House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Glossary

The following abbreviations and acronyms are used throughout this Explanatory Memorandum.

General outline and financial impact

Losses from non-commercial business activities

Schedule 1 to this Bill amends the ITAA 1997 to improve the integrity of the tax system by limiting the extent to which non-commercial losses from an individual's business activities are used as tax deductions to reduce the tax paid on other income such as salary or wage income.

The amendments will ensure that individual taxpayers carrying on a business activity either alone or in partnership may only claim a loss from that activity in an income year against their other income in that year if they satisfy one of 5 tests.

The new rules do not:

•

change the general law tests that determine whether an individual is carrying on a business activity; or

•

deny the deductibility of a loss from that business activity. Where a test is not satisfied in an income year, the deductibility of the loss against income not related to the business activity is deferred to a future income year in which a test is satisfied. If the business activity is profitable then any deferred loss can be offset against that profit

Date of effect: The measure will apply to assessments for the 2000-2001 income year and later income years.

Proposal announced: The proposal was originally announced in Treasurer's Press Release No. 74 of 11 November 1999.

Financial impact: New rules will increase revenue as set out in the following table.

Compliance cost impact: A separate regulation impact statement is available for the measures in this Bill.

Deducting prepayments

Schedule 2 to this Bill amends the ITAA 1936 to:

•

deny an immediate deduction for prepayments for assets or services in respect of 'tax shelter' type arrangements; and

•

spread these deductions over the period during which the assets or services are provided.

The amendments also include consequential amendments relating to this measure.

Date of effect: The amendments will apply to prepayment expenditure incurred by all taxpayers under certain managed arrangements after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999.

Proposal announced: The proposal was originally announced in Treasurer's Press Release No. 74 of 11 November 1999 (in particular refer to Attachment C).

Financial impact: The financial impact of the new rules is set out in the following table:

Compliance cost impact: A separate regulation impact statement is available for the measures in this Bill.

Summary of Regulation Impact Statement

Regulation impact on business

Impact: The measures contained in this Bill are part of the Government's broad ranging reforms that will give Australia a New Business Tax System. These reforms are based on the Recommendations of the Review that the Government established to consider reforms to Australia's business tax system.

The measures may cause an increase in compliance costs for some taxpayers, however these increases will be offset by broader economic benefits from increasing the integrity of the tax system.

Main Points:

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Potential compliance, administrative and economic impacts of the measures contained in this Bill have been carefully considered by the Review and the business sector. Substantial consultation with the business sector was an important part of the Review.

•

The measure limiting the extent to which non-commercial losses can be used to reduce the tax paid on other income may lead to increased record-keeping costs for individuals carrying on business activities.

•

The measure applying to prepayments for services in respect of 'tax shelter' arrangements will impact on taxpayers who invest in tax shelter arrangements.

•

The measures will contribute significantly to the fairness, integrity and equity of the tax system by reducing the opportunities to avoid tax which arise from complexities and certain anomalies in the current taxation legislation.

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:

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.

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.

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.

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]

Chapter 2 - Deducting prepayments

Outline of Chapter

2.1 This Chapter explains the amendments to the ITAA 1936 made by Parts 1 to 3 of Schedule 2 to this Bill. The amendments implement the Government's decision to prevent prepayments under tax shelter arrangements being immediately deductible. These prepayments must be deducted on a proportional basis over the period during which the benefits attributable to the prepayment are provided.

Context of Reform

What is the current treatment of prepayments?

2.2 Section 82KZM of the ITAA 1936 disallows an immediate deduction for prepayments that are deductible under the general deductions provision, section 8-1 of the ITAA 1997, unless they are incurred for something that is to be done wholly within 13 months.

2.3 Amendments made by the Integrity and Other Measures Actto Subdivision H of Division 3 of Part III of the ITAA 1936 changed the law in relation to deducting prepayments. The change provided that, for prepayments incurred after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, immediate deductibility is no longer available to businesses other than small businesses, subject to a 4 year transitional period. These taxpayers are now always required to spread deductions for prepayments incurred in carrying on a business over the period the prepayment covers or 10 years if that is less. These amendments are referred to as 'stage 1' amendments.

2.4 Prepayments by small business and non-business taxpayers for things to be done within 13 months are unaffected by the stage 1 amendments.

Why is the current law being changed?

