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Subject: Non commercial losses - Commissioner's Discretion for Special Circumstances

Question 1

Whether the Commissioner will exercise the discretion in paragraph 35-55(1)(a) of the Income Tax Assessment Act 1997 ( ITAA 1997) to allow you to include any losses from your breeding activity in your calculation of taxable income for the income tax year ended 30 June 2010?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2010

The scheme commences on:

1 July 2000

Relevant facts and circumstances

You operate two farms, farm 1 was purchased in the year 2000 with your activity commencing the same year.

You have been leasing farm 2 since 2004.

Your business is the operation of breeding animals, from which offspring are raised and then sold.

The purchase of farm 1 was funded by commercial bills. Interest costs over time have been greater than expected as a result of drought conditions impacting the earning capacity of the properties. This has resulted in commercial bills not being reduced as planned and thus made interest expenditure higher than forecast over the period of time since your business commenced.

The district in which the properties are located was a drought declared area.

The area was also covered by the Governments 'Exceptional Circumstances - Drought' declaration.

Drought broke towards the end of 2010 financial year.

Taking the commercially viable period of no greater than four years for your activity into consideration, the interaction between the drought (special circumstances) and commercially Viable period (lead time) would suggest that the extended commercially viable period to finish in the 2014 year.

From the projected income calculations attached you expect to make a profit from 2014 onwards.

Having limited ability to stock the property at normal capacity has resulted in less stock during the 2001-2010 financial years and in turn has impacted the number of animals available to be sold.

This statement supports how the drought has affected the taxpayer's ability to produce sufficient income to exceed costs incurred 2010 financial year.

The taxpayer projects that the properties will hold around xx head of animals with offspring of around yy to be sold each year. It is expected that this will be achieved after the spring 2012, with full sales capacity achieved during the year ending 30 June 2014. The stock on hand balance at 30 June 2010 substantiates the effect the drought has had on farming operations and the inability for the taxpayer to stock the property to its full potential.

Due to the scale of the business, significant fixed expenditure has been incurred in the day to day running, and significant income is required from animal sales for the business to be profitable. Accordingly the reduction in income has not only resulted in losses being made but debt increasing to fund the cash expenditure that was in excess of revenue.

Calculations supplied show the taxpayer forecasts the business to be profitable by 30 June 2014 with significant profits made thereafter.

You have met three, of the four, Division 35 of the ITAA 1997 tests:

Assessable income s35-30 of the ITAA 1997.

Meet

Profits Test s35-35 of the ITAA 1997.

Not meet

Real Property s35-40 of the ITAA 1997.

Meet

Other Assets s35-45 of the ITAA 1997.

Meet

Summary of Arrangement

Description

Your business activity is buying and selling animals, on 2 adjoining properties, farm 1 and farm 2.

You have around zz animals, from which offspring are raised and sold.

You commenced your activity in the year 2000 following the purchase of farm 1.The properties were not purchased as a going concern and you have been building up your stock of animals.

Lead time

You make the statement that when taking the commercially viable period of no greater than four years for your activity into consideration, the interaction between the drought (special circumstances) and commercially viable period (lead time) would suggest that the extended commercially viable period to finish in the 2014 year.

From the projected income calculations attached you expect to make a profit from 2014 onwards.

Having limited ability to stock the property at normal capacity has resulted in fewer increases during the 2001-2010 financial years and in turn has impacted the number of animals available to be sold.

The Special Circumstances - Drought

You have stated that you commenced your activity in the year 2000 following the purchase of farm 1.

The purchase of farm 1 was funded by commercial bills. You state that the interest costs over time have been greater than expected as a result of the drought conditions impacting the earning capacity of the properties.

You have provided a copy of the maps showing the drought declared area.

You state the drought broke towards the end of the 2010 financial year.

Relevant legislative provisions

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

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

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

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

Income Tax Assessment Act 1997 Subsection 35-55(1)

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

Reasons for decision

Summary

The Commissioner will not exercise the discretion in paragraph 35-55(1)(a) of the ITAA 1997 in relation to your activity for the income year ended 30 June 2010 as the Commissioner is not satisfied that your activity would have made a tax profit for the year ended 30 June 2010 but for the drought.

Detailed reasoning

Division 35 of the ITAA 1997

Division 35 of the ITAA 1997 applies to prevent the losses from a non-commercial business activity carried out by an individual taxpayer alone or in a partnership being offset against other assessable income in the year in which the loss is incurred.

Under these measures losses that cannot be offset against other incomes in the year in which they arise (i.e. quarantined losses) may be carried forward to be offset in a future year, when there is a profit from the non-commercial activity, or against other incomes, if certain criteria are satisfied or the Commissioner exercises his discretion.

For the 2009-2010 and later income years, the 'income requirement' in paragraph 35-10(2E)(a) of the ITAA 1997 applies. This change prevents taxpayers who do not satisfy the 'income requirement' from claiming losses from their business activities merely by satisfying one or more of the tests.

The income requirement in subsection 35-10(2E) of the ITAA 1997 provides that:

You satisfy this subsection for an income year if the sum of the following is less than $250,000:

(a) your taxable income for that year;

(b) your reportable fringe benefits total for that year;

(c) your reportable superannuation contributions for that year;

(d) your total net investment losses for that year.

