Edited version of private ruling

Authorisation Number: 1011810041210

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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 to 2011-12 financial years?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 19XX

Relevant facts

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 private ruling application and

· additional information.

You contracted the Department of Agriculture's soil assessment experts to test a number of potential properties.

Following this, you settled on purchasing a property. The property contained soil that good crops were likely to prosper on.

An industry expert advised you that your land selection and strategy was good and if you undertook appropriate techniques and methodology, you should be able to produce a very high quality produce. He did caution you that it was a difficult business and that your particular methodology would make it unlikely that the business would be cash positive for at least a decade and possible longer.

Your business commenced some years ago and you began planting in the following year.

You aimed to establish a particular crop based on industry leaders.

Your spouse worked on the farm and ran the business. You have put in a considerable amount of work also, mostly on the weekends and holidays, as have your children.

You are hoping to go from full-time employment to part-time employment in the near future and after that you plan to make your living running the business.

In 19XX you planted another XX acres of crop.

You planted further crops in two later years.

Your produce has been highly successful in the marketplace.

Your first crop was in 200X

The subsequent 200Y crop was subject to a perception of being a very poor crop. You are currently negotiating to sell that crop overseas. Although the climate was unusual that year and the crop took several weeks longer than usual to ripen, you had anticipated this forecast and kept your yields very low so that the crop would become properly ripe and in balance. This crop will be sold at a significant loss.

It became clear that you would not be able to manage the business yourselves.

After further consultation, you employed a number of full- time employees and you have also employed casual workers over the years on a seasonal basis.

Your manager left after some time years which provided a saving in salaries and you have also cut the contract labour you are using. Your family are undertaking more of this labour on weekends.

You had significant dealings with pests in the early years when you did not have full-time employees. Pests are an occasional problem in the industry.

You put a considerable amount of planning, energy and money into managing the pest problem in the early years, as there is always a risk that they will damage the young crop. A spray was used to alleviate this problem.

In the first couple of years you had the spray done by a contractor where due to negligence he destroyed about half of the then planted crop in the large affected area. He had no insurance.

You also had a certain deficiency in the soil in part of the farm which was not picked up until further soil testing was done and that slowed the growth significantly.

You estimate that the pests were not significant external factors in slowing down the profitability of the business, as these were day to day issues that were dealt with. However, the negligence of the contractor probably cost you two years of sales.

You have had the same distributor in city A for a number of years and have recently changed to a distributor in city B who specialises in your crop. You also now have a distributor in city C.

You were hoping by now to have begun exporting your produce, but the rise in the Australian dollar has put that on hold. You met a number of potential distributors overseas in a recent year all of whom were very interested in importing your produce once the dollar returned to a more reasonable point.

You have had meetings with a potential buyer from overseas for your product and are hopeful that there is a serious market there at a reasonable price.

Partly for cost cutting reasons and for current cash flow, you have a contract for the supply of about XX tonne of produce per year.

Cost reductions are also being achieved by a diminution of packaging, transport and storage costs.

You have also reduced costs in the business itself by moving to some mechanised farming.

The losses you incurred in the particular recent years were as a result of the global financial crisis and the drop in sales.

You took expert advice before starting your business and you proceeded cautiously. You continue to take expert advice from a number of sources. You always intended the business to be a profit making commercially viable business.

An industry expert stated that the leading produce farmers all took at least 11 or 12 years before becoming profitable. Even now, the profitability may be under short term threat due to the global financial crisis and other external factors.

The industry expert stated that your initial crop should be producing about a 50% crop by year five and a full crop by year six or seven. He said your issues with pests would delay these timeframes by a year or two.

The industry expert believes that your business could not have been profitable for at least 10 years after its first planting and states that this is the norm for the relevant business.

In December 200Y you predicted to be profitable by 2008-09 financial year.

You are currently negotiating sales and expect a small profit in 2011-12 financial year.

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

You advise that the introduction of the income requirement came at a most difficult time and did not allow you sufficient time to make the dramatic changes necessary in terms of cost cutting and change of business plan, so that the effects of those changes would be felt in the 2009-10 financial year.

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 business activity requires to make a tax profit is not simply a result of the nature of the activity. Evidence provided states that the commercially viable period to make a tax profit for your type of activity is 10 to 12 years. The Commissioner is not able to conclude that the 14 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 activity is 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 will not satisfy subsection 35-10(2E) of the ITAA 1997 for the relevant years.

Therefore as you do not satisfy the income test 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:

· 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 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 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. That is, the business activity has inherent characteristic that cannot be overcome by conducting the business activity in a different way.

The phrase 'objection 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.

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.

As highlighted in Scott's case, the reference to the period that is commercially viable involves an enquiry into whether the business activity in question will produce a profit within the time frame in which other business activities in the same industry, which behave in a commercially viable manner, do so.

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:

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.

Where the initial period has passed, any continuing failure to produce a tax profit will be reasons outside paragraph 35-55(c) of the ITAA 1997 and the discretion will not be exercised unless the special circumstances limb is satisfied.

As highlighted in paragraph 13A of TR 2007/6 for those individuals who do not satisfy the income requirement in subsection 35-10(2E) of the ITAA 1997 special circumstances are those which have materially affected the business activity, causing it to make a loss.

In the context of Division 35 of the ITAA 1997, special circumstances are ordinarily those affecting the business activity such that it would be unreasonable for the loss deferral rule to apply. TR 2007/6 states at paragraph 47 that ordinary economic, weather or market fluctuations that might reasonably be predicted to affect the business activity would not be considered to be special circumstances. These fluctuations are expected to occur on a regular or recurrent basis when carrying on a business activity and affect all businesses within a particular industry.

In your case, you commenced your business activity in 1XXX. In the early years you experienced pests and contractor spraying problems. The Commissioner does not consider these circumstances to be special circumstances that have materially affected your business activity causing it to make a loss in the 2009-10 to 2011-12 financial years.

An industry expert advised that it takes at least 10 years to be profitable for your industry. He also advised that other leading farmers took at least 11 or 12 years before becoming profitable.

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 location, climate or soil conditions are not relevant.

You advise your activities have been affected by the global financial crisis as well as the export market, domestic supply and cost increases. It is considered that a particular variance of supply of product and the rise in the Australian dollar is the result of ordinary market fluctuations that affects all businesses within that industry, and is a circumstance that might be reasonably expected to occur when carrying on a business activity. Also whilst we accept that the global financial crisis was not within your control, we consider the fluctuations and drop in sales to be a normal part of the industry.

The fact that some of the crops weren't planted until 200X may have impacted on the length of time required before your business activity will make a profit. However, this and your brand building relate more to your individual circumstances rather than the nature of the business.

You predict that your business will not produce a tax profit until the 2011-12 financial year, or in the 14th year of operation. It is considered that the fact that your activity will require 14 years for it to become profitable is not simply a result of the nature of the activity. This is beyond the 10, 11 or 12 years that was referred to as a commercially viable period.

From the information provided, the Commissioner is not able to conclude that the 14 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.