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Ruling

Subject: Non-commercial losses - Commissioner's discretion

Questions and answers

1. Will the Commissioner exercise the discretion in paragraph 35-55(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your business activity in the calculation of your taxable income for the 2009-10 and 2010-11 financial years?

No.

2. Will the Commissioner exercise the discretion under paragraph 35-55(1)(c) of the ITAA 1997 to allow you to include losses from your business activity in the calculation of your taxable income for the 2009-10 to 2012-13 income years?

No.

This ruling applies for the following period

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

June 2009

Relevant facts

The business activity was conducted by a third party under a management contract.

Management was transferred to another operator in order to reduce costs and achieve greater income through better marketing and exposure. This again did not meet expectations.

It has now been decided to employ a person on a full time basis to be responsible for the marketing and management.

The business activity passed both the assessable income test and the other assets test for the years ended 30 June 2010 and 2011 and is expected to meet these tests in the current and subsequent years.

Your other taxable income exceeds $250,000 in each of these years.

The most significant factor affecting the business' ability to make a tax profit is the large capital outlay and the associated depreciation.

You would have hoped that the business would have made a profit before depreciation from the outset, and after depreciation in approximately four years. The flow on effects of the global financial crisis coupled with the poor management by the two management companies has contributed to the tax losses made to date.

Steps have now been taken to improve the exposure and the service to the target market and it is expected that this will result in a significant increase in both income and profits in the short term.

Discussions are now being held to employ a full time person to manage and market. These discussions have resulted in the development of a marketing strategy which involves approaching certain companies to secure a contract.

You expect to make a profit in the 2013-14 income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 35-10(2)

Income Tax Assessment Act 1997 Paragraph 35-55(1)(a)

Income Tax Assessment Act 1997 Paragraph 35-55(1)(c)

Reasons for decision

For the non-commercial losses rules to apply to an individual they have to be carrying on a business for taxation purposes. You have stated in your application that you commenced a business in June 2009 and have not indicated that you would like the Commissioner to consider whether your activity is a business activity. This ruling is issued based on the assumption that you are carrying on a business for the relevant years.

The effect of the non-commercial losses legislation is to restrict the circumstances where a business loss can be offset against other income. The losses are in effect quarantined to that business activity and can only be offset against future income of that or similar business activities.

Prior to the 2009-10 income year if you could pass one of four tests, obtained the Commissioner's discretion or if an exception applied, the losses could be offset against your other income.

Changes were made to the operation of the non-commercial losses rules to apply for the 2009-10 and later income years to further restrict the circumstances where a business loss can be offset against other income with the introduction of an 'income requirement'. To satisfy the income requirement for an income year the sum of the following has to be less than $250,000; your taxable income for that year; your reportable fringe benefits total for that year; your reportable superannuation contributions for that year; your total net investment losses for that year. For the purposes of calculating your taxable income you do not take into account any excess from the business activity affected by the non-commercial losses. You have provided information indicating that you do not meet the income requirement, therefore the new restrictions will apply to you for 2009-10 and possibly, later income years.

Under these changes you do not have access to the four tests. You are limited to getting the Commissioner's discretion or one of the exceptions. Previously there were two types of discretions referred to as 'special circumstances' and 'lead time' discretions. For the special circumstances discretion to apply you have to show that special circumstances stopped you from making a profit in any particular year. A new lead time discretion was introduced at paragraph 35-55(1)(c) of the ITAA 1997 for individuals who do not meet the income requirement. They no longer have access to the normal 'lead time' discretion at paragraph 35-55(1)(b) of the ITAA 1997.

Previously for an individual starting up a business, if you could show that 'because of the nature' of your business you could not pass one of the four tests and there was an objective expectation that within a commercially viable period for the industry concerned, the business will either meet one of the tests or you could produce assessable income for an income year greater than the deductions attributable to it for that year, a discretion could be obtained. There is a note in the legislation that explains this further. It refers to business activities that have a lead time between the commencement of the activity and the production of any assessable income (for example the planting of hardwood forestry trees for harvest).

The Commissioner's discretion under paragraph 35-55(1)(b) of the ITAA 1997 was not available to certain activities as there was no lead time between the commencement of the activity and the potential to produce assessable income. These activities normally passed at least one of the four tests, which allow the losses to be offset against other income.

Special circumstances discretion

Paragraph 35-55(1)(a) of the ITAA 1997 sets out the first arm of the Commissioner's discretion as follows:

The Commissioner may, on application, decide that the rule in subsection 35-10(2) does not apply to a *business activity for one or more income years (the excluded years) if the Commissioner is satisfied that it would be unreasonable to apply that rule because:

(a) the business activity was or will be affected in the excluded years by special circumstances outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster; or

Note: This paragraph is intended to provide for a case where a business activity would have satisfied one of the tests if it were not for the special circumstances.

The above paragraph refers to 'special circumstances' outside of the control of the operators of the business activity. No exhaustive definition is given of 'special circumstances' but the paragraph does include drought, bushfire and other natural disasters.

