Edited version of private ruling

Authorisation Number: 1011485677124

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Ruling

Subject: business set up costs

1. Are the costs of your equipment an allowable deduction?

No.

2. Are the costs of your courses an allowable deduction?

No.

3. Are you entitled to a deduction for your home office and home rental costs?

No.

4. Are the costs incurred for your internet and phone an allowable deduction?

No.

5. Are you entitled to other items purchased when you have not commenced earning assessable income in your business?

No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

You decided to research, develop and create your own business.

You have several years experience in the relevant area. You were made redundant and are currently not employed and receiving Centrelink benefits.

You have no savings and decided to develop the business slowly.

You decided to launch part of the business while you were saving to get the other relevant certificates.

You purchased equipment for more than $5,000.

You purchased computer software.

Shortly afterwards you contracted an illness and were unwell for several months.

During this time you continued to develop the business and attend some of the short courses that you needed to do.

You paid for a course in 2010.

You also purchased resources, material, office supplies and internet domain website hosting.

You paid for an agency fee.

You have spent money on relevant equipment and supplies.

You had further health problems. As a result you spent time in hospital.

You have spent money on internet and mobile phone contracts.

You have registered the business with Yellow Pages and obtained an ABN and certificate of registration of business name.

You used a room of your rented house as an office, which is also a store room for the equipment. This office, which is approximately 20% of the total house area is deadlocked when not in use.

There are a number of people living in the house and you pay your share of the electricity, internet, landline phone and mobile phone bills.

Due to your health you are uncertain if or when you will be able to launch the business. You are hoping to have the business running by late 2010.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Division 40.

Income Tax Assessment Act 1997 Section 40-25.

Income Tax Assessment Act 1997 Section 40-880.

Reasons for decision

Summary

As your business income producing activities have not yet commenced, you are not entitled to a deduction for costs incurred in the 2009-10 income year. The expenses are incurred at a point too soon.

Detailed reasoning

Commencement expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. Federal Commissioner of Taxation (1958) 100 CLR 478; (1958) 11 ATD 404; (1958) 7 ATR 166)

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin N.L.Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; (1956) 11 ATD 147; (1956) 6 AITR 379; Federal Commissioner of Taxation v. Hatchett (1971) 125 CLR 494; 71 ATC 4184; (1971) 2 ATR 557).

Generally, the expenses connected with the acquisition, establishment and enlargement of a business or with the acquisition of fixed capital assets are not deductible under section 8-1 of the ITAA 1997.

The costs of establishing a business are not considered as a cost of carrying on the business for the purpose of gaining or producing assessable income, unless it is an operating expense.

This is supported by the comments of Menzies J in John Fairfax and Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346:

To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income; such a payment in the case of a trading company, occurs at a stage too remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense.

Expenses associated with the establishment or purchase of a business, are incurred at a point too soon to be regarded as being incurred in carrying on the business.

There are some costs that may be allowed prior to income earning activities. Taxation Ruling TR 2004/4 discusses the issue of deductions for interest expenses incurred prior to the commencement of the relevant income earning activities.

Paragraph 9 of TR 2004/4 states, it follows from Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities

· the interest is not private or domestic

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

While Steele's case deals with the issue of interest, the principles can be applied to other types of holding expenditure.

In your case, your expenses were for no other purpose than to produce assessable income in the form of the operation of a business, however, due to your health, continuing efforts to commence your business have not occurred.

We acknowledged that many of the expenses incurred were not for a private or domestic purpose. However, there is uncertainty as to when you will commence the earning of assessable business income. Therefore, the period between the incurring of the expenses and the earning of your assessable business income is too remote and come at a point too soon to be an allowable deduction.

As all the conditions set out in TR 2004/4 for the allowance of a deduction incurred prior to the commencement of the income-earning activity have not been met you are not entitled to claim a deduction for your associated business expenses incurred under section 8-1 of the ITAA 1997.

Equipment

Equipment is generally regarded as capital assets. Expenses of capital, or of a capital nature, cannot be claimed as a deduction under section 8-1 of the ITAA 1997.

An expense will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205; (1926) 10 TC 155).

Division 40 of the ITAA 1997 creates specific deductions for items that may be capital or capital in nature provided they are depreciating assets.

A depreciating asset is an asset with a limited affective life that is reasonably expected to decline in value over time. Your equipment is regarded as a depreciating asset for tax purposes.

Under Division 40 of the ITAA 1997 you may claim deductions for the decline in value of depreciating assets that you hold, to the extent to which you use the assets for a taxable purpose. The amount of your deduction is determined by the cost of the asset, its effective life and the percentage of taxable purpose the asset is used for.

In your case, your equipment has not been used to produce assessable income, that is, it has not been used for a taxable purpose. A deduction for the decline in value (depreciation) can only be claimed to the extent that the asset has been used for a taxable purpose (subsection 40-25(2) ITAA 1997). Therefore, no deduction is allowed for the 2009-10 income year.

However, should you start to use your equipment for income producing purposes, the relevant decline in value of your depreciating assets is an allowable deduction. For more information in relation to calculating any allowable deduction for depreciating assets in future years, please refer to the Guide to depreciating assets (NAT 1996) available on the Australian Taxation Office website www.ato.gov.au.

Self education expenses

Self education expenses are deductible under section 8-1 of the ITAA 1997 where they have a relevant connection with your current income producing activities.

Taxation Ruling TR 98/9 sets out the Commissioners view on self- education expenses.

Self education expenses are deductible under section 8-1 of the ITAA 1997 if:

· they have a relevant connection to your current income-earning activities

· your income earning activities are based on the exercise of a skill or some specific knowledge and the subject of self education enables you to maintain or improve that skill or knowledge, and

· the study of a subject of self education objectively leads to, or is likely to lead to, an increase in your income from your current income-earning activities in the future. However, it should be noted that such a finding is not a prerequisite for deductibility.

