Act which are about deductions. Item 2 of Schedule 1 inserts an item into the list to refer to Division 35, which limits deductions from non-commercial business activities. [Schedule 1, item 2]


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