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Ruling

Subject: Commissioner's discretion for lead time

Question:

Will the Commissioner exercise his discretion under paragraph 35-55(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to offset losses from your primary production activity against your other assessable income?

Answer:

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commences in:

September 2010

Relevant facts and circumstances

You have requested the Commissioner to exercise his discretion under paragraph 35-55(1)(b) of ITAA 1997 for five income years to allow you to claim the loss from your business activity.

You satisfy the income requirement contained in subsection 35-10(2E) of ITAA 1997 for non-commercial loss purposes.

You have purchased a farm property.

You intend to carry on a business of primary production from this property.

Your purpose in engaging in the business activity is to create a second income for your family and to obtain a return on the investment you made in purchasing the property.

The income and expenses projections you provided in your response to our request for further information shows that you intend on earning income from two different sources being, livestock and bodily produce sales.

The income and expenses projections that you provided also show that your business will not make a profit until five income years after the one in which you purchased the farm property.

For the second and third income years after the one in which you purchased the farm property, the total revenues expected to be received from a combination of livestock and bodily produce sales.

Your farm currently has some stock.

You are currently preparing the property to be used in carrying on your business in the future.

A number of preparatory activities have been completed.

There are a number of other preparatory activities that still need to be completed.

There are a number of assets required that are required for your activity. Only 40% of the required assets have been purchased at this stage. The remaining assets at this stage are either borrowed, not yet purchased or in the process of being purchased.

You hold a genuine and reasonable belief that your activity will generate a profit by making livestock and bodily produce sales to the market for the products.

Relevant legislative provisions

Subsection 35-5(2) of Income Tax Assessment Act 1997

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

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

Reasons for decision

Division 35 of ITAA 1997 aims to prevent losses from non-commercial activities that are carried on as businesses by individuals, either alone or in partnership, being offset against other assessable income. The consequences of the application of Division 35 are outlined in section 35-10(2) of ITAA 1997. Where Division 35 applies, the loss that you incur from your business activities will be quarantined and deferred, rather than disallowed, until a later income year in which the business activity, or one of a similar kind, is carried on.

As outlined in subsection 35-5(2) of ITAA 1997, Division 35 only applies to a taxpayer's activities that constitute carrying on a business. Paragraphs 13 and 18 of Taxation Ruling 97/11 (TR 97/11) list indicators that the court considers to be relevant in determining whether a business of primary production is being carried on. These factors include:

· Purpose and intention of the taxpayer in engaging in the activity;

· Whether the taxpayer has more than just an intention to engage in business;

· Whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

· The size, scale and permanency of the activity;

· Whether there is repetition and regularity of the activity;

· Whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

· Whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit;

· Whether the activity is better described as a hobby, a form of recreation or a sporting activity;

· Amount of commercial sales of products;

· Whether the activity has a significant commercial purpose or character; and

· Whether the taxpayer has knowledge or skill.

It was established in Evans v Federal Commissioner of Taxation (1989) that there is no one indicator that is decisive and all indicators must be considered in combination and as a whole. The decision on whether a business is being carried on is dependent on the 'large or general impression gained' from looking at all indicators (Martin v Federal Commissioner of Taxation (1953)). These notions are reflected in paragraphs 15 and 16 of TR 97/11.

In your case:

A notion established in Thomas v Federal Commissioner of Taxation (1972) ("Thomas"), and reiterated at paragraph 39 of TR 97/11, is that the intention of the taxpayer in engaging in the activity is a relevant indicator. However, the mere intention to carry on a business is not enough; there must be activity.

You stated in your response to our request for information that the purpose in engaging in the activity is to create a second income for your family and to obtain a return on the investment you made in purchasing the property. However, the activity that is carried on at present is not the actual activity you intend to carry on in your activity of primary production; the activity that is carried on at present involves repairing and improving the property to a state fit for use in your activity in the future. Therefore, at present, based on the preparatory activities you have completed and are planning to complete, there is only a mere intention to carry on a business.

