Edited version of private ruling

Authorisation Number: 1011807494112

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Ruling

Subject: Non-Commercial Losses Lead Time

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 fruit growing business in your calculation of taxable income for the 2009-10 to 2010-11 financial years?

Answer: No

This ruling applies for the following periods

Year ended 30 June 2010

Year ending 30 June 2011

The scheme commenced on

1 July 2000

Relevant facts

You purchased a property in 2000 with the intention of growing fruit.

You staggered the planting of the fruit trees over 4 years.

You failed the income requirement under subsection 35-10(2E) of the ITAA 1997 in the 2009-10 financial year and you have stated that you will also fail the income requirement in the 2010-11 financial year.

You expect to make a tax profit in 2011-12.

According to a letter you supplied by an industry expert, the typical lead time for fruit trees is 4 years until the first commercial harvest, with maximum production coming in years 6-7.

Relevant legislative provisions

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

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

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

Reasons for decision

From the 2009-10 financial year, the non-commercial loss (NCL) legislation has been amended to include an income requirement. The four NCL tests are only available to taxpayers who meet the income requirement.

Consequently, if the income requirement is not met, the taxpayer must defer their business loss unless the Commissioner exercises a discretion. A discretion is only available in certain circumstances.

The income requirement under subsection 35-10(2E) of the ITAA 1997 is satisfied if your income for non-commercial loss purposes is less than $250,000. In your case, you do not meet the income requirement. Therefore, your losses from your fruit growing activity for the 2009-10 and 2010-11 financial years must be deferred unless a discretion is exercised.

The discretion that is relevant in your circumstances is provided by paragraph 35-55(1)(c) of the ITAA 1997. This states that the Commissioner may decide that the loss deferral rule in subsection 35-10(2) does not apply to a business activity for one or more income years (the excluded years) if the Commissioner is satisfied that it would be unreasonable to apply that rule because the business activity has started to be carried on and, for the excluded years:

1. because of its nature, it has not produced, or will not produce, assessable income greater than the deductions attributable to it; and

2. 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)).

Therefore, in order to exercise the discretion, the Commissioner must be satisfied that there is an objective expectation, based on evidence from independent sources, that your business activity will produce a tax profit within a commercially viable period.

Also, for the Commissioner to exercise the discretion, you must be able to show that the reason your business activity is producing a loss is inherent to the nature of the business and is not peculiar to your situation.

The phrase 'objection expectation' was discussed in the Administrative Appeals Tribunal case of Scott v. Commissioner of Taxation [2006] AATA 542; VS2005/31-33 (Scott), 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.

Further, in the case of Scott, additional plantings made at a later time were not permitted to be included in the commercially viable period, as follows:

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 s 35-55 in his or her favour because, to do so, would effectively render nugatory the rule dealing with losses from non-commercial business activities.

The sole reliance on objection 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.

Further, the Explanatory Memorandum provides the following relevant examples:

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 tax 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 the 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.

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.

You commenced your fruit growing business in 2000. You staggered planting the fruit trees over 4 years. Since the business has commenced you have made losses and you project you will continue to make losses until the 2011-12 financial year when you predict you will make a tax profit.

It is accepted that it is in the nature of your business activity to require a lead time before it produces a tax profit. However, there must also be an objective expectation this lead time is within a period which is commercially viable for this industry. You have predicted that you will not make a tax profit until the 2011-12 financial year. For the purposes of addressing this point, subjective considerations, such as staggering the planting of the fruit trees over four years, are not relevant.

Your decision to delay planting the fruit trees until up to three years after the initial planting would have impacted on the length of time required before your business will make a profit. These are individual circumstances affecting your activity rather than an inherent characteristic of the industry.

You predict that your business will not produce a tax profit until the 2011-12 financial year, or in the twelfth year of operation. It is considered that the fact that your activity will require 12 years for it to become profitable is not simply a result of the nature of the activity. Rather your individual circumstances have impacted on the length of time required before a tax profit is made in your case.

You have provided independent evidence from an industry expert who states 'The typical lead time for fruit trees is 4 years until the first commercial harvest, with maximum production coming in years 6-7'.

It would be expected that for a business to be commercial, it would be making a tax profit when it reached, or shortly after it reached, full production. You will not be making a tax profit until 5 or 6 years after full production would be expected. You have not provided any evidence to show that the commercially viable period to make a tax profit for your industry is 12 or more years. That is, you have not shown that your business activity will make a tax profit within a period that is commercially viable for your industry.

Therefore, the Commissioner will not exercise the discretion under paragraph 35-55(1)(c) of the ITAA 1997 and the losses from your business will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997 in the 2009-10 and 2010-11 financial years.