2.5 Under the current law, including stage 1 amendments, the key feature of many tax minimisation arrangements (or so-called 'tax shelters'), particularly end-of-year schemes, is the reliance on the existing 13 month prepayment rules to obtain a tax benefit. This is particularly the case where the benefit is derived from the mismatch between the time when the assets or services are provided and the earlier time when the deduction may be claimed.

2.6 The measure contained in this Bill ('stage 2 amendments') will provide a structural solution to limit the tax advantages that are derived from participation in tax shelter arrangements by limiting immediate deductibility for certain prepayments. This is achieved by requiring deductions for those prepayments to be matched to the time over which the benefits are provided.

Summary of new law

2.7 The stage 2 amendments will not allow immediate deductibility for prepayments of expenditure under 'tax shelter' type arrangements. The prepaid expenditure to which the rules apply is that which is deductible under section 8-1 of the ITAA 1997. The rules do not affect the entitlement to the deduction nor the amount which may be deducted, rather they alter the timing of deductibility of prepayments made under those arrangements.

2.8 The deduction for the expenditure will have to be apportioned over the period that the prepaid benefits are provided. An apportionment rule will determine how much of the prepaid expenditure a taxpayer may deduct for each income year.

2.9 Prepayments by businesses other than small businesses, which are not in respect of tax shelter arrangements, will still be covered by the stage 1 transitional rules.

2.10 A number of specific prepayments are excluded from the scope of the measure. The excluded prepayments are:

•

interest for the acquisition of, and building, contents and rent protection insurance in respect of, real property;

•

interest for the acquisition of listed shares and widely held units;

•

interest on a loan used to acquire infrastructure borrowings under the former tax exempt infrastructure borrowing scheme;

•

prepaid 'excluded expenditure';

•

those made under a pre-existing contractual obligation that existed before 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999; or

•

those made under arrangements which, prior to the announcement of the measure, had obtained, or had applied for and later obtained, a favourable ATO product ruling in respect of the arrangement.

2.11 The stage 2 amendments apply to prepaid expenditure incurred under tax shelter arrangements after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999.

Prepayment rules after stage 2 amendments

Detailed explanation of amendments

2.12 The stage 2 amendments will prevent immediate deductibility for prepaid expenditure for things that relate to a tax shelter type arrangement. Instead, the deduction for the expenditure will be apportioned over the period that the benefits are provided.

2.13 The central conditions under which this measure will apply describe the type of payment and the type of arrangement to which the payment relates. Where these conditions are satisfied, the deduction for the prepaid expenditure will be apportioned over the period that the benefits are provided. [Schedule 2, item 7, sections 82KZME and 82KZMF]

Treatment of the prepaid expenditure

Apportionment of the deduction

2.14 The operative provision is stated as a proportional deduction and applies to expenditure incurred by a taxpayer in a year of income. The fraction of the amount subject to the new treatment is worked out by dividing the number of days (including part days) the prepaid expenditure covers in the current income year by the total number of days it covers. The formula in paragraph 82KZMF(1)(b) implements this. [Schedule 2, item 7, subsection 82KZMF(1)(b)]

Example 2.1

Claire makes a prepayment of $10,000 for services in relation to a managed vineyard on 14 June 2000. The services are to be provided between 14 June 2000 and 30 December 2000.

Claire may claim a deduction for $850 in the 2000 income year (i.e.

17 / 200 x $10,000)


and $9,137 in the 2001 income year (i.e.

183 / 200 x $10,000)


.

2.15 If the stage 2 amendments apply to prepayments that would otherwise fall within the transitional rules in the stage 1 amendments, those transition rules do not operate [Schedule 2, item 7, subsection 82KZMF(3)] . The rules apply immediately from 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999, as discussed in paragraph 2.40.

2.16 The new rules have effect despite section 8-1 of the ITAA 1997. Whilst the prepaid expenditure must first be deductible under section 8-1, the new rule will override section 8-1 to apportion the amount deductible over the period that the services for which the prepayment is made are performed. [Schedule 2, item 7, paragraph 82KZMF(2)(a)]

To what prepaid expenditure do the new rules apply?

2.17 For the stage 2 amendments to apply, there must first be expenditure which is deductible under the general deduction provision section 8-1 ITAA 1997. [Schedule 2, item 7, paragraph 82KZME(1)(a)]

2.18 The expenditure must be incurred after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999 under an arrangement that provides for the doing of a thing that is not to be wholly done within the expenditure year, that is, the expenditure is a prepayment. [Schedule 2, item 7, subsection 82KZME(2)]

Arrangements covered by the measure

What is the scope of arrangement?

