Edited version of private ruling

Authorisation Number: 1011595553039

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Ruling

Subject: Non-commercial losses - Commissioner's discretion - Special circumstances/Lead time

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 beef cattle farming activity in your calculation of taxable income for the 2009-10 and 2010-11 income years?

No.

2. Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of the ITAA 1997 to allow you to include any losses from your beef cattle farming activity in your calculation of taxable income for the 2009-10 and 2010-11 income years?

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2000

Relevant facts

Your employment and trust income is in excess of $250,000 in the 2008-09 income year. It is estimated that you will have primary production losses for the 2009-10 and 2010-11 income years.

The primary production activity of breeding and selling cattle as weaners, was initially conducted through a partnership with your spouse starting in 2000-01 and since 2007-08 is conducted by you as an individual.

You have undertaken a farm improvement program over a period of time.

The enterprise is also subject to a share farming arrangement with third parties.

In recent years the property has been heavily stocked due to high propagation rates. As a result feed costs have increased and some calves have been marketed early. Further, high quality breeding stock has been purchased to improve the quality of the general stock population.

An amount of money was spent buying stud cattle, male and female to establish a stud and to improve the genetics of the herd. The progeny will be available for sale in the 2010-11 year.

You have increased the herd from 2001 to 2010. There are over 400 breeders. Weaner sales have increased, with prices increasing from $270 to $480 per head. You sold some cattle in the 2008-09 income year, with a similar outcome expected for 2010.

The total value of real property for non-commercial losses purposes would be in excess of three million dollars.

Income and expenses figures show substantial losses from the 2000-01 to 2009-10 years and forecasts indicate a profit will not be made until the 2011-12.

You have provided evidence from reliable sources to support the extent of drought during this period.

Relevant legislative provisions

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

Summary

It is considered that there are not special circumstances in the 2009-10 income year that would allow the Commissioner to grant a discretion under subsection 35-55(a)(1) to include any losses from your beef cattle farming activity in your calculation of taxable income.

The Commissioner cannot exercise his discretion under subsection 35-55(1)(c) of the ITAA 1997 to include any losses from your beef cattle farming activity in the calculation of your taxable income for the 2009-10 and 2010-11 years as there is not an objective expectation that the activity will produce assessable income greater than the deductions attributable to it within a commercially viable period.

Detailed reasoning

For the non-commercial losses rules to apply to an individual they have to be carrying on a business for taxation purposes. It is accepted that you are carrying on a business. The effect of the non-commercial losses legislation is to restrict the circumstances where a business loss can be offset against other income.

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 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. The 'special circumstances' legislation has had no changes, but with the 'lead time' legislation there is a new paragraph 35-55(1)(c) of the ITAA 1997 with a new discretion 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).

Special circumstances

The Commissioner's discretion in paragraph 35-55(1)(a) of the ITAA 1997 may be exercised for the income years in question where the business activity is affected by special circumstances outside the control of the operator of the business activity.

You have asked the Commissioner to consider special circumstances such as drought, the nature of farming activities and the difficulties faced by farmers in deriving profits. Further, you ask the Commissioner to consider your individual circumstances and the difficulties faced in meeting the new Income Requirement Test.

The individual circumstances in meeting the income requirement test are not considered to be special circumstances that can be considered for the purposes of the Commissioner giving a discretion under paragraph 35-55(1)(a) of the ITAA 1997. This is not something that impacts on the business activity itself.

The general issue of the nature of farming activities and the difficulties faced by farmers in deriving profits are not considered to be special circumstances in terms of this subsection.

The impact of drought can be considered to be special circumstances in a cattle breeding business, but we have to consider the extent of the drought in each year and see what impact it had on the business activity. A discretion for the 2010-11 income year could not be considered at this time as the conditions for that year are not known and cannot be predicted.