For the purposes of paragraph (a), when working out your taxable income, disregard any excess mentioned in subsection (2) for any business activity for that year that you could otherwise deduct under this Act for that year.

In your case you have not met the income requirement in subsection 35-10(2E) of the ITAA 1997.

Application of paragraph 35-55(1)(a) of the ITAA 1997 special circumstances (Commissioners discretion) to this arrangement

The discretion in paragraph 35-55(1)(a) of the ITAA 1997 relates to special circumstances applicable to the business activity.

Subsection 35-55(1) of the ITAA 1997 sets out this Commissioners discretion as follows:

The Commissioner may, on application, decide that the rule in subsection 35-10(2) of the ITAA 1997 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 was or will be affected in the excluded years by special circumstances outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster; or

Note: This paragraph is intended to provide for a case where a business activity would have satisfied one of the tests if it were not for the special circumstances.

The question of what constitutes special circumstances has been judicially considered on many occasions. In the Federal Court case of Community Services Health, Minister for v. Chee Keong Thoo (1988) 8 AAR 245; (1988) 78 ALR 307, Burchett J considered special circumstances in the context of the Health Insurance Act 1973 and made the following observation:

Those discretions are intended to be applied to a great variety of situations. In such a context, the core of the idea of 'special circumstances' is that there is something unusual or different to take the matter out of the ordinary course

Later, in the Federal Court Case of Department of Employment, Education, Training Youth Affairs of v. Barrett (1998) 82 FCR 524; (1998) 27 AAR 291; (1998) 52 ALD 499 (1998) 3 SSR 38 'special' was considered in the context of special weather conditions for the purposes of the Austudy Regulations 1990. Tamberlin J observed that:

The word special must be read in context. In normal parlance it signifies that the event or circumstances in question are out of the ordinary or normal course.

Tamberlin J then quoted the following passage with approval from the AAT case of Re Beadle v. Director-General of Social Security (1984) 1 AAR 362; (1984) 6 ALD 1:

An expression such as special circumstances is by its very nature incapable of precise or exhaustive definition. The qualifying adjective looks to circumstances that are unusual, uncommon or exceptional. Whether circumstances answer any of these descriptions must depend upon the context in which they occur. For it is the context which allows one to say that the circumstances in one case are markedly different from the usual run of cases. This is not to say that the circumstances must be unique but they must have a particular quality of unusualness that permits them to be described as special.

It can be seen that to determine what is special circumstances, we need to look at the context in which the phrase is used. Also, it is clear that special circumstances will be something out of the ordinary or unusual. Special circumstances in paragraph 35-55(1)(a) of the ITAA 1997 is used in the context of a situation occurring such that it would be unreasonable for the Commissioner to apply the loss deferral rule for a particular year or years. For this to be the case, it will not only be necessary that an event or situation has occurred which is of itself unusual, but that it has resulted in the business activity failing to pass a test.

Clearly, if the business activity would not have passed a test even if the event or situation had not arisen, we cannot say that the business activity was affected by special circumstances as the note to paragraph 35-55(1)(a) of the ITAA 1997 indicates.

You claim that the special circumstances were the drought conditions. The information you have provided was the drought maps that indicate that the area where your activity is conducted has been experiencing drought. The drought has adversely affected your activity and as a result the interest costs over time on your commercial bills that were taken out to purchase farm 1 have been greater than expected and the drought has affected the earning capacity of your properties. This has resulted in the commercial bills not being reduced as planned and has made interest expenditure higher than forecast over the period of time since your business has commenced.

Further you state that you have had limited ability to stock the property at normal capacity and this has resulted in less natural increases during the 2001-2010 financial years and in turn has impacted the number of animals available to be sold.

You project that the properties will hold around xx animals with offspring of around yy to be sold each year.

Your stock on hand balance at 30 June 2010 substantiates the effect the drought has on your farming operations and the inability for you to stock the property to its full potential.

You have provided forecast calculations that show that your breeding business will be profitable by 30 June 2014.

The Commissioner is satisfied from the information that you have provided that your properties were affected by drought conditions for the period stated.

Your properties can hold around xx animals with offspring of around yy to be sold each year.

The stock figures provided by you show that in the 2009 and 2010 financial years you have sold in excess of yy animals.

Accordingly in these years you have sold more than the number of animals that you projected to sell if there was no drought. This shows that your sales activity was either not affected or only marginally affected by the drought.

The Commissioner has considered your sales figures and expenses and he will not accept that the drought has affected your activity during these years to the extent that it could not make a profit; or that but for the drought it would have made a tax profit.

On the basis of your past income and expenses, the Commissioner is not convinced that your activity will be able to achieve the projected income and reduction in expenses required to make a tax profit, as suggested in your income projection.

In summary, the Commissioner does not accept that the drought was the only reason that prevented your activity from producing a tax profit. Therefore the Commissioner will not exercise his discretion under paragraph 35-55(1)(a) of the ITAA 1997 for the year ended 30 June 2010.

29. As the Commissioners Discretion is not being granted for the income year ended 30 June 2010, the rule in subsection 35-10(2) of the ITAA 1997 will apply to defer to a future income year any loss that arises from your activity for that year. A deferred loss is not disallowed and will be deductible against any taxation profit from your activity, or similar business activity, in future years.