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Ruling

Subject: Non-commercial losses - Commissioner's discretion

Question 1

Were you carrying on a business in the relevant financial year?

Answer

No.

Question 2

Can the Commissioner exercise the discretion in paragraph 35-55(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include losses from your activity in your calculation of taxable income for the relevant financial year?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2009

Relevant facts

You purchased several assets from a company (the supplier).

You signed an agreement with another company (the deployer) to manage the day to day operation of the machines. The agreement allowed that you would be paid a minimum commission per machine per month.

You chose to pay the deployer to perform all of the duties related to the ongoing performance of the assets.

According to the contract between you and the deployer, the deployer was, among other things, responsible for;

· the installation of the assets

· the payment of all charges and expenses in operating the assets

· providing maintenance of the assets

· providing insurance for the assets

· removing and relocating the assets at it's discretion

· paying you either a minimum monthly amount or a certain amount per transaction which ever is greater.

According to the contract you agreed, among other things, to;

· use the deployer's services exclusively; and

· comply with all legislative requirements

The supplier and deployer, which were related companies, were placed into voluntary administration during the relevant income year.

You received some commission in the relevant financial year, but the administrators took control of the assets and put them into storage so no further income was generated.

You satisfy subsection 35-10(2E) of the ITAA 1997 as your adjusted taxable income is less than $250,000 in the prior financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 995-1

Income Tax Assessment Act 1997 Division 35

Reasons for decision

Carrying on a business

The question of whether a business is being carried on is a question of fact and degree to be determined on a case by case basis. The courts have developed a series of indicators to determine the matter, which are summarised in Taxation Ruling TR 97/11. Although TR 97/11 specifically refers to primary production, the same principles apply to all businesses. Some indicators of carrying on a business which the courts have considered to be relevant include:

· whether the activity has a significant commercial purposes or character

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

· whether there is regularity and repetition of the activity

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

· whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

· the size, scale and permanency of the activity, and

· whether the activity is better described as a hobby, a form of recreation or sporting activity.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' from looking at all the indicators and whether these factors provide the operations with a 'commercial flavour.

However, the weighting to be given to each indicator may vary from case to case, and no one indicator will be decisive (Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922).

To be carrying on a business, a taxpayer must be involved in the activities that make up that business. This would be evidenced by an element of control over, and/or an ongoing participation in, the business. The involvement should be direct or immediate, rather than passive. The payment of expenses relating to the ownership of property would not, without more, be sufficient. In the absence of such an involvement, an owner of property would not be regarded as being engaged in the business. The mere receipt by the property owner of a payment from users for the use of the item of property would be in the nature of income from property rather than from the carrying on of a business.

The fact that the sale of machines may be promoted as a business does not necessarily preclude you from being an investor, notwithstanding the existence of a business plan.

The activity does not have to be profit-generating in the first year of operation or in the short term to be characterised as a business. Bowen CJ and Franki J in Ferguson v Federal Commissioner of Taxation (1979) 79 ATC 426; (1979) 9 ATR 873 at ATC 4262; ATR 876 stated that '…an immediate purpose of profit-making in a particular income year does not appear to be essential…'. Thus, where short term losses are expected it may be that a business is nevertheless carried on: see Tweddle v. FC of T (1942) 7 ATD 186; (1942) 2 AITR 360. As a result, the fact that a loss results in a particular income year does not necessarily add weight to the conclusion that the taxpayer was not carrying on a business.

In determining whether a taxpayer is carrying on a business, the number of assets the taxpayer has will be a relevant factor, but not determinative. The volume of the operations and the amount of capital employed by the taxpayer was considered in TR 97/11. However, even machine owners with a large number of machines may not be carrying on a business if they display a lack of active participation in the activity.

A taxpayer should undertake at least minimum activities necessary to maintain a commercial quantity and quality of product for sale. Although business owners do not necessarily have to manage the day-to-day operations themselves, it is expected that they would have control over the assets and business performance.

Additionally, in reviewing the terms of a contract, both the express terms of the contract and the substance or reality of the contractual relations (in other words, the actual behaviour of the parties) are relevant. The approach under Australian common law is to find the true substance of the relationship, often referred to as the 'substance over form' approach.

It is acknowledged that where there is a management agreement in place, the day to day activities of operating a business can be attributed to the taxpayer. However, the indicators of a bona fide management agreement can include:

· the owner of the item of property shares in the risks and rewards of the business activity;

· the contract for the provision of the property to the user highlights that the manager/operator is acting as the agent of the property owner in the arrangement;

· the property owner derives income and incurs expenses relating to the use of the asset by third parties; and

· the property owner maintains a sufficient level of control of the property/asset.

Indicators against a bona fide management agreement can include:

· the property owner has little control over the property/asset

· rights of exclusive use of the item of property;

· a right to all income with the owner being entitled to a fixed amount per month; and

· the manager/operator does not act demonstrably in the best interests of the property owner but just in their own interests.

Application to your circumstances

You bought several assets and signed a contract to give the daily operation and management of the assets to a deployer company.

This deployment meant that you were not actively involved in the income producing activity. You had limited control of the assets, their placement, maintenance and repairs. You received payments on a per transaction basis from machines. You were guaranteed a minimum monthly return on each of your assets regardless of the number of transactions on each asset which reduced/limited your ability or incentive to be involved in the daily operation or to improve the performance.

You had no ability to increase your profits through cost cutting or to instigate strategies to increase revenue, which would be normal practice for an entity in business. This indicates that the elements that are usually indicative of a business are absent in the present case.

The ordinary trade in a business of operating such assets involves maintenance, electricity connection, data connection, insurance, compliance with legislation, software upgrades, on screen advertising, collection of proceeds and engaging with the premises owners. An example would be where an owner owns several assets, moves them around to various venues/events to maximise potential income and is actively involved in the day to day activities of the operation.

We do not consider that you carried on your activity in a similar manner to that of ordinary trade in that line of business. The deployment company planned, organised and carried out the management of the assets in a businesslike manner. This allowed the contracted payments to be made to you on a monthly basis but you have not demonstrated that you had any involvement in that planning or management of the assets.

As the agreement with the deployer did not display the indicators of a bona fide management agreement, the repetition and regularity of the activities would be that of the deployment company and not something that could be attributed to you.

Conclusion

After considering all of the relevant indicators discussed in TR 97/11 and the circumstances of this case, it is considered that you were not carrying on a business of operating assets in the relevant financial year. Based on the factors above, the overall impression gained from your activity is that you were an investor rather than a business owner.

Non-commercial loss discretion

Division 35 of the ITAA 1997 will apply to defer a non-commercial loss from a business activity unless certain criteria are met.

As you are not considered to be carrying on a business these provisions do not apply and the Commissioner is unable to exercise any discretion in this matter.