Edited version of private ruling

Authorisation Number: 1011743515207

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Ruling

Subject: Non-Commercial Losses Special Circumstances

Question

Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) (lead time) to allow you to include any losses from your wine grape growing business in your calculation of taxable income for the years in question?

Answer

No.

Relevant facts

You are a partner in a partnership which operates a grape farm.

The partnership leased a property.

The property already had a small area of wine vineyard however, the grape varieties were of a poor quality, many of the vines were diseased and the majority of the trellising needed to be replaced. On the existing vineyard all vines were cut back to their base and grafted with high quality stock from neighbouring vineyards.

It is your aim to revive the existing run-down vineyard and expand the business into a commercial sized vineyard. You, the other partner and another party set about developing plans to expand the vineyard size, install water irrigation and plant top quality vine clones in all of the new blocks. In order to develop the vineyard up to full commercial capacity, it is planned to install approximately ten new vineyard blocks. This requires the land to be graded level, new trellising and vines installed and irrigation run out to all of the new blocks.

A water bore was drilled on the property and in the current income year irrigation will be completed to the three existing vineyard blocks. You also have access to a secured water licence for the property from an artesian bore which makes a vast amount available per year. The quality of the water is excellent.

Over the next 5 years, the blocks will be developed at a rate of 2 blocks per year in order to spread the capital cost. The entire vineyard is forecast to be producing fruit at full capacity in 9 years time. The plan for the business is to eventually be able to sell high quality fruit to premium wineries in the surrounding region that cannot produce sufficient quantity of their own grapes to meet market demand for their wine.

The selection of varieties of grapes will be re-assessed against market forces each season prior to planting being conducting. This strategy and the plan to plant a wide range of varieties, including some alternative varieties, will buffer the project from adverse market changes.

You have engaged another party to employ local manpower and plant hire equipment, operate the vineyard and proceed with the new vine plantings.

You and the other partner carried out detailed soil and hydrological investigations. These investigations demonstrated that the site had highly suitable soils, had adequate water that can be collected and stored and is in a proven area for high quality wine grape production.

The success of wine grape growing profitability relies on fruit sales. This can be facilitated with long term contracts with wineries. This will be your intention and local wineries are regularly consulted as to up-coming long term demands. As a result of a world-wide oversupply of wine, the pace of vineyard block development at your vineyard has been timed to match the forecast industry recovery and future market demand.

In consideration of the forecasted recovery of the global wine industry in the 2013-14 income year and the low level of current viticulture investment, the timing of your gradual increasing production levels should provide far stronger fruit marketability than currently experienced by poorly planned vineyards.

Your income for the 2009-10 income year from other sources was in excess of $250,000.

You have stated that you intend to stagger your plantings to save on capital costs and have the ability to choose a suitable vine based on current market conditions. You used a ready reckoner tool distributed by the Wine Federation Australia (WFA). The following variables were input into the ready reckoner:

· Planting of 10 hectares

· Land was already paid

· 0t/ha in year 1 & 2, 3-4t/ha in year 3, 5-6t/ha in year 4 and 9-10t/ha at full production; and

· Fruit prices based on $1,400 per tonne.

Using the above input data the ready reckoner projected that the project would be profitable in 9 years.

According to the Production guidelines for Australian table grape varieties Agricultural notes dated February 2002 "for most varieties it will take 4-5 years for vines to reach full production".

Relevant legislative provisions

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

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

Reasons for decision

Division 35 of the ITAA 1997 prevents losses from non-commercial business activities (being conducted by an individual or a partner in a partnership) being offset against other assessable income in the year the loss is incurred. The loss is deferred unless:

You satisfy the income requirement under subsection 35-10(2E) of the ITAA 1997 and pass one of the following four tests:

(a) at least $20,000 of assessable income in that year from the business activity (assessable income test)

(b) the business activity results in a taxation profit in three of the past five income years (profits test)

(c) at least $500,000 of real property, or an interest in real property, (excluding any private dwelling) is used on a continuing basis in carrying on the business activity in that year (real property test), or

(d) at least $100,000 of certain other assets (excluding cars, motor cycles and similar vehicles) are used on a continuing basis in carrying on the business activity in that year (other assets test) or

the Commissioner exercises his discretion (special circumstances or lead time) or

you meet the exception test (can only be met if the activity is a primary production or a professional arts business and your assessable income from that year from other sources that do not relate to that activity is less than $40,000).

The income requirement under subsection 35-10(2E) of the ITAA 1997 is met if the sum of the following is 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.

Losses that cannot be taken into account in a particular year of income, because of subsection 35-10(2) of the ITAA 1997, can be applied to the extent of future profits from the business activity, or are deferred until one of the tests is passed (including the income test under subsection 35-10(2E) of the ITAA 1997), the discretion is exercised, or the exception applies.

Are you carrying on a business?

