Edited version of your written advice

Authorisation Number: 1012692680467

Ruling

Subject: Losses associated with the sale of a vessel

Question 1

Will section 26-47 of the Income Tax assessment Act 1997 (ITAA 1997) prevent the loss realised on the sale of the vessel in the 2014 financial year being taken into account in determining the net income or loss of The Partnership under Division 5 of the Income Tax Assessment Act 1936 (ITAA 1936) for the year ended 30 June 2014?

Answer

No

Question 2

Provided each partner individually satisfies the 'income requirement' in in subsection 35-10(2E) of the ITAA 1997, will Division 35 of the ITAA 1997 prevent a partner's share of the loss realised on the sale of the vessel being deductible to the partner for the year ended 30 June 14?

Answer

No

Question 3

If the loss is not a business loss, will it be treated as a capital loss for The Partnership?

Answer

No

This ruling applies for the following period:

01 July 2013 to 30 June 2014

The scheme commences on:

01 July 2014

Relevant facts and circumstances

1. The Partnership is a partnership of individuals that has been operating various forms of businesses for many years.

2. The Partnership commissioned the construction of a vessel 'The First Vessel'.

3. Prior to The First Vessel being built The Partnership attended several vessel shows with plans, models and visual displays.

4. The First Vessel was built to survey and commercial use standard.

5. The First Vessel continued to be shown at vessel shows until it was sold to a charter vessel operator.

6. The Partnership made a profit on the sale of The First Vessel which was returned as income in the income tax return of The Partnership.

7. A second vessel 'The Vessel' was commenced after the sale of The First Vessel based on:

• feedback from sea trials and inspections of The First Vessel, and

• interest from the purchaser of the purchaser of The First Vessel.

8. The Vessel was intended as a prototype for a 'built to order line' of vessels.

9. The Vessel was a more upmarket version of The First Vessel, also built to survey and commercial standard.

10. The Vessel was constructed to hull and deck stage by a contractor and completed by The Partnership.

11. The unfinished Vessel was displayed at a vessel show and taken directly back to its marina for completion.

12. Once complete brochures were printed and display boards were made to exhibit The Vessel as vessel shows.

13. The Vessel was regularly advertised for sale in trade magazines.

14. During its period of ownership enquiries and inspections of The Vessel were carried out by interested purchasers, numerous potential buyers were given inspections and taken out in The Vessel.

15. The Partnership:

• registered a business name,

• set up a website, and

• had business cards printed.

16. With the onset of the global financial crisis vessel sales and enquiries regarding The Vessel dropped suddenly and dramatically.

17. After the global financial crisis the business name was cancelled.

18. After engaging various Australian vessel brokers to undertake sales programs The Vessel was sold in the financial year ended 30 June 2014, for an amount in excess of $100,000.

19. There was a material loss on the sale of The Vessel due to the:

• unexpected amount of time taken to sell The Vessel,

• maintenance costs of holding The Vessel,

• costs spent in developing and modifying The Vessel in the design, pre-production, production and post-production phases, and

• reduced value of vessels since the global financial crisis.

20. The Vessel was only used whilst showing and promoting it for sale to entice purchasers.

21. There has never been any private use of The Vessel.

Relevant legislative provisions

Income tax assessment Act 1997, section 8-1

Income tax assessment Act 1997, section 26-47

Income tax assessment Act 1997, subsection 26-47(2)

Income tax assessment Act 1997, subsection 26-47(3)

Income tax assessment Act 1997, Division 35

Income tax assessment Act 1997, subsection 35-10(2)

Income tax assessment Act 1997, subsection 35-10(2E)

Income tax assessment Act 1997, section 35-30

Income tax assessment Act 1997, section 35-35

Income tax assessment Act 1997, section 35-40

Income tax assessment Act 1997, section 35-35

Income tax assessment Act 1997, subsection 106-5(1)

Reasons for decision

Issue 1

Question 1

Will section 26-47 of the ITAA 1997 prevent the loss realised on the sale of The Vessel in the 2014 financial year being taken into account in determining the net income or loss of The Partnership under Division 5 of the ITAA 1936 for the year ended 30 June 2014?