You have a purpose of profit and a prospect of profit. However, the prospect of profit is not significant. The income and expenses projections you provided for your activity show that no profit will be generated from your activity until 5 income years after the one in which you purchased the farm property.

The size and scale of your activity is not significant. Paragraph 77 of TR 97/11 states that the larger the scale of the activity, the more likely it will be that the taxpayer is carrying on a business of primary production. While Thomas established that the size or scale of the activity is not a determinative test, and a person may carry on a business in a small way, paragraph 78 of this Ruling states that the smaller the scale of the activity, the more important the other indicators become when deciding whether a taxpayer is carrying on a business of primary production. As per paragraph 80 of TR 97/11, the scale of the activities may be small but still result in more produce than is required for the taxpayer's own domestic needs.

You stated in your response to our request for information that your activity currently has some stock. You further stated in your response that you intend on having a larger amount of stock by 5 income years after the one in which you purchased the property. It is clear that although the scale of your activity in future will result in more produce than is required for your own domestic needs, your current operations are small in both size and in scale. While this is not a decisive indicator that you are not carrying on a business, more emphasis is required to be placed on the other considerations in determining whether a business is being carried on.

Furthermore, you have stated in your response that while you currently hold a small amount of stock, you intend on carrying a larger amount of stock in the income year ended 30 June 2016. The income and expenses figures you provided indicates that you will make a small profit in the fifth income year after the one in which you purchased the property, only after your stock would have increased to ten-fold. Therefore, at this stage, taking into account the size and scale of your activity, we cannot be satisfied that you are carrying on a business.

Paragraph 55 of TR 97/11 states that it is often a feature of a business that similar sorts of activities are repeated on a regular basis. It is further stated that the repetition of activities by the same person over a period of time on a regular basis indicates that a business is being carried on. The case of Hope v The Council of the City of Bathurst (1980) established that where transactions are entered into on a continuous and repetitive basis, it may manifest the essential characteristics required of a business.

Although there is repetition and regularity in the amount of time you have spent on improving the property and bringing it to a state suitable for use in your business in the future, there is little repetition and regularity in your actual activity. You have purchased only a small amount of stock as at 30 June 2011. Furthermore, the lack of repetition and regularity in the actual business activity that you intend to carry on is reflected in the income and expenses projections you provided which show that your activity has, so far, made only an insignificant amount of wool sales.

Paragraph 63 of TR 97/11 states that an activity is more likely to be a business when it is carried on in a manner similar to that in which other participants in the same industry carry on their activities. According to paragraph 64 of this Ruling, consideration should be given factors such as the volume of sales, the types of customers to whom the taxpayer sells the products, the sort of expenses incurred by the taxpayer and the amount invested in capital items.

Your activity is of the same kind to that of the ordinary trade in your industry. However, the activity is not carried on in a similar manner as other businesses in that industry. This is because other businesses are carrying on a business by making livestock and bodily produce sales, while your activity currently involves preparing the farm to be used in carrying on your business in the future.

Furthermore, you stated in your response to our request for information that your activity requires a number of capital items. Only 40% of these items have been purchased outright, with the remainder borrowed, not yet purchased or in the process of being purchased for your activity over the next three years. Your activities cannot be carried on in a similar manner as other businesses in that industry because you do not hold the required assets to carry on your activity in a manner that is similar to other businesses in your industry.

For these reasons, while we believe that your activity is of the same kind to that of the ordinary trade in your industry, we do not consider that your business is carried on in a similar manner to other businesses in your industry.

For an activity to be planned, organised and carried on in a businesslike manner, a reasonable person would expect a business to produce and retain records and business documents such as a business plan. In our letter, we requested that you provide a copy of your business plan. A business plan is a formal statement that details a set of business goals, the achievability of the goals and how these goals are to be reached. Other basic elements of information that would be included on a business plan are listed at paragraph 111 of TR 97/11. On the other hand, a mission statement summarises the aims and values of the business. In your response, you did not provide a business plan. Rather, you provided a mission statement.