2.19 In the income tax law the concept of an agreement has a very broad meaning, including amongst other things an 'arrangement undertaking or scheme'. The stage 2 amendments apply to prepaid expenditure under agreements for the doing of things in respect of tax shelter agreements. In order that the scope of an 'agreement' is not limited the amendments provide that an 'agreement' referred to in the new rules includes all activities that relate to the agreement, including those that give rise to deductions or assessable income. [Schedule 2, item 7, subsection 82KZME(4)]

2.20 The broader 'tax shelter arrangement' includes all the particular contracts for the performance of specific things in relation to the tax shelter. Contracts which provide for borrowings and prepayments can be considered a subset of the broader tax shelter arrangement. For example, in an agricultural scheme, the broader arrangement would encompass the financing of and investment by the taxpayer in the scheme and the operation of the scheme by the promoter or manager. Under the new rules, the specific contract or contracts for planting, watering or pest control would be subsets of the broader arrangement. This may also be described in terms of the arrangement producing assessable income and deductions, whereas the individual contract(s) give rise to specific deductions. [Schedule 2, item 7, subsection 82KZME(4)]

Example 2.2

Greg decides to invest in a pine plantation scheme. The investment is essentially a passive one, so he chooses a scheme under which the scheme promoter organises financing for him, transfers the funds invested to the scheme and liaises with the plantation manager.

In this situation the organising of the financing for Greg by the promoter, the provision of the funds to the scheme and the management of the scheme are the activities which subsection 82KZME(4) requires to be taken into account in describing the arrangement to which the tests in subsection 82KZME(3) would be applied.

Example 2.3

Another taxpayer, Bill, decides to invest in an ostrich farming scheme. He arranges his own financing for the investment, but the other aspects of the investment are similar to those for Greg's pine scheme.

In this situation Bill's arrangement of his own financing for the investment would be an element of the arrangement, as well as the transfer of the funds to the manager and the management of the scheme on behalf of Bill and other investors. This is because the funds that Bill borrows and the interest deduction are directly related to the activities under the arrangement.

When is an arrangement a tax shelter?

2.21 The arrangements at which these rules are targeted are those that may be characterised as tax shelter arrangements. The term 'tax shelter' is not used in the legislation. Rather, the legislation describes these arrangements by focussing on 3 required characteristics. The deduction apportionment rule will apply where these characteristics exist for an arrangement and the requirements for the prepayment are also satisfied, unless one of the specific exclusions referred to in paragraph 2.26 to 2.34 applies.

2.22 The first required characteristic is that, for the year when the prepayment is incurred, the taxpayer's allowable deductions under the arrangement exceed the taxpayer's assessable income from the arrangement [Schedule 2, item 7, paragraph 82KZME(3)(a)] . The tax shelter effect arises from the fact that the taxpayer would, apart from this measure, offset the excess of the deductions over assessable income from the arrangement against their other income, thereby reducing their taxable income and tax payable. This requirement would include circumstances where no assessable income is derived in particular income years.

2.23 The second required characteristic is that the taxpayer does not have the day-to-day control of the arrangement, even though they may have organised their own finance, have occasional input in some decisions or occasionally participate in the activities [Schedule 2, item 7, paragraph 82KZME(3)(b)] . In practice, all significant aspects of the day-to-day conduct of the arrangement are managed by someone else.

2.24 The third key characteristic of the arrangements to which the new rules are to apply, is that they are promoted to a group of investors by those that arrange, manage or promote them.

2.25 This characteristic of the arrangement is encapsulated in the law by 2 alternative requirements. The first requirement is that there is more than one participant in the arrangement, not only the taxpayer. The alternative requirement is that the person who manages, arranges or promotes the arrangement, or an associate of such a person manages, arranges or promotes similar arrangements for other taxpayers. [Schedule 2, item 7, subparagraphs 82KZME(3)(c)(i) and (ii)]

Exclusions from the operation of the rules

2.26 Certain prepayments are specifically excluded from the operation of the new rules.

2.27 The first category of excluded prepayments are those that are in respect of certain investments that are commonly negatively geared. This category of exclusion will ensure that such investments entered into by investors are not affected by the new stage 2 amendments. [Schedule 2, item 7, subsection 82KZME(5)]

2.28 The specific types of prepaid expenditure which are excluded are:

•

premiums for building, contents or rent protection insurance; or

•

interest on borrowings to acquire real property or interests in real property, publicly listed shares or units in widely held unit trusts,

but only where:

•

the only income derived from the investment is rent, dividends or trust income; and

•

the arrangement is conducted at arm's length.