Reason for decision

Section 8-1 of the ITAA 1997 provides a deduction for losses or outgoings to the extent that they are necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Does The Partnership vessel activity amount to carrying on a business?

The question as to whether a business is being carried on is a question of fact to be determined on a case by case basis. No single indicator is determinative and the determination is based on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551).

Taxation Ruling TR 2003/4 Income tax: vessel hire arrangements set out the relevant indicators for determining if a business is being carried on, these indicators are described as:

• significant commercial purpose or character,

• prospect of a profit,

• activities carried on in a similar manner to those of ordinary trade,

• organised, systematic, business-like manner

• repetition and regularity, and

• the size and scale of the activity.

Importantly paragraph 66 of TR 2003/4 states:

The indicators of a business [above] therefore, provide characteristics which indicate that an activity may amount to a business. However, they are only a guide. Whether a business being carried on is still determined based on the overall impression gained after looking at the activity as a whole and the intentions of the taxpayer undertaking it. Consequently, while no single indicator is determinative, the lack of significant commercial purpose and a prospect of profit will strongly influence the large or general impression gained to being that a business is not being carried on (see [Stone v. FC of T [2002] FCA 1492 at paragraph 68]).

The above indicators were considered with approval by Deputy President Hack in Peerless Marine Pty Ltd v. FC of T [2006] AATA 765 (Peerless Marine) at paragraph 69:

There was no real dispute about the legal principles involved. It was accepted on both sides that the question was one of fact. Mr Logan SC relied, in particular, upon the well-known passage from the judgement of Bowen CJ and Franki J in Ferguson v FCT (1979) 37 FLR 310 at p 314 where their Honours said:

"There are many elements to be considered. The nature of the activities, particularly whether they have the purpose of profit-making, may be important. However, an immediate purpose of profit-making in a particular income year does not appear to be essential. Certainly it may be held a person is carrying on business notwithstanding his profit is small or even where he is making a loss. Repetition and regularity of the activities is also important. However, every business has to begin, and even isolated activities may in the circumstances he held to be the commencement of carrying on business. Again, organization of activities in a business-like manner, the keeping of books, records and the use of system may all serve to indicate that a business is being carried on. The fact that, concurrently with the activities in question, the taxpayer carries on the practice of a profession or another business, does not preclude a finding that his additional activities constitute the carrying on of a business. The volume of his operations and the amount of capital employed by him may be significant. However, if what he is 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."

Following on from the successful promotion of your abilities using The First Vessel, The Vessel was built as a prototype for a 'built to order' line of vessels. The evidence suggests that significant effort was devoted to promoting your ability to produce custom made vessels using The Vessel. The Vessel was exhibited at several vessel shows and significant marketing activities were undertaken. You registered a business name, brochures were printed, business cards were made and The Vessel was demonstrated to a number of prospective customers.

It is quite evident from about the time of the global financial crisis that the activity you devoted to promoting your ability to produce custom made vessels began to decrease, culminating in the cancellation of your business name. It is considered that from around this time the nature of your vessel business changed from, promoting your ability to produce made to order vessels, to disposing of The Vessel to recoup some of the losses associated with the cessation of your earlier business venture.

In your case it can be seen from the history of the vessel activities undertaken by The Partnership the indicators provide the overall impression that a business was being carried on, especially up to the point of the global financial crisis. Your circumstances are analogous to those in Peerless Marine in that once it was concluded that it was not viable to continue the ongoing vessel making, business focus shifted to disposing of The Vessel in order to recoup your investment. It is accepted that at all times The Vessel was available for sale and as such constituted trading stock.

As such, it is accepted that your vessel activity amounted to the carrying on of a business.

