Edited version of private ruling

Authorisation Number: 1011720807468

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Ruling

Subject: Am I in Business

Question 1

Is Company X carrying on a business and therefore entitled to deduct an outgoing incurred in connection with acquiring an item of trading stock pursuant to paragraph 8-1(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) and the excess value of its trading stock at the start of the income year over the value at the end of the income year calculated in accordance with subsection 70-35(3) of ITAA 1997?

Answer

Yes.

Question 2

If the answer to Question 1 is negative such that it is the Commissioner's view that Company X is not carrying on a business and cannot deduct any outgoings or losses, then having regard to the relevant facts and circumstances, would the Commissioner conclude that the loss arising from the sale of the product is deductible on the basis that is was incurred in gaining or producing assessable income pursuant to section 8-1(1)(a) of ITAA97?

Answer

Not required to answer.

Relevant facts

Background

Company X was incorporated for the purpose of entering into contracts in the industry.

Company X engaged a specialist and long term participant in the industry to commence market research on a new business venture.

Research was conducted, including engaging internationally recognised specialists.

Company X developed a concept.

Market research and refinement of the product was undertaken by Company X.

Company X identified significant demand for the product.

Company X further agreed with its design on additional product shortly after.

Strong demand for the product continued, and international specialists estimated that the product would yield high returns.

Company X committed funds toward the design of more product.

Due to the capital commitment for the product, Company X considered a joint venture with a company to construct the more product.

Discussions with international specialists indicated that the product would still sell on completion for a profit.

Costs continued to rise and another review of the product markets concluded that a profit could still be made. It was decided that because there was still a prospect of profit and that product completion was effectively beyond the point of no return that the product production would continue.

The demand and value for completed product started to fall as a result of the global financial crisis.

As the impact of the global financial crisis continued, the demand and value of the product in the international marked significantly diminished.

There was no private use of the product by Company X.

The product was completed, and formal independent valuations were obtained from two valuers.

Company X subsequently sold the product

Company X is claiming a deduction for the loss in value of its trading stock.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 8-1(1)(a)

Income Tax Assessment Act 1997 Subsection 8-1(1)(b)

Income Tax Assessment Act 1997 Subdivision 70-C

Income Tax Assessment Act 1997 Subsection 70-10(a)

Income Tax Assessment Act 1997 Subsection 70-35(3)

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

As Company X is carrying on a business they are entitled to deduct an outgoing incurred in connection with acquiring an item of trading stock pursuant to paragraph 8-1(1)(b) of the ITAA 1997 and the excess value of its trading stock at the start of the income year over the value at the end of the income year calculated in accordance with subsection 70-35(3) of ITAA 1997.

Detailed reasoning

In order to qualify for the trading stock provisions it is necessary to consider whether the activity in question constitutes the carrying on of a business.

Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

The question of whether a business is being carried on is a question of fact and degree.

In determining whether someone is carrying on a business the facts of each individual case must be examined. In Martin v. Federal Commissioner of Taxation (1953) 90 CLR 470; (1953) 10 ATD 226; (1953) 5 AITR 548 Webb J said:

The test is both subjective and objective. It is made by regarding the nature and extent of the activities under review as well as the purpose of the individual engaging in them, and as counsel for the taxpayer put it, the determination is eventually based on the large or general impression gained.

Taxation Ruling TR 97/11 "Am I carrying on a primary production business" sets out a number of factors that must be considered in determining whether a taxpayer is carrying on a business. Although TR 97/11 relates directly to primary production, the indicators apply generally to the determination of whether a business is being carried out.

In establishing whether a taxpayer's activities amount to the carrying on of a business, consideration is given to the overall impression gained after examining the activities as a whole and the intention of the taxpayer undertaking it. As such regard should be had to all of the indicators provided in TR 97/11 and no single indicator will be determinative in any particular case.

As provided in TR 97/11, the main indicators to consider include:

· whether the activity has a significant commercial purpose or character;

· whether there is more than just an intention to engage in business;

· whether there is a purpose of profit as well as a prospect of profit;

· whether there is repetition and regularity to the activity;

· whether the activity is of the same kind and carried on in a similar manner to businesses in the industry;

· whether the activity is planned, organised and carried on in a business-like manner;

· the size, scale and permanency of the activity; and

· whether the activity is better described as a hobby or recreation.

