Edited version of private ruling

Authorisation Number: 1011808385458

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Ruling

Subject: non-commercial losses

Question

Will the Commissioner exercise the discretion under paragraph 35-55(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your primary production activity in your calculation of taxable income for the 2009-10 financial year?

Answer: No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced in

1989

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· your previous private rulings,

· correspondence, and

· cash flow for years ended 30 June 2010 to 30 June 2014,

You commenced breeding animals in 1989. Since then you have bred hundreds of animals. You have concentrated on hybrid vigor to develop a commercial animal displaying superior carcass qualities, confirmation and temperament.

By the end of the 1990s you had over 100 breeders. Between 1999 and 2003 due to the drought and lack of fodder you had to sell animals until the numbers were reduced to about ten breeders. Since then you had been rebuilding the numbers. You have stated that the rebuilding process is very slow.

You advised that a animal cannot breed before it is about 20 to 24 months old and will be about 30 to 33 months when it has its first produce.

The saleable age of commercial progeny is 12 to 18 months. The saleable age of stud progeny is two and a half to three years.

You have recently started to establish a different breed. You purchased an additional property in 2008 to help establish the breed.

You purchased three of the new breed approximately five years ago and another one was purchased two years ago. One animal has since died and been replaced.

In addition to the above stock you purchased seven more animals two and a half years ago. All nine animals have produced at least once, and are pregnant again.

Embryos were purchased from overseas about three years ago for breeding purposes but you could not implant the embryos earlier because you did not have the necessary facilities. The embryos are very sensitive to light. You have the proper facilities now and had the embryos implanted in 2010 by a vet who specialises in this work.

You expect to ultimately have over 300 animals and to be able to sell at least 200 a year, but you advise that it will take time to get to this stage.

You already have animals being born over the coming weeks.

The long-term activity has been to develop a superior commercial product based on crossbreeding. The current venture is to breed animals to enhance your commercial herd so that the other breeders can see the benefits of introducing new blood into their own commercial animals. You also intend to import different blood lines to augment the limited lines presently available in Australia so you can sell to other breeders wishing to expand their genetic base.

You joined an animal association approximately three years ago and since 2008 you have been on the association's executive committee. You have also formed a loose association with a number of breeders in your area in order to expand. This group meets on a regular basis to assess ways of improving sales.

In the current year you have spent a considerable amount of money on fixing the run down property and this includes the purchase of new yards and other assets. You have also undertaken considerable repairs and maintenance to fences, buildings and equipment.

Your farming activity operates on multiple properties. When you first started you had 120 acres. Now you have approximately 1,400 acres in total.

The animals feed on all properties depending on the available pastures and feed conditions.

The original animals use traditional breeding methods while the new breed use artificial insemination and has new state of the art equipment.

Your spouse undertook an artificial insemination course some years ago and it was anticipated that she would use that skill in breeding.

However your spouse is ill and is unable to be help out with the business.

In about 2003, you retained the services of a successful local farmer with over 30 year's experience in the industry, as a part-time manager to assist you in the conduct of your business and the marketing of your animals, due to the hard times all breeders were experiencing.

You state that you have been frustrated in your efforts to make a profit due to the depressed prices caused by producers flooding the market with animals that they can not feed. Also the strong Australian dollar has forced exporters to sell locally, and at a discounted price.

The breaking of the drought is allowing you to increase the size of your animal numbers by buying in animals of breeding age from other producers. This allows the numbers to grow much faster than simply relying solely on progeny bred by you.

You hope that within the next five years you will be able to turn-off approximately 100 animals per annum at 18 months, and to double that output within eight years.

You have forwarded a letter from an industry expert who states that to achieve a top producing commercial business takes approximately eight years. Most breeders would not be able to achieve an income successfully for eight to ten years, and that for anyone undertaking to set up a viable business, it is going to be about a ten year program.

You have made losses for the last ten financial years.

You predict a taxable profit in 2013-14 financial year.

You have been approached by another entity to purchase one of your properties. If this sale happens, this will reduce your liabilities and you may be profitable before this. This property has considerable value, but less commercial value in terms of operating your enterprise due to its smaller size and immediate proximity to city A.

Once you have sold this property, you will have sufficient operating capital to be able to buy substantial number of animals with a view of turning off 20 to 30 each two months.

You are intending to diversify the nature of your operation. To date you have only traded your own animals. You propose to purchase animals from third parties.

Current prices are high in the domestic market. It is expected that the domestic prices will remain high all year, however the export market does not look favourable because of the high Australian dollar.

