Edited version of private ruling

Authorisation Number: 1011898349897

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Ruling

Subject: Commissioners Discretion - Lead time

Question

Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your vehicle hire business in your calculation of taxable income for the 2009-10 to 2013-14 income years?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010
Year ended 30 June 2011
Year ending 30 June 2012

Year ending 30 June 2013
Year ending 30 June 2014

The scheme commenced on

1 July 2008

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:

· the application for private ruling

· further documentation

· information contained in the email

· further information in the letter and attachments

This ruling has been prepared on the basis that your activity is being conducted as a business.

You purchased a vehicle in the 20XX-XX financial year to establish a business. You borrowed funds to the extent of 65% to purchase the vehicle.

You have based your depreciation claims in 2009 and 2010 on the Commissioner's assessment of a 20 year useful life for vessels exceeding 10 meters in length, and the associated Diminishing Value Method (DVM) rate of 10%. In your forecasts you have proposed reducing this by 30% to 7% DVM so that you can achieve profitability within 5 years. You have received advice from the distributor that the actual depreciation of such vessels to be in the order of: 1^st 18 months - 15%, 2^nd 18 months - 10%, then 5% per annum thereafter.

You have made contact with a firm of accountants who have some experience with vehicle operators. They have advised that from within their client base they do not have any clients that have yet produced a profit. This is because their clients are all within a few years of commencement of operations. Your contention is that there is a lead time before operations generate a profit of at least 3 years, and in your case is projected to be 5 years.

The vehicle was fitted out to conform to state survey requirements and was advertised available for hire.

The market was not as successful as expected and income for the 2009-2010 financial year was minimal.

You changed your plan and the vehicle was then hired out through a management operator under an agreement.

You passed the assets test upon purchase of the vehicle.

You expect to pass the assessable income test in the 2010-11 financial year and future years.

You have provided income and expenses figures to date as well as forecast figures through to the 2013-14 financial year when you expect to make a profit.

Your income for non-commercial loss purposes was more than $250,000 for the 2009-10 financial year. You expect this will also be the case for the 2010-11 to 2013-14 financial years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 35-10
Income Tax Assessment Act 1997 Subsection 35-10(2E)
Income Tax Assessment Act 1997 Section 35-55
Income Tax Assessment Act 1997 Paragraph 35-55(1)(c)

Reasons for decision

Summary

Based on the consideration that neither of the requirements to obtain the Commissioner's discretion under paragraph 35-55(1)(c) are met, the Commissioner will not exercise the discretion under paragraph 35-55(1)(c) of the ITAA 1997 for the 2009-10 to 2013-14 years of income. We accept that you are carrying on a business and therefore the losses from your business will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997.

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. The losses are in effect quarantined to that business activity and can only be offset against future income of that or similar business activities.

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 possibly, 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).

The Commissioner's discretion under paragraph 35-55(1)(b) was not available to hire vehicle activities as there was no lead time between the commencement of the activity and the potential to produce assessable income. These activities normally passed at least one of the four tests, which allow the losses to be offset against other 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 (because of the nature) and is still a two step process. 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 if the 'because of the nature' applies (step 1), 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.

There has been no change in the legislation to indicate that the lead time discretion would apply to the vehicle industry. There is nothing inherent in this type of activity that stops it from producing income from commencement.

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 for a discretion, to apply the losses against other income. However, you have to be able to meet the specific requirements of the section to be able to get the Commissioner's discretion. You have to show that it is because of the nature and 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 and updated 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 possibly 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). This is the law that has to be applied for these cases to determine if the Commissioner can grant a discretion.

Income tax legislation.

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

It is not accepted that there is anything inherent in the nature of vehicle business that is the reason the business activity does not or will not make a profit.

Secondly, if there was something inherit in the nature of the activity, you have been unable to establish that there is a commercially viable period or if there is one, what that period is.

The phrase 'objective expectation' was discussed in the Administrative Appeals Tribunal case of Scott v. Commissioner of Taxation 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.

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, 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.

The vehicle industry has been established for a substantial period of time and there are a number of management operators who have a substantial number of vehicles available for hire through management agreements with owners. They would have substantial data from prior years that could provide evidence of income and expenses in this industry and would be seen as the main source of such data. There does not appear to be any truly independent industry association that has been formed to represent owners involved in the industry, as is the case in other industries. In the absence of such a body the operators would be the main source of information but no evidence has been provided from this source.

You have not provided objective evidence from an independent source of the commercially viable period to make a tax profit for your type of activity. We acknowledge that you have provided comments from another accounting firm who have some experience with vehicle operators and they advised you that from within their client base they do not have any clients that have yet produced a profit. This is because their clients are all within a few years of commencement of operations. You argue that this supports your contention that there is a lead time before operations generate a profit of at least 3 years, and in your case projected to be 5 years. We consider that no firm conclusions about a commercially viable period can be drawn from these comments.

Based on the consideration that neither of the requirements to obtain the Commissioner's discretion under paragraph 35-55(1)(c) are met, the Commissioner will not exercise the discretion under paragraph 35-55(1)(c) of the ITAA 1997 for the 2009-10 to 2013-14 years of income. We accept that you are carrying on a business and therefore the losses from your business will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997.