Main indicators of a business

Significant commercial purpose or character

Paragraph 28 of TR 97/11 provides that in showing that a business is being carried on, it is important that the taxpayer is able to provide evidence that shows there is a significant commercial purpose or character to the activity, i.e that the activity is carried on for commercial reasons and in a commercially viable manner.

The phrase "significant commercial purpose" is referred to by Justice Walsh in Thomas v. FC of T 72 ATC 4094 (Thomas' case). Whether there is a significant commercial activity is closely linked to the other indicators and is a generalisation drawn from the interaction of the other characters.

Justice Walsh also noted that any knowledge, previous experience or skill of the taxpayer in the activity, and any advice taken by the taxpayer in the conduct of the business should also be considered but are not necessarily determinative.

In Thomas' case, Justice Walsh found that the taxpayer's activities in growing macadamia nut trees and avocado pear trees amounted to the carrying on of a business. The court was influenced by the scale of the activity, and the taxpayer's expectation of an ongoing financial return. Consideration should also be given to whether the taxpayer is a pioneer in the activity or has developed a new method of undertaking the activity, whether successful or not.

Intention of the taxpayer

Although the intention of the taxpayer in engaging in the activity is a relevant indicator a mere intention to carry on a business is not enough. There must be an activity (see Thomas' case).

Brennan J in Inglis v FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497 said that:

The carrying on of a business is not a matter merely of intention. It is a matter of activity ……. At the end of the day, the extent of activity determines whether the business is being carried on. That is a question of fact and degree.

Further, paragraph 40 of TR 97/11 states:

This indicator is particularly related to:

· whether the activity is preparatory or preliminary to the ultimate activity;

· whether there is an intention to profit; and

· whether the activity is better described as a hobby or the pursuit of a recreational or sporting activity.

Prospect of profit

In the matter of Hope v. The Council of the City of Bathurst (1980) 144 CLR 1 (Hope's case), Justice Mason noted that usually the carrying on of a business is such that the activities are:

…engaged in for the purpose of profit on a continuous and repetitive basis.

Likewise in Smith v Anderson (1880) 15 Ch D 247 at 258, Jessell MR said that:

... anything which occupies the time and attention and labour of a man for the purpose of profit is business.

In addition, as provided at paragraph 50 of TR 97/11, taxpayers need to show that the other indicators of business are present in sufficient strength to outweigh any objective view that the activity may be inherently unprofitable.

Repetition and regularity

Paragraph 55 of TR 97/11 provides that it is often a feature of a business that similar sorts of activities are repeated on a regular basis. The repetition of activities by the same person over a period of time on a regular basis helps to determine whether there is the 'carrying on' of a business.

For example, in Hope's case, the 'transactions were entered into on a continuous and repetitive basis', such that the taxpayer's activities 'manifested the essential characteristics required of a business'.

As provided at paragraph 56 of TR 97/11 the taxpayer should undertake at least the minimum activities necessary to maintain a commercial quantity and quality of product for sale. It may be that there are no minimum levels for this activity. Where there are minimum levels necessary for this activity which the taxpayer fails to maintain, it may be that for a period the taxpayer has ceased to carry on a business of primary production.

Is the activity of the same kind and carried on in a manner that is characteristic of the industry

TR 97/11 at paragraph 63 provides that an activity is more likely to be a business when it is carried on in a manner similar to that in which other participants in the same industry carry on their activities.

As noted by Lord Clyde in IR Commissioners v Livingston at TC 542:

… the test, which must be used to determine whether a venture … is, or is not, 'in the nature of trade', is whether the operations involved in it are of the same kind, and carried on in the same way, as those which are characteristic of ordinary trading in the line of business in which the venture was made.

In considering this indicator the following factors might be compared with the characteristics of others engaged in the same type of business:

· the volume of sales. If there is a small number of sales it is less likely that a business is being carried on. The volume of sales should be capable of producing a profit at some time. However, allowance is made for droughts, fires and other uncontrollable events which may effect the volume of sales. We also accept that in the early stages of an activity, sales may be low;

· the types of customers the taxpayer sells his/her product to - wholesalers, retailers, the public at large, or friends or relatives - and the manner in which this marketing takes place;

· the sort of expenses incurred by the taxpayer;

· the amount invested in capital items;

· previous experience of the taxpayer. A taxpayer who does not have any knowledge or experience may be expected to have sought advice from experts. However, it is recognised that a taxpayer may be a pioneer in the industry. The taxpayer may have conducted research into the activity, decided that the traditional approach is wrong. He/she may be trying to conduct the activity with a view to profit in a new but businesslike way; and

· the activity should also be compared with that of a keen amateur. The sales of a keen amateur may only be a way of obtaining 'new' funds to continue with the personal interest.