[Schedule 2, item 7, subsection 82KZME(5)]

2.29 The second category is a specific exclusion from the measure for prepayments in respect of infrastructure bonds under which the lender is entitled to a tax concession under Division 16L of Part III of the ITAA 1936.

2.30 The third category of prepaid expenditure excluded from the operation of the apportionment rules is that which is 'excluded expenditure' under the existing rules. This applies where the prepaid expenditure under the arrangement is less than $1,000, is a payment of salary and wages or is required to be paid by law or a court order. [Schedule 2, item 6, subsection 82KZME(7)]

2.31 The fourth exclusion category provides that the new rules will not apply to prepayments under existing contractual obligations. The contractual obligations must:

•

exist under an arrangement at or before 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999;

•

require the payment of an amount before the doing of the thing it is for; and

•

not be avoided by unilateral action of the taxpayer.

[Schedule 2, item 7, subsection 82KZME(8)]

2.32 This exclusion category ensures that taxpayers who have committed themselves to making a prepayment before the commencement of the stage 2 amendments will not be affected by the new rules.

2.33 The final specific exclusion excludes the operation of the new rules to investors in an arrangement for which, at 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999;

•

an ATO product ruling had issued; or

•

a formal application for an ATO product ruling had been lodged with, and acknowledged by, the ATO and this leads to the issue of a product ruling.

[Schedule 2, item 7, subsection 82KZME(9) and (10)]

2.34 This exclusion applies to all investors for prepaid expenditure in respect of that project and over the whole term of the project.

Application of new rules to medium and large businesses

2.35 The stage 1 amendments provided that from 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, medium and large business taxpayers must apportion prepaid expenditure, subject to certain exclusions and transitional, rules over the period that the benefits are provided.

2.36 The special transitional rules which apply under stage 1 are, in effect, switched off where the prepaid expenditure is under a 'tax shelter arrangement'. [Schedule 2, item 7, subsection 82KZMF(3)]

2.37 Other prepaid expenditure incurred by medium and large business taxpayers will continue to be apportioned by the stage 1 rules, subject to the 4 year transitional rules from 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999.

Prepayments are still subject to the commercial debt forgiveness rules

2.38 The new rules for prepayments under tax shelter arrangements will operate subject to Division 245 of Schedule C of the ITAA 1936, which deals with the forgiveness of commercial debts. In general terms, a taxpayer who has a commercial debt that is forgiven may be required to reduce some of their deductions, including those for prepayments covered by the rules explained in this Chapter. [Schedule 2, item 7, paragraph 82KZMF(2)(b)]

2002 and later expenditure

2.39 Part 2 of Schedule 2 to this Bill amends the new and existing rules in Subdivision H of Division 3 of Part III of the ITAA 1936 in respect of prepayments made after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 to take account of the cessation of the operation and repeal of the transitional rules from the stage 1 amendments for businesses that are not small businesses. [Schedule 2, items 8 to 10]

Application and transitional provisions

2.40 The stage 2 amendments made by Part 1 of Schedule 2 apply to expenditure incurred by a taxpayer after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999, and the taxpayer's assessments for the year of income including that day and for later years of income. [Schedule 2, subitem11(1)]

2.41 The amendments made by Part 2 of Schedule 2 to repeal redundant references apply to expenditure incurred by a taxpayer in a year of income after the taxpayer's year of income that includes 21 September 2002. [Schedule 2, subitem 11(2)]

Chapter 3 - Regulation Impact Statement

Policy objective

The objectives of the New Business Tax System

3.1 The measures in this Bill are part of the Government's broad ranging reforms which will give Australia a New Business Tax System. The reforms are based on the Recommendations of the Review, instituted by the Government to consider reform of Australia's business tax system.

3.2 The Government instituted the Review to consult on its plan to comprehensively reform the business income tax system (as outlined in ANTS). The Review made 280 recommendations to the Government, designed to achieve a more simple, stable and durable business tax system.

3.3 The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings, as well as providing a sustainable revenue base so the Government can continue to deliver services to the community.

3.4 The New Business Tax System also seeks to provide a basis for more robust investment decisions. This is achieved by:

•

improving simplicity and transparency;

•

reducing the cost of compliance; and

•

providing fairer, more equitable outcomes.

3.5 This Bill is part of the legislative program implementing the New Business Tax System. Other Bills have been introduced and passed as listed in table 3.1.