A deduction is not allowable if the education is designed to enable you to get employment, to obtain new employment, or to open up a new income producing activity. The expenses are incurred at a point too soon to be regarded as incurred in gaining or producing assessable income.

In your case, you cannot claim deductions for the expenses in doing your courses. The expenses were incurred prior to commencing your relevant income earning activity. They were incurred to allow you to start your new income earning activity.

That is, the expense was not incurred in gaining or producing your assessable income or in carrying on a business to gain or produce your assessable income. The expenses were incurred before the income earning activity and at a point too soon.

Home office

For a deduction to be allowable for home office expenses, the expenses must satisfy the requirements of section 8-1 of the ITAA 1997.

Normally, expenses associated with a person's home are private or domestic in nature, and therefore do not qualify as an allowable deduction (Handley v FC of T 81 ATC 4165; (1981) 11 ATR 644; and FC of T v Forsyth 81 ATC 4157; (1981) 11 ATR 657).

However, where the home is used for income producing activities and has the character of a 'place of business', a deduction may be allowable for a portion of 'occupancy expenses' such as rent and 'running expenses' such as electricity charges for heating and lighting (Taxation Ruling TR 93/30).

If the home office is used in connection with the person's income producing activities, but does not constitute a 'place of business', only a proportion of the running expenses are allowable.

Taxation Ruling TR 93/30 sets out the criteria to be considered in determining whether a home office is a 'place of business'. Whether an area of the home has the character of a place of business is a question of fact.

Where a room in a house is used for storage and doing office work, it is not generally considered to be a place of business.

Although the area in which you operate your home office is a room set aside exclusively for work purposes, your third bedroom is not regarded as a place of business. Therefore, no amount of your rental expenses is an allowable deduction.

Furthermore, as you do not currently carry out any income producing business activities in your home office, you are not entitled to deductions for the running expenses such as electricity.

Given, however, that you may perform income-producing activities in a separate room in your house in the future, you are entitled to deductions for the running expenses such as electricity attributable to the income-producing activities in this room, once your income producing activities commence.

The amount that you are entitled to claim is the difference between what was actually paid for electricity such as lighting and what would have been paid had you not worked from home.

You may calculate your allowable deduction based on actual expenses. The appropriate formula for calculating the additional electricity expenses is set out in TR 93/30 at paragraph 24. Alternatively, the Commissioner accepts a deduction calculated at the rate of 26 cents per hour for the time when you use the room exclusively for work related purposes. This rate covers home office running expenses for electricity and the decline in value of office furniture.

The Commissioner does not consider an apportionment based on floor area as appropriate in calculating your work related home office running expenses. Different parts of a house require different amounts of electricity. As stated above it is only the additional costs in using your room at home for income producing purposes that is allowed as a deduction.

The number of hours the home office is used for income producing purposes during a year must be based from a diary showing the business related use of the home office for a representative four week period during the year. Copies of electricity bills are not sufficient evidence to calculate any business related portion.

Please ensure for future years sufficient documentation is kept to calculate the correct income producing portion. That is, a diary should be kept for four weeks showing the number of hours you use your home office for income producing purposes.

Internet expenses

A deduction is allowable for the income producing portion of the costs of an internet service provider under section 8-1 of the ITAA 1997.

As you have not started to earn income from your business as yet, no deduction is allowable for your internet rental or internet domain website hosting.

Please note for future years, a reasonable estimate of income producing internet use may be based on diary entries of internet use made over a period of one month, together with the relevant accounts will be acceptable for substantiation purposes.

Copies of your internet bills alone is not sufficient evidence for calculating any business related use. When you commence business, you need to keep a diary or evidence to support your business related percentage. The diary should show your business use as well as your private use and use by other people to accurately calculate the business percentage.

Telephone costs

The cost of telephone calls directly related to your income producing activities is an allowable deduction under section 8-1 of the ITAA 1997. However, the rental costs of a home telephone have a private or domestic character and are not an allowable deduction under section 8-1 of the ITAA 1997.

In your case, as you have not commenced your income producing business activities, no deduction is allowable for your landline or mobile phone costs.

When you commence your business, your business related calls may be identified from an itemised telephone account. If such an account is not provided, a reasonable estimate of call costs, based on diary entries of calls made over a period of one month, together with relevant telephone accounts is acceptable for substantiation purposes. Please note, that dividing the total bill by the number of people in your house or your share is not acceptable substantiation for claiming any business related calls.

Other expenses

Office supplies, material, equipment and agency fees are not connected to your current assessable income and are incurred at a point too soon to be an allowable deduction. The items were purchased in the 2009-10 income year when you did not earn any assessable business income. Therefore, no deduction is allowable for these costs.

Black hole expenditure

Capital expenditure that is not otherwise deductible (black hole expenditure) and relates to a business that is proposed to be carried on for a taxable purpose may be deductible under section 40-880 of the ITAA 1997. However, section 40-880 specifically denies a deduction for costs of a depreciating asset.

In your case, your expenditure relates to either depreciating assets or non deductible revenue items. Section 40-880 of the ITAA 1997 does not apply to such costs. Therefore, no deduction is allowable under this provision.

Conclusion

We acknowledge that your have spent a lot of time and money in setting up your business. However, as you have not commenced to earn assessable income from your activities, the expenses are not an allowable deduction.

As your business income earning activities have not yet commenced and your expenses are not allowable in the 2009-10 income year, there is no provision by which the losses could be carried forward and/or recouped in future years.

Once you begin to earn assessable income from the business, your business related expenses incurred after that point will generally be an allowable deduction. Where an expense relates to both business and private purposes, only the income producing portion is an allowable deduction.