While your response provided a general overview of the goals your business aims to achieve, it would not be recognised by a reasonable person to be a business plan. You also did not provide any other business documents that could be said to amount to a business plan, the existence of which would reasonably be considered to be standard amongst all businesses. Whilst this is not determinative of whether your business activity is planned, organised and carried on in a businesslike manner, it is relevant in deciding whether this factor has been satisfied.

As discussed previously, the activity that is carried on at present is not the actual activity you intend to carry on in your actual business activity. Therefore, while your activity may be planned and organised to be carried on in a businesslike manner in the future, it cannot be carried on in a businesslike manner as the actual activity has not yet commenced. As such, we are not satisfied that your business activity is planned, organised and carried on in a businesslike manner.

While your activity would not be better described as a hobby or a form of recreation, it must also be noted that there are insignificant amounts of commercial sales of both livestock and bodily produce. So far, only an insignificant amount of income has been produced from bodily produce sales. For the following two income years, the total revenues expected to be received from a combination of livestock and bodily produce sales are only slightly larger.

In accordance with paragraph 30 of TR 97/11, when determining whether your activity has a significant commercial purpose or character, consideration must be given to factors such as whether a business plan has been drawn up; established that the land is suitable for the activity which the taxpayer intends to carry on; considered whether there is a market for the product and looked into potential markets for the product; investigated properly the capital requirements of the venture; ensured the size and scale of the activity is sufficient for a commercial enterprise; and an intention to make a profit, having regard to the existence of a reasonable belief that the activity is likely to generate a profit.

You hold a genuine and reasonable belief that your activity will generate a profit by making livestock and bodily produce sales to the market for the product. You also believe that the farm property that you purchased is suitable for the activity that you intend to carry on, which is evidenced by your continued efforts to repair and improve the property to bring it to a state that is suitable for use in your activity.

However, while you have ensured that the size and scale of the activity in the future is sufficient for a commercial enterprise, evidenced by the scale of your activity being in excess of your personal needs and large enough to ensure the venture is profitable, the size and scale of your activity at present is not sufficient for a commercial enterprise. Furthermore, as discussed previously, you do not have a business plan.

It must also be noted that in your response, you have stated a number of times that you do not believe that your activity has actually commenced, but forecast that the actual activity will commence four income years after the one in which you purchased the property. Therefore, a business cannot be carried on.

Taking into consideration all these factors, we are not satisfied that you are carrying on a business for the purposes of Division 35 of ITAA 1997. However, your circumstances, and therefore our decision, may change as the size and scale of your activities increase. As the size and scale of your activities increase, it is likely that more of the discussed factors would indicate that a business is being carried on by you. Where you believe that your circumstances have changed, you are able to lodge another application asking for the Commissioner to exercise the appropriate arm of his discretion. However, where you circumstances remain unchanged in future income years, this same decision will apply to those years.

Because you are not carrying on a business and therefore do not satisfy subsection 35-5(2) of ITAA 1997, the Commissioner is unable to exercise the discretion contained in paragraph 35-55(1)(b) of ITAA 1997.

It was established in Softwood Pulp and Paper v Federal Commissioner of Taxation (1976) and Goodman Fielder Wattie Ltd v Federal Commissioner of Taxation (1991) that expenses incurred in conducting preparatory activities which do not amount to a business and do not result in any assessable income being produced are not deductible. It was concluded in Ferguson v Federal Commissioner of Taxation (1979) that only such activities of a preparatory nature that have a sufficient commercial character to be regarded as a business in their own right are deductible.

As the activities that have been completed by you since the purchase of the property are considered to be preparatory in nature, you are unable to claim a deduction for the expenses that you have incurred to date.

You also stated in your response that there are still a number of major activities that need to be completed before the business itself can commence. As these activities are also considered preparatory in nature, you are unable to claim a deduction for the expenses that you have incurred.