Organisation in a businesslike manner and the use of system

It is considered that a business is characteristically carried on in a systematic and organised manner rather than on an ad hoc basis. An activity should generally conform with ordinary commercial principles to amount to the carrying on of a business.

Generally, most business have some form of forward planning to take account of contingencies and market fluctuations, as well as setting profit targets, budgets, periodic financial reviews, record keeping systems, an appropriate office, etc.

Size and scale of activity

In Thomas' case it was determined that generally, the larger the scale of the activity the more likely it will be that the taxpayer is carrying on a business. However, this factor is not a determinative test as a person may still be considered to be carrying on a business even on a small scale.

Relevantly, paragraph 82 of TR 97/11 provides that the smaller the scale of the activity the more important the other indicators become when deciding whether a taxpayer is carrying on a business.

Hobby or recreation

If the taxpayer's activities are being conducted primarily for pleasure or because of an interest in the activity, the fact that the activities may be done on a substantial scale is not enough to decide that a business is being carried on.

In Ferguson v Federal Commissioner of Taxation 79 ATC 4261; 9ATR 873 at ATC 4265; and ATR 877, it was said:

..… if what he was doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business, even though his operations are fairly substantial.

Application to your circumstances

It is considered Company X's activities displayed significant commercial purpose.

Company X made a large capital investment to build its first product and committed funds for a second product even though this product was never constructed.

Company X's activity did not produce a profit, however, Hack J in Peerless Marine Pty LTD V FCT 2006 ATC 2419 (Peerless) stated that producing income this is not the test, and close attention should be given to what motivated the taxpayer on setting up, and then driving the activity. It is accepted that Company X undertook the activity with a view and intention to make a profit. This was evidenced by the fact that it committed funds for a more product to sell at a profit. The Commissioner acknowledges that factors beyond the control of the parties, and the impact of the global economic downturn had on the success of Company X's activities.

The Commissioner accepts that Company X undertook the activity intending to make a profit. The Commissioner accepts as J Hack found in Peerless.

The business plan Company X provided clearly indicates the intention of Company X's business to build and sell the product. Company X believed they had found a substantial demand in the international market for high quality luxury products and this demand is growing quicker than supply. The intention of the Company X's business was to benefit from this gap in the market place.

It is considered that Company X was run in a businesslike manner. This is evidenced by the fact that:

· Company X sought expert advice, and conducted approximately 12 months of research into the operation or viability of the activity;

· Company X also produced a draft advertising brochure and undertook "soft marketing' throughout the product construction phase;

· Company X received two formal valuations for the product; and

· Company X disposed of the product for an average of the two valuations which was its stated business intention.

The above factors demonstrate Company X's activity was systematic and organised, and would amount to carrying on a business.

Although there was limited repetition and regularity of sales, and the fact that the size and scale of Company X's activities were small, these indicators are outweighed by the indicators discussed above.

The Commissioner does not consider Company X's activity as private or domestic, there was no private use of the product; nor is it considered to be a hobby.

On balance of the indicators in TR 97/11 and the legal principles discussed above, it is considered that Company X's activities amount to the carrying on of a business.

The applicant has requested that the Commissioner consider whether the excess value of its trading stock at the start of the income year over the value at the end of the income year calculated in accordance with subsection 70-35(3) of ITAA 1997.

Trading stock is defined as including anything produced, manufactured or acquired that is held for the purpose of manufacture, sale or exchange in the ordinary course of business under section 70-10 of the ITAA 1997. 

Subdivision 70-C of the ITAA 1997 contains the provisions designed to bring into account the value of trading stock for taxpayers in business the assessable income, or to provide an allowable deduction.

To work out the value of your trading stock, section 70-35 of the ITAA 1997 states that:-

(1) If you carry on a business, you compare:

(a) the value of all your trading stock on hand at the start of the income year; and

(b) the value of all your trading stock on hand at the end of the income year.

(2) Your assessable income includes any excess of the value at the end of the income year over the value at the start of the income year.

(3) On the other hand, you can deduct any excess of the value at the start of the income year over the value at the end of the income year.  

As the Commissioner considers Company X is carrying on a business and the product is part of Company X's trading stock, Company X can claim a deduction for the loss in value of its trading stock as at 30 June 2009 as prescribed under section 70-35(3) of the ITAA 1997.

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