You are therefore concentrating on domestic trade.

You do not satisfy the income requirement under subsection 35-10(2E) of the ITAA 1997.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 Subsection 35-10(4).

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 35-45.

Income Tax Assessment Act 1997 Section 35-55.

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

Reasons for decision

Summary

It is considered that the length of time your primary production business requires to make a tax profit is not simply a result of the nature of the activity. Rather your individual circumstances, for example, the ongoing development of your business and your decision to have a new breed commence a few years ago, have substantially affected the period that will elapse before a tax profit is made.

Also, you have been unable to provide objective evidence of the commercially viable period to make a tax profit for your type of activity. Without this information the Commissioner is not able to conclude that the 23 years your activity will take from commencement to the achievement of a tax profit is 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.

Detailed reasoning

Division 35 of the ITAA 1997 applies to losses from certain business activities. Under the rule in subsection 35-10(2) of the ITAA 1997, a loss made by an individual (including an individual in a general law partnership) from a business activity will not be taken into account in an income year unless:

· the exception in subsection 35-10(4) of the ITAA 1997 applies,

· you satisfy subsection 35-10(2E) of the ITAA 1997 and one of four tests in sections 35-30, 35-35, 35-40 or 35-45 of the ITAA 1997 are met, or

· the Commissioner exercises the discretion in section 35-55 of the ITAA 1997.

Business activity

Your activity will only be potentially subject to Division 35 of the ITAA 1997 if it is carried on as a business. In your case, you advise that your primary production activities are carried on as a business.

Exception

Under subsection 35-10(4) of the ITAA 1997, there is an exception to the general rule in subsection 35-10(2) of the ITAA 1997 where the loss is from a primary production business activity or a professional arts business activity and the individual taxpayer has other assessable income for the income year from sources not related to that activity, of less than $40,000 (excluding any net capital gain).

In your case, the exception in subsection 35-10(4) of the ITAA 1997 has no application.

Subsection 35-10(2E) of the ITAA 1997

The income requirement in subsection 35-10(2E) of the ITAA 1997 applies from 1 July 2009 and will be met where the sum of the following amounts for an income year is less than $250,000:

· taxable income (ignoring losses subject to the non commercial loss rules)

· reportable fringe benefits

· reportable superannuation contributions

· net investment losses

You have advised that you do not satisfy subsection 35-10(2E) of the ITAA 1997.

Therefore as you do not satisfy the income requirement and the exception does not apply, the losses from your activities will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997, unless the Commissioner exercises a discretion under section 35-55 of the ITAA 1997.

For an applicant who carries on a business activity and does not satisfy subsection 35-10(2E) of the ITAA 1997 for the most recent income year ending before the application is made, paragraph 35-55(1)(c) of the ITAA 1997 states 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:

(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.

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 assessable income greater than the deductions attributable to it for that year, 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's case) 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 Scott's case, 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.

Paragraphs 84 and 85 of Taxation Ruling TR 2007/6 state:

The Commissioner needs to be satisfied that there is an objective expectation that the business activity will satisfy a test or produce a tax profit in some future income year falling within a period that is commercially viable for the industry concerned. If the business activity is not expected to satisfy a test or produce a tax profit within this period then the discretion will not be exercised.

The objective expectation does not have to be held by, or attributed to, a particular person. The Commissioner need only be satisfied that, based on the available supporting material, an objective expectation exists.

In your case, you commenced your primary production activity in 1989. You have since bought further properties and have applied significant resources towards improving the property.

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. For the purposes of addressing this point, subjective considerations, such as the condition of property at purchase, location, climate, soil conditions or the level of debt funding are not relevant.

Your decision to establish a new breed in the last few years has also impacted on the length of time required before your primary production activity will make a profit. It is also acknowledged that you started out in a small way and have expanded over the years. Like the ongoing improvements to the property and your level of debt, these are individual business decisions affecting your activity rather than an inherent characteristic of the industry.

You predict that your enterprise will not produce a tax profit until the 2013-14 financial year, or in the 23rd year of operation. It is considered that the fact that your activity will require 23 years for it to become profitable is not simply a result of the nature of the activity. Rather your individual circumstances have substantially impacted on the length of time required before a tax profit is made.

You have been unable to provide objective evidence of the commercially viable period to make a tax profit for your type of activity. We acknowledge that you included a letter from an industry expert regarding a viable business. However, your business is not solely with one breed and you commenced breeding cattle in 1989. The Commissioner is not able to conclude that the 23 years your activity will take from commencement to the achievement of a tax profit is 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.