Integrity measures relating to non-business vessel activities

Section 26-47 of the ITAA 1997 can operate to quarantine non-business vessel activity losses from being offset against assessable income from other (non-vessel) activities.

Specifically the rule in subsection 26-47(2) of the ITAA 1997 states:

This Act applies to you as if so much of the amounts relating to using or holding vessels that you could otherwise deduct for an income year as exceeds your assessable income from using or holding vessels for that year:

(a) were not deductible for that income year; and

(b) were an amount (a quarantined amount) relating to using or holding vessels that you can deduct for the next income year.

Subsection 26-47(3) of the ITAA 1997 provides four 'business use' exceptions to the rule in subsection (2) if the amounts attributable to holding vessels relate to:

• holding a vessel as your trading stock,

• using a vessel (or holding it) mainly for letting it out on hire in the ordinary course of a business that you carry on,

• using a vessel (or holding it) mainly for transporting the public or goods for payment in the ordinary course of a business that you carry on, or

• using a vessel for a purpose that is essential to the efficient conduct of a business that you carry on.

Importantly all of the business use exceptions contained in subsection 26-47(3) of the ITAA 1997 require a business to be being carried on by the entity wishing to offset vessel deductions against other assessable income.

As The Vessel was built with the intention of resale and has at all times remained available for sale it is your trading stock. It is also accepted that The Vessel has been an integral part of your business operation, especially prior to the onset of the global financial crisis.

For completeness, it should be noted that had the use of The Vessel changed from being held as trading stock, to being used for another purpose, such as a depreciating asset in another business activity or for private purposes the conclusion regarding the application of section 26-47 of the ITAA 1997 may be different. But given that you have told us that there has been no private use and it has always been your intention that the vessel would be sold for a profit it is accepted that the exceptions in subsection 26-47(3) of the ITAA 1997, relating to trading stock and using a vessel for a purpose that is essential to the efficient operation of your business, would apply. Because the exceptions in subsection 26-47(3) of the ITAA 1997 apply, the integrity measures in section 26-47 of the ITAA 1997 will not apply to quarantine losses from your vessel activity.

Conclusion

Based on the information you have provided the vessel activity of The Partnership amounts to the carrying on of a business. The Vessel was built as a prototype of what you could achieve and constituted trading stock for your vessel business.

As you were operating a vessel business the exceptions to the integrity rules in section 26-47 of the ITAA 1997 relating to non-business vessel activities do not operate to deny a deduction against other assessable income of The Partnership.

Question 2

Provided each partner individually satisfies the 'income requirement' in in subsection 35-10(2E) of the ITAA 1997, will Division 35 of the ITAA 1997 prevent a partner's share of the loss realised on the sale of The Vessel being deductible to the partner for the year ended 30 June 14?

Reason for Decision

Division 35 of the ITAA 1997 provides general integrity measures for non-commercial business losses. Broadly the rule in subsection 35-10(2) of the ITAA 1997 operates to quarantine non-commercial business losses from a business activity deferring them to such a time that they can be offset against profits from that business activity.

Subject to the individual partners meeting the 'income requirement' in subsection 35-10(2E) of the ITAA 1997, the loss deferral rule in subsection 35-10(2) of the ITAA 1997 will not apply to a business activity for an income year if the relevant business activity satisfies one of the following tests:

(i) The assessable income test (section 35-30 of the ITAA 1997) - assessable income from the business activity for the year is at least $20,000.

(ii) The profits test (section 35-35 of the ITAA 1997) - the business activity has been profitable in at least three of the last four years,

(iii) The real property test (section 35-40 of the ITAA 1997) - the value of real property used on a continuing basis in the business activity has a value of at least $500,000.

(iv) The other assets test (section 35-45 of the ITAA 1997) - the value of other assets, including trading stock, used on a continuing basis in the business activity has a total value of at least $100,000.