In the 2009-10 income year the rainfall records indicate a substantial improvement in the amount of rainfall received with an indication of a possible above average rainfall in that year. In the forecast financial figures you have provided, there does not appear to be any impact on the number of cattle sold in the 2010 year with a similar number of head being sold. The income and expenditure figures are similar to previous years and there is no excessive amounts shown for fodder expenses. The losses in the 2010 year are not being caused by the impact of drought, they relate more to the way the business has been developed and expanded over a period of time.

It is considered that there are not special circumstances in the 2009-10 income year that would allow the Commissioner to grant a discretion under subsection 35-55(a)(1) of the ITAA 1997 to include any losses from your beef cattle farming activity in your calculation of taxable income.

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, but 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 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.

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 to apply the losses against other income. However, 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 paragraphs of TR 2007/6 Income tax: non-commercial losses: Commissioner's discretion is 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 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.

Income tax legislation.

Paragraph 35-55(1)(c) of the ITAA 1997 for an applicant who carries on the business activity who does not satisfy subsection 35-10(2E) of the ITAA 1997 (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.

The phrase 'objective expectation' was discussed in the Administrative Appeals Tribunal case of Scott v. Commissioner of Taxation [2006] AATA 542; VS2005/31-33, where it was said:

…in determining a commercially viable period, the test is primarily an objective one based on independent sources. According to the Commissioner, this approach was taken by the Federal Court in Commissioner of Taxation v Eskandari (2004) 134 FCR 569 where Stone J said, at 581-582:

In some cases it may be a straight forward exercise to identify the industry in which the business activity takes place. Some industries are well-established and the basis for an ''objective expectation'' can readily be based on a comparison between the tax payer's business and other businesses within that industry, particularly where businesses or business associations within the industry produce material such as annual reports or industry papers ...

Despite what Stone J said, Mr Scott contended that there were other circumstances which had to be taken into account when determining the commercially viable period expressed in the Olives Australia document. However, according to the Commissioner, this is impermissible because, as the Federal Court held in Eskandari, in most cases only objective material will be considered. It is only where, because of the nature of the industry, there is very little or no objective evidence that recourse may be had to the circumstances of the tax payer. That is not the case in the olive industry, which has been established for centuries. I agree with that submission. It seems to me that if it were permissible to take into account subjective considerations of each individual grower, there might be an almost infinitely variable period which could be described as the commercially viable period. [emphasis added]

The sole reliance on objective evidence and the impermissibility of subjective considerations was further emphasised in the Explanatory Memorandum to the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 as follows:

2.30 The taxpayer is required to establish objectively that the business is commercial in nature and will become profitable in a commercially viable timeframe. Objective evidence from independent sources can include evidence from an individual or organisation experienced in the relevant industry, such as industry or regulatory bodies, tertiary institutions, industry specialists, professional associations, government agencies or other independent entities with a similar successful business activity. Evidence from independent sources can also include evidence from business advisers (such as business plans), financiers and banks.

2.34 For taxpayers that do not meet the income requirement, the Commissioner may exercise a discretion after an application by a taxpayer, where the Commissioner is satisfied that - based on evidence from independent sources - the business will produce assessable income greater than available deductions, in a timeframe that is considered commercially viable for the industry concerned.

2.35 The discretion is not intended to be available in cases where the failure to make a profit is for reasons other than the nature of the business, such as, a consequence of starting out small and needing to build up a client base, or business choices made by an individual that are not consistent with the ordinary or accepted practice in the industry concerned - such as the hours of operation, location, climate or soil conditions, or the level of debt funding.

Example 2.5

Tracey carries on a business of primary production from breeding and selling cattle. Their profit projections indicate that they do not expect to make a profit for six years.

Independent evidence provided by Tracey indicates the lead time period begins from the commencement of the activity and includes the time taken to raise females to a breeding age, allowing for the gestation period of those animals to finish, and finishes when the progeny have reached a saleable age. On the evidence provided, the period for a typical business activity of breeding and selling cattle to become commercially viable is no greater than three years. Therefore, Tracey will not be able to produce a tax profit within a period that is commercially viable for the industry concerned and the Commissioner will not be able to exercise the discretion to allow the losses.