The objectives of measures in this Bill

Non-commercial losses

3.6 The objective of the non-commercial losses measure is to specify the time when individual taxpayers can claim deductions for expenditure on certain business activities. A Tax System Redesigned described many of these activities as more like hobbies and/or lifestyle choices. Further, while these activities may have business-like characteristics (according to the law), experience shows they are often unlikely ever to make a profit and have little, if any particular commercial purpose.

Application of 13 month prepayment rule to tax shelters

3.7 The objective of this measure is to limit the tax advantages that are derived from participation in tax minimisation schemes, particularly end of year schemes.

Implementation options

3.8 The measures in this Bill arise from recommendations of the Review. Those Recommendations were the subject of extensive consultation. The implementation options for these measures can be found in A Tax System Redesigned. Table 3.2 shows where the measures (or the principles underlying them) are discussed in those publications.

Assessment of impacts

3.9 The potential compliance, administrative and economic impacts of the measures in this Bill have been carefully considered, both by the Review and by the business sector. The Review focussed on the economy as a whole in assessing the impacts of its recommendations and concluded that there would be net gains to business, government and the community from business tax reform.

Impact group identification

3.10 The groups affected by measures in this Bill are identified in Table 3.3.

Analysis of costs/benefits

Compliance costs

3.11 As is standard with new measures, groups affected by them will need to incur a small up-front cost in either familiarising themselves with the new law or having advisers familiarise themselves with the new law and, if necessary, communicating the necessary information to taxpayers affected.

3.12 However, overall, the measures in this Bill are expected to reduce compliance costs for business as it will provide a more consistent and easily understood business tax system.

3.13 The measures in this Bill may increase compliance costs for some taxpayers. However, these costs are considered to be outweighed by the improvement in the equity, fairness and integrity that the measures will introduce to the tax system. The compliance cost impact of each of the measures is discussed on a measure-by-measure basis in paragraphs 3.14 to 3.18.

Non-commercial losses

3.14 The measure will have a compliance impact on individuals and individuals in partnership involved in business activities that may produce losses when, in an income year, deductions exceed assessable income.

3.15 Individual taxpayers claiming deductions arising from business activities against other income will need to become familiar with the new provisions. These taxpayers will need to determine whether the tests apply to them and if so whether they satisfy any one of the tests in order to be able to offset losses from the activity against their other income.

3.16 Individuals who fail to satisfy any of the tests for a particular business activity will need to maintain records of those loss amounts in order to defer them to a future year in which they pass any of the tests. The deferred loss can be claimed as a deduction in the year a test is passed. These records will need to separately identify the deductions from each activity which were not permitted to be claimed.

3.17 The tests are designed to allow taxpayers to use information that is already available to them, such as tax values of assets, assessable income and taxable income.

Application of 13 month prepayment rule to tax shelters

3.18 The main compliance cost implication arises for taxpayers, who make prepayments under tax shelter arrangements, and taxation professionals having to familiarise themselves with the new rules. The proposed measure will further align the deductibility of expenditure with the income year in which the expenditure was incurred.

Administration costs

3.19 The measures will be administered by the ATO using existing resources.

Government revenue

3.20 The measures raise revenue in the year of introduction and in subsequent years. The estimated increases in revenue are set out in the General Outline and Financial Impactsection of this Explanatory Memorandum.

Economic benefits

3.21 The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The economic benefits of these measures are explained in more detail in the publications of the Review, particularly A Platform for Consultation and A Tax System Redesigned.

Other issues consultation

3.22 The consultation process began with the release of ANTS in August 1998. The Government established the Review in that month. Since then, the Review has published 4 documents about business tax reform; in particular A Platform for Consultation and A Tax System Redesigned in which it canvassed options, discussed issues and sought public input.

3.23 Throughout that period, the Review held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 of the Overview of A Tax System Redesigned.

3.24 In analysing options, the Review was guided by, and frequently referred to, views expressed during the consultation process.

3.25 Consultation with professional associations, tax shelter arrangement promoters and industry representatives was undertaken following the announcement of the measures in this Bill.

Conclusion and recommended option

3.26 The recommended option should be adopted. The option will contribute significantly to the fairness, integrity and equity of the tax system by reducing the scope for minimisation and deferral of tax by taxpayers which arises from complexities and certain anomalies in the current taxation legislation.

3.27 These measures may increase compliance costs for business taxpayers but the overall changes to business taxation will provide business taxpayers with greater flexibility in managing their affairs and contribute to the integrity of the tax system.