Your activities will only be subject to these provisions if it is carried on as a business. You stated in your private ruling application that your activity was carried on as a business from 1 December 2008. This ruling is made on the basis of accepting this claim.

Application of section 35-55 of the ITAA 1997 (Commissioners discretion) to this arrangement

As your activities have commenced, and are carried on as a business, they are subject to the provisions in Division 35 of the ITAA 1997.

As you have failed the income requirement under subsection 35-10(2E) of the ITAA 1997 you cannot rely on passing one of the four tests outlined above.

You only have access to section 35-55 of the ITAA 1997 (under either special circumstances or lead time)

The first arm of the discretion in paragraph 35-55(1)(a) of the ITAA 1997 relates to special circumstances applicable to the business activity, and has no relevance for the purposes of this private ruling.

The second arm of the discretion in paragraph 35-55(1)(b) of the ITAA 1997 may be exercised for one or more income years where:

You have satisfied the income requirement under subsection 35-10(2E) of the ITAA 1997, and

(b)        the business activity has started to be carried on; and for those years:

(i)      because of its nature it has not satisfied, or will not satisfy, one of the tests set out in Division 35 of the ITAA 1997, and

(ii)     there is an objective expectation that the business activity of an individual taxpayer will either satisfy one of the tests or produce a taxation profit within a period that is commercially viable for the industry concerned.

As you have failed the income requirement, paragraph b, above, is not applicable.

The third arm of the discretion in paragraph 35-55(1)(c) of the ITAA 1997 may be exercised for one or more income years where:

you have failed the income requirement, and

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

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 greater than the deductions attributable to it for that year.

 The note to paragraphs b & c states:

Note: Paragraphs b & 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.

By asking the Commissioner to consider using his discretion under paragraph 35-55(1)(c) of the ITAA 1997 it is assumed that the activity has not produced or will not produce assessable income greater than the deductions attributable to it.

The type of feature contemplated by the phrase 'because of its nature', in the context in which it appears, is that referred to in the note quoted above. That is, that there is 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. This is borne out further by paragraph 1.51 of the Explanatory Memorandum for the New Business Tax System (Integrity Measures) Act 2000, which states:

This arm [paragraph 35-55(1)(b)] of the safeguard discretion will ensure that the loss deferral rule in section 35-10 does not adversely impact on taxpayers who have commenced to carry on activities which by their nature require a number of years to produce assessable income. Examples of activities which would fall into this category are forestry, viticulture and certain horticultural activities.

The note and the passage cited above do not support any view that the discretion should 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. Those sorts of constraints on being able to satisfy that test are far removed from the specific one referred to in the note and the Explanatory Memorandum.

The test to determine a commercially viable period is primarily an objective one based on independent sources. This approach was undertaken in the Federal Court case 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 with the industry produce material such as annual reports or industry papers…"

You have stated that you intend to stagger your plantings to save on capital costs and have the ability to choose a suitable vine based on current market conditions. You used a ready reckoner tool distributed by the Wine Federation Australia (WFA). The following variables were input into the ready reckoner:

· Planting of 10 hectares

· Land was already paid

· 0t/ha in year 1 & 2, 3-4t/ha in year 3, 5-6t/ha in year 4 and 9-10t/ha at full production; and

· Fruit prices based on $1,400 per tonne.

Using the above input data the ready reckoner projected that the project would be profitable in 9 years. According to the article "Production guidelines for Australian table grape varieties" Agricultural Notes dated February 2002, the commercially viable period for grapes is 4-5 years.

The fact that you have worked out a commercially viable period for your project using the ready reckoner is subjective and which was based on the data specific to your situation and not indicative of the industry as a whole.

In Scott v. Commissioner of Taxation [2006] AATA 542; Member Fice stated:

"the fact that a grower elects not to plant sufficient trees at the outset to ensure the business is commercially viable is a decision for that individual grower. Such a grower could not expect the Commissioner to exercise his discretion under s35-55 in his or her favour because, to do so, would effectively render nugatory the rule dealing with losses from non-commercial business activities"

The fact that you have chosen to stagger the planting of vines has a huge impact on how long it will take to make a taxable profit. You have chosen to stagger plantings to save on capital costs and to better choose varieties of vines to plant. You have also chosen to stagger your plantings to match the recovering wine market. The oversupply of grapes to the market is part of normal operations of the market. At times there is a shortage of grapes and other times there is an oversupply.

The commercially viable period for grapes is 4 to 5 years. The fact that you have chosen to take longer than this time frame cannot be taken into account in the Commissioner's decision.

We do not consider that there is anything inherent in the nature of your business activity that prevented you from being able to produce a taxable profit within 4 to 5 years of commencing the business.

In conclusion, the requirements of paragraph 35-55(1)(c) of the ITAA 1997 have not been met. Consequently, you are not eligible for the Commissioner's discretion for the years in question.