Example 2.6

Joe earns in excess of $250,000 and has a substantial rural property which he and his wife visit most weekends. The property has a family residence and sheds and, apart from one area of the property where a few goats are kept, is otherwise developed with nut trees.

Joe planted a large number of nut trees on the land in 2007, and has been claiming his losses from this activity, having passed the real property test in prior years. As his income is higher than $250,000, Joe applies to the Commissioner seeking the exercise of the discretion in new paragraph 35-55(1)(c) to allow him to access his losses in 2009-10.

In support of his application, Joe provides a letter from the secretary of the Nut Tree Growers' Association that states that yields from that number and type of trees would ordinarily be sufficient to allow Joe to make a profit within about six years. This is the industry norm for growers of that type of nut tree. However, because the soil on the property is not very fertile and the site does not get a lot of sun, Joe accepts that the lead time for his particular nut-growing activity will be nine years not six years. Joe otherwise manages his nut tree orchards in accordance with industry management practices.

Having examined the case, the Commissioner concludes that, despite the large number of trees on the property and the fact that the business is being conducted in accordance with industry management practices, the discretion should not be exercised in Joe's favour. This is because the lead time for this activity to become profitable is greater than the industry norm: the failure to make a profit within a commercially viable period is due to factors that are peculiar to Joe's local environment. Despite the fact that these factors are out of Joe's control, and the fact that the activities are otherwise carried on in a commercially viable way, the excessive lead time before making a profit for Joe's activities are caused by the poor soil quality and lack of sunlight. The Commissioner does not exercise the discretion in Joe's favour because there is an excessive lead time before making a profit, when compared to other businesses in the industry.

Application to your situation

Your business activity consists of breeding cattle and selling the offspring as weaners. The lead time period begins from the commencement of the activity and includes the time to acquire the females to breed from, allowing for the gestation period, and finishes for when the progeny have reached a saleable age. The period for a typical business activity of breeding and selling cattle as weaners to become commercially viable is no greater than three to four years.

Your business activity commenced with the purchase of the first property in the 2001 year. The herd has been increased from 2001 to 2010 year. When the property was purchased in 2001 it was in a run down, relatively unproductive state. You purchased the adjoining property in 2003 and commenced a farm improvement program. The area was subject to drought in the 2001 to 2003 years and you had to buy feed to keep cattle alive.

The income that has been produced by your cattle activity is evidence that you have been in a position to produce substantial assessable income for a period of time with substantial cattle sales since the 2009-04 income year. Substantial losses have been made in each of these years.

As explained above, there would have to be an objective expectation that you could produce a profit within four years of commencement, which would be the 2004-05 income year. This has not occurred and from your projections a profit will not be made until the 2011-12 income year, some 11 years since the commencement of the business.

Even if we consider the possible interaction between the special circumstances discretion and the lead time discretion it may be possible that the drought period from 2001 to 2003 could extend this commercially viable period out to the 2008 year, by allowing an extra three years. The information that you have provided indicates that a profit will not be made until the 2012 year. This is well outside the possible extended commercially viable period. The longer period of time for you to be able to produce a profit would appear to relate to the particular way you have gone about your activity. The property was purchased in a run down state. You then purchased another neighbouring property. Expenses have been increased by the amount of the improvements that were required and the overall borrowing to meet capital expenses. Further capital has been invested into the activity with the introduction of the stud cattle.

The Commissioner cannot exercise his discretion under subsection 35-55(1)(c) of the ITAA 1997 to include any losses from your beef cattle farming activity in the calculation of your taxable income for the 2009-10 and 2010-11 years as there is not an objective expectation that the activity will produce assessable income greater than the deductions attributable to it within a commercially viable period.