It can be seen that to determine what is 'special circumstances', we need to look at the context in which the phrase is used. Also, it is clear that 'special circumstances' will be something out of the ordinary or unusual. 'Special circumstances' in paragraph 35-55(1)(a) of the ITAA 1997 is used in the context of a situation occurring such that it would be unreasonable for the Commissioner to apply the loss deferral rule for a particular year or years.

The application of this paragraph for where you do not meet the income requirement is set out in Taxation Ruling TR 2007/6. There has to be special circumstances and these circumstances have to affect the business activity to the extent to cause it to make a loss. For this discretion we are limited in your case, at looking at the 2009-10 and 2010-11 income years because you have to be able to show that the special circumstances actually stopped you from making a profit.

You have stated that unfortunately the flow on effects of the global financial crisis coupled with poor management by the two management companies has contributed to the tax losses made to date.

In certain circumstances it may be arguable that the global financial crisis (GFC) was considered special circumstances, but the poor management by the companies is not considered special circumstances. At the time of purchase of the equipment you would have been aware of the GFC which impacted on the share market from March 2008, with it reaching a low in March 2009. It would not be considered special circumstances in your situation.

Because there are no special circumstances affecting your business in the relevant years the Commissioner cannot exercise a discretion under paragraph 35-55(1)(a) of the ITAA 1997.

New lead time discretion for individuals who do not meet the income requirement, applicable to the 2009 -10 income year and future years

The new discretion has similar terminology (because of the nature) and is still a two step process. The changes for the new discretion are that you no longer get access to the four tests under the discretion. You have to be able to show that if the 'because of the nature' applies (step 1), you can produce assessable income for an income year greater than the deductions attributable to it for that year, within the commercially viable period for the industry concerned. The same note applies to this discretion. It is for those types of activities that have a lead time between the commencement of the activity and the production of assessable income.

There has been no change in the legislation to indicate that the lead time discretion would apply to your industry. There is nothing inherent in this type of activity that stops it from producing income from commencement.

In reading some of the comments made about the new legislation and specifically this new discretion the explanation is somewhat abbreviated and it talks about, where a taxpayer can demonstrate that their business activity is genuinely commercial, they can apply to the Commissioner for a discretion, to apply the losses against other income. However, you have to be able to meet the specific requirements of the section to be able to get the Commissioner's discretion. You have to show that it is 'because of the nature' and you also have to show that you can make a tax profit in a year for that activity within the 'commercially viable period for the industry' concerned. The meaning of commercially viable period has not changed. The relevant and updated paragraphs of TR 2007/6 Income tax: non-commercial losses: Commissioner's discretion are still applicable. The meaning is further clarified in the explanatory memorandum to the amended legislation.

Where the income requirement test is not met, there is only one discretion in the legislation that is possibly applicable for a business starting up, that because of its nature there is lead time and this is shown at paragraph 35-55(1)(c) of the ITAA 1997. This is the law that has to be applied for these cases, to determine if the Commissioner can grant a discretion.

Paragraph 35-55(1)(c) of the ITAA 1997 states:

for an applicant who carries on the business activity who does not satisfy subsection 35-10(2E) (income requirement) for the most recent income year before the application is made - the business activity has started to be carried on and, for the excluded years:

(i) because of its nature, it has not produced, or will not produce, assessable income greater than the deductions attributable to it; and

(ii) there is an objective expectation, based on evidence from independent sources (where available) that, within a period that is commercially viable for the industry concerned, the activity will produce assessable income for an income year greater than the deductions attributable to it for that year (apart from the operation of subsections 35-10(2) and (2C)).

Note: Paragraphs (b) and (c) are intended to cover a business activity that has a lead time between the commencement of the activity and the production of any assessable income. For example, an activity involving the planting of hardwood trees for harvest, where many years would pass before the activity could reasonably be expected to produce income.

The explanatory memorandum to this new legislation explains that individuals:

….must demonstrate that the reason they do not or will not make a profit is because of the nature of the business and not for some other reason which is peculiar to that individual's particular business.

The individual is required to establish objectively the commercially viable period for the industry concerned.

It is not accepted that there is anything inherent in the nature of your business that is the reason the business activity does not or will not make a profit. You have used two different managers and as you were not getting satisfactory results from them, you now intend to use different methods to use and promote the services.

You have indicated that:

The most significant factor affecting the business' ability to make a profit is the large capital outlay to purchase the equipment and the associated depreciation.

In an ideal world it was hoped that the business would have made a profit before depreciation from the outset, and after depreciation in approximately four years.

The figures you have provided show income from the activity in the 2009-10 income year was approximately $100,000 and a forecast income of ten times this amount, of $1,000,000 in the 2013-14 year (which will be the first year you make a profit). It would appear to be the development and changes to your business over a period of time that will lead to it making a profit. These factors are not considered to be something that is 'in the nature' of a business in terms of this legislation. You are gradually increasing your clientele over a period of time and this may lead to profitability.

Based on the consideration that neither of the requirements to obtain the Commissioner's discretion under paragraph 35-55(1)(c) of the ITAA 1997 are met, the Commissioner will not exercise the discretion under paragraph 35-55(1)(c) for the 2009-10 to 2012-13 years of income. You have stated that you are carrying on a business and therefore the losses from your business will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997.

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