Edited version of your private ruling

Authorisation Number: 1012558496172

Ruling

Subject: non-commercial losses

Question 1

Are you carrying on a business?

Answer

No.

Question 2

Will the Commissioner exercise the discretion in paragraph 35-55(1)(b) 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 2012-13 financial year?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2013

The scheme commences on

1 July 2012

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· the application for private ruling,

· the documents provided with the application for private ruling and

· the further information provided.

You were made redundant from your employment during the 2012-13 financial year.

Your income for the 2012-13 financial year is more than $250,000.

You commenced activities to develop a product in the 2012-13 financial year.

Due to the nature of your activities, you will not earn any assessable income until the products are complete and available for sale.

You anticipate that this will occur in the last quarter of the 2013-14 financial year. However, you have stated that realistically this will probably not occur until the first quarter of the 2014-15 financial year.

You have incurred various costs during the 2012-13 financial year.

You have not been employed since you were made redundant.

You have stated that due to the nature of your activities, there is a lead time before you will make a profit.

You have a business plan.

You hire specialists in each field that relate to your activities.

You design all commercial aspects of the program, including documentation of functional specifications and process flow charting.

You hire developers, designers and other specialists to undertake work with your product.

You do not have any previous experience in the product. However, you undertook an extensive tender process in order to find an experienced, high calibre company to not only do some of the work but to provide the technical expertise required for your activities.

As at 30 June 2013, you had invested approximately $Y into your activities.

As at 30 September 2014, you anticipate you will have invested approximately $Z.

You spend a large number of hours per week on your activities.

You have not undertaken any advertising yet. This will take place once the first product is launched.

Relevant legislative provisions

Income Tax Assessment Act 1997 paragraph 35-55(1)(b)

Reasons for decision

Question 1

Business losses from activities that do not meet any of the four tests under Division 35 of the ITAA 1997, or the exception in subsection 35-10(4) of the ITAA 1997, will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997, unless the Commissioner exercises a discretion under section 35-55 of the ITAA 1997 that it would be unreasonable to defer the loss.

In order for Division 35 to apply, a taxpayer must have commenced business. In determining when a business commences, there are three indicators that must be present before it can be said that a business has commenced. These are:

• purpose, intention and decision;

• acquisition of a business structure; and

• commencement of business operations

We must examine the above indicators in light of the characterisation of your business activity. In Goodman Fielder Wattie Ltd v. Federal Commissioner of Taxation 29 FCR 376; (1991) 22 ATR 26; 91 ATC 4438, Hill J stated:

Critical to the resolution of the present controversy, is the characterisation of the business activity itself which is said to have commenced. It was conceded properly by the applicant that if the business claimed to be carried on by it was to be characterised as one of manufacturing and selling monoclonal antibody products, then that business did not commence until around November 1982...

For example, for a primary production activity involving the planting and cultivating of trees, then the planting of the trees could be seen as the commencement of that business. Alternatively, if your business activity is characterised as a trading activity, involving conducting services in return for a fee, the business would generally be considered to have commenced once you begin conducting the services for a fee.

The information which you have provided indicates that your intended business activity is best characterised as a trading activity. Your intention is to develop a product and receive income in the form of sales of this product.

Purpose, intention and decision:

The chain of events leading to the commencement or start-up of a business activity often begins with a mere intention to establish the business activity.  This is developed by researching the proposed business and, in some instances, by experiment.  This process culminates in a final decision on whether to commence business.  However, not all businesses commence in such an orderly manner.

It is clear from the information you have provided that you had decided the form of that business and had shown some commitment to it by conducting market research and trials and investing time in developing the materials that will become your product.

Acquisition of a business structure:

For a business activity to commence, an appropriate business structure should be in place. As to what this structure will consist of, and its size, this will be a question of fact and degree, and depend on the nature of the business activity. It is usually a collection of capital assets. What the particular capital assets are will depend on the particular business activity.

In Calkin v. CIR [1984] 1 NZLR 440 Richardson J said at 446-447:

'Clearly it is not sufficient that the taxpayer has made a commitment to engage in business: he must first establish a profit-making structure and begin ordinary business operations.'

In your case, you had not actually acquired all of the business assets that you needed to commence your business activity, including a finalised product to sell.

Commencement of Business Operations:

As noted by Brennan J in Inglis v. Federal Commissioner of Taxation (1979) 10 ATR 493; 80 ATC 4001, the level of activity is important in deciding whether a business is being carried on.  Brennan J stated at ATC 4004-4005;  ATR 496-497 that:

The carrying on of a business is not a matter merely of intention.  It is a matter of activity.  Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted.

In your case, you had not begun ordinary business operations during the 2012-13 financial year. At that point in time you did not have your product ready for sale.

We consider that, up to this point, your activities were preliminary to the carrying on of your intended business. The costs associated with the establishment of a trading entity are capital in nature as they relate to the structure of the business rather than the daily activities from which the business gains its assessable income (see Federal Commissioner of Taxation v. Maddalena 71 ATC 4161; (1971) 2 ATR 541.

Question 2

Non-commercial loss discretion

For the 2009-10 and later income years, Division 35 of the ITAA 1997 will apply to defer a non-commercial loss from a business activity unless:

· you satisfy the income requirement and you pass one of the four tests

· the exceptions apply

· the Commissioner exercises his discretion.

In your situation, none of the exceptions would apply and you do not satisfy the income requirement. Your losses are therefore subject to the deferral rule, unless the Commissioner exercises his discretion.

The relevant discretion may be exercised for the income year in question where:

· it is in the nature of the business activity that there will be a period of time before it can be expected to pass one of the four tests

· there is an objective expectation your business activity will produce a tax profit or meet one of the four tests within a commercially viable period for your industry.

This discretion is intended to cover a business activity where there is an inherent period of time between the commencement of the activity and the production of 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.

For the discretion to be applied there needs to be an inherent or innate feature of the activity resulting in an inability to produce income in the year of commencement and (in most cases) a number of years thereafter. Further examples that fall into this category are forestry, viticulture and certain horticultural activities.

The discretion should not be exercised for any start-up activity that is yet, for example, to satisfy the assessable income test in section 35-30 of the ITAA 1997, simply because of the small scale on which it was started, or because a client base is being built up.

As you are not considered to be carrying on a business the non-commercial loss provisions do not apply and the Commissioner is unable to exercise any discretion in this matter.

However, even if you had commenced business, you have not produced any objective evidence to show that there is an inherent or innate characteristic preventing a business of producing and selling your product from producing assessable income for any period of time (F C of T v Eskandari [2004] FCA 8; 54 ATR 695). On the contrary, some similar products may be successful soon after they are available for sale.

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