It is considered that your vessel business activity satisfies:

• the assessable income test, because The Vessel was sold for more than $20,000 and

• the other assets test because The Vessel is trading stock and has a value of at least $100,000.

It is important to note that while the losses may be available in the partnership, it would be up to the individual partners to determine if they meet the 'income requirement' before they ultimately offset any losses from The Partnership against their individual assessable income.

Paragraphs 5 and 6 of Taxation Ruling TR 2003/3 Income tax: Non-commercial Losses - application of subsection 35-10(2) and 35-10(4) of the ITAA1997 to business activities carried on in partnership state:

5. In accordance with the object of Division 35, where an individual taxpayer carries on multiple business activities in partnership, the correct application of subsection 35-10(2) is not one that looks at the result for the partnership as a whole. Therefore, subsection 35-10(2) should not be applied to such cases simply by using the amount of assessable income, or of the allowable deductions, the individual partner would calculate otherwise under section 92 of the ITAA 1936.

6. In a case of this type, for the individual taxpayer, any excess of their share of otherwise allowable deductions over their share of any assessable income, for each separate business activity, will be subject to the requirements of Division 35, and may be deferred under subsection 35-10(2) to the next year the activity in question is carried on.

While it is permissible to group similar business activities, as explained by paragraph 6 (and the note in paragraph 4) of TR 2003/3, where a partnership carries out multiple business activities, the integrity rules in Division 35 of the ITAA 1997 need to be applied to each non-similar partnership business activity separately, not to the net income of the partnership as a whole.

In the case of The Partnership it has been established that the loss deferral rule in section 35-10(2) does not apply to your vessel business activity. However, the losses from the vessel activity cannot simply be combined with other assessable income of The Partnership and distributed to each partner. Rather the look-through approach described in paragraph 3 of TR 2003/3 would apply, meaning each partner would need to satisfy the income requirement before they offset losses from The Partnership vessel business activity against their individual assessable income.

The income requirement is explained in paragraph 13A of Taxation Ruling TR 2001/14 Income Tax: Division 35 - non-commercial business losses in the following way:

The income requirement in subsection 35-10(2E) is met when, in a given income year the sum of the individual's taxable income, *reportable fringe benefits, *reportable superannuation contributions and *total net investment losses is less than $250,000. When calculating whether an individual has met the income requirement, they must disregard any excess deductions that are subject to Division 35.

Thus, provided the individual partners meet the income requirement, the integrity rules in Division 35 of the ITAA 1997 will not prevent any losses incurred by your vessel activity in 2014 from being offset against any other assessable income of the partners in The Partnership.

Conclusion

The general non-commercial business loss integrity rules in Division 35 of the ITAA 1997 will not operate to deny a deduction against other assessable income of the individual partners, subject to the individual partner meeting the income requirement.

Question 3

If the loss is not a business loss, will it be treated as a capital loss for the partnership?

Reason for decision

As explained above in question 1, it is accepted that your vessel activity amounts to the carrying on of a business and The Vessel was trading stock. The disposal of trading stock is inherently a revenue item. As such there will be no capital loss associated with the disposal of The Vessel.

For completeness it should be noted that, subsection 106-5(1) of the ITAA 1997, in relation to partnerships, states that:

Any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets is made by the partners individually.

Each partner's gain or loss is calculated by reference to the partnership agreement, or partnership law if there is no agreement.

Any capital loss associated with a CGT asset of The Partnership will be made by the partners individually, not The Partnership. Thus any losses not on revenue account will not be capital losses of The Partnership but may be capital losses of the individual partners, depending on the nature of the partnership as defined by the partnership agreement or partnership law. There is an exception to this general rule relating to CGT event K7 for balancing adjustments for depreciating assets for purposes other than taxable purposes. But in all other circumstances it would not be strictly correct the describe capital losses as a 'capital loss of the partnership'; rather the capital loss would be a loss of each partner individually.

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