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Ruling

Subject: Non-commercial losses - Commissioner's discretion - lead time

Question:

Will the Commissioner exercise the discretion in paragraph 35-55(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your retail activity in your calculation of taxable income for the income tax years ended 30 June 2012 to 30 June 2016?

Answer:

No.

This ruling applies for the following period

Years ended 30 June 2012 to 30 June 2016

The scheme commenced on

1 July 2011

Relevant facts

You conduct a small retail business.

You have purchased substantial amounts of stock for resale. The business has been slow to take off and you have paid out more for stock, advertising and other expenses than what you are making. You have made the decision to close the business once all current stock has been sold. You will not be able to meet the assessable income test.

You have provided a profit and loss statement for the year ended 30 June 2012 and forecast figures for the year ended 30 June 2013. There are losses in each of these years and the assessable income is less than $20,000 in each.

Relevant legislative provisions

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

Reasons for decision

Note that all subsequent legislative references are to the Income Tax Assessment Act 1997.

Summary

The 'lead time' or 'because of its nature' discretion is provided by paragraph 35-55(1)(b). This discretion may be available where a business activity cannot meet one of the four non-commercial loss (NCL) tests 'because of its nature'.

The legislation contains a 'note' to this provision which indicates that the application of this discretion is very limited. It is those types of businesses that cannot produce assessable income in the early stages (because there is no produce available for sale), that falls into the category of, 'because of its nature'. That is, the discretion is for a business that because of its nature, requires a lead time before any assessable income can be produced. For example, grape vines take four years to produce grapes, so they could not possibly pass the assessable income test in the first few years as there is no produce for sale. This is where the 'lead time' or 'because of its nature' discretion would apply.

The Commissioner is not satisfied that it is because of the nature of your retail business activity, that it has not yet satisfied one of the four NCL tests. The building up of a client base is not considered to fall within the meaning of 'because of its nature'. It is not in the inherent nature of your activity that it requires a lead time to produce assessable income. Therefore, the Commissioner will not exercise this discretion in relation to your retail business activity.

Detailed reasoning

Division 35 Overview

Division 35 applies to losses from certain business activities for the income year ended 30 June 2001 and subsequent years. Under the rule in subsection 35-10(2), 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) applies; or

· you meet the income requirement and one of four tests in sections 35-30, 35-35, 35-40 or 35-45 is met; or

· if one of the tests is not satisfied, the Commissioner exercises the discretion in section 35-55.

Generally, a loss in this context is, for the income year in question, the excess of a taxpayer's allowable deductions attributable to the business activity over that taxpayer's assessable income from the business activity.

Losses that cannot be taken into account in a particular year of income, because of subsection 35-10(2), can be applied to the extent of future profits from the business activity, or are deferred until you meet the income requirement and one of the tests is passed, the discretion is exercised, or the exception applies. In effect the losses are quarantined to the business activity unless one of the tests are passed.

Exception

Under subsection 35-10(4), there is an 'Exception' to the general rule in subsection 35-10(2) 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).

On the facts given, the exception in subsection 35-10(4), has no relevance for the purpose of this ruling.

Tests

In broad terms, if you meet the income requirement (adjusted taxable income for NCL purposes less than $250,000) the tests require:

(a) at least $20,000 of assessable income in that year from the business activity (section 35-30);

(b) the business activity results in a taxation profit in 3 of the past 5 income years (including the current year) (section 35-35);

(c) at least $500,000 of real property, or an interest in real property, (excluding any private dwelling) is used on a continuing basis in carrying on the business activity in that year (section 35-40); or

(d) at least $100,000 of certain other assets (excluding cars, motor cycles and similar vehicles) are used on a continuing basis in carrying on the business activity in that year (section 35-45).

In the context of Division 35, a taxation profit for the income year in question is where the amount of assessable income from the business activity for that year, is greater than the sum of the deductions attributable to it for that year (apart from the operation of subsection 35-10(2)).

Application of section 35-55 (Commissioner's discretion) to this arrangement

As your retail activity has commenced, and is carried on as a business, it is subject to the provisions in Division 35. Information provided with the application for this private ruling indicates you pass the income requirement and that your retail business activity is yet to pass one of the tests or produce a taxation profit.

As no test seems likely to be satisfied for the income years ended 30 June 2012 and 30 June 2013 or later years, the rule in subsection 35-10(2) will apply to defer to a future income year any loss that arises from retail business activity for those years, unless the Commissioner exercises an arm of the discretion under paragraphs 35-55(1)(a) or (b).

The first arm of the discretion in paragraph 35-55(1)(a) relates to 'special circumstances' applicable to the business activity, and has no relevance for the purposes of this private ruling. In addition, the Commissioner would decide that he should not exercise the second arm of the discretion in paragraph 35-55(1)(b) for your activity, as described above.

The second arm of the discretion in paragraph 35-55(1)(b) may be exercised where:

(i) the business activity has started to be carried on; and

(ii) because of its nature it has not yet met one of the tests set out in Division 35; and

(iii) there is an expectation that the business activity of an individual taxpayer will either pass one of the tests or produce a taxation profit within a period that is commercially viable for the industry concerned.

The 'Note' to paragraph 35-55(1)(b) states:

This paragraph is 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.'

It has been accepted based on the information you have supplied that you started carrying on your retail business activity from mid 2011, and that it is yet to pass one of the four tests. However, it is not accepted that it is because of the nature of your activity that it is yet to have passed one of the tests.

The type of feature contemplated by the phrase 'because of its nature', in the context in which it appears, is that referred to in the 'Note' quoted above. That is, that there is an inherent or innate feature of the activity resulting in an inability to produce income in the year of commencement and (in most cases) a number of years thereafter. This is borne out further by paragraph 1.51 of the Explanatory Memorandum for the New Business Tax System (Integrity Measures) Act 2000, which states;

This arm [paragraph 35-55(1)(b)] of the safeguard discretion will ensure that the loss deferral rule in section 35-10 does not adversely impact on taxpayers who have commenced to carry on activities which by their nature require a number of years to produce assessable income. Examples of activities which would fall into this category are forestry, viticulture and certain horticultural activities.

The Note and the passage cited above do not support any view that the discretion should be exercised for any start-up activity that is yet, for example, to satisfy the assessable income test in section 35-30, simply because of the small scale on which it was started, or because a client base is being built up. Those sorts of constraints on being able to satisfy that test are far removed from the specific one referred to in the Note and the Explanatory Memorandum.

We do not consider that there is anything inherent or innate in the nature of your business activity which means that it has not yet been able to satisfy one of the tests. In particular, we think your activity is of a type that is able to produce assessable income quite soon after its commencement. We believe it is because a client base is being built up that is the major reason why it will not pass the assessable income test or make a profit for the early years, and not its inherent nature.