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Ruling

Subject: Non-commercial losses - Commissioner's discretion - special circumstances

Question 1

Will 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 any losses from your primary production activities in your calculation of taxable income for the income year ended 30 June 2012?

Answer

No.

Question 2

Will the Commissioner exercise the discretion in paragraph 35-55(1)(a) of the ITAA 1997 to allow you to include any losses from your primary production activities in your calculation of taxable income for the income years ended 30 June 2013 to 2015?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

The scheme commenced on

1 May 2002

Relevant facts

The arrangement that is the subject of this ruling is described below. The following documents have been relied upon to reach a decision:

Your application for private ruling, including:

· Strategic Plan

· Production Summary

· Budget Summary Projections

· Annual Report

· Independent Expert Review of activity

· Joint Venture Agreement

You are a joint venturer in a large primary production enterprise.

The activity was established on a substantial area of suitable land.

The crops were planted over a two year period.

The activity is funded through a combination of Joint Ventures' capital subscription together with finance provided by a bank.

The activity is professionally managed by contractors.

The activity produced its first full crop some years back and produced an overall profit in that year.

You have provided the actual and forecast figures for the joint venture showing production, income and expenses. Losses have been incurred in the last four years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 35-1

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

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

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

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

Reasons for decision

For the non-commercial losses rules to apply to an individual they have to be carrying on a business for taxation purposes. We are not disputing that you are carrying on a business. 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.

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 for certain taxpayers, with the introduction of an 'income requirement'. The rules have become very restrictive and mean that the losses for these taxpayers will be quarantined to the business activity except for the very limited circumstances where the Commissioner's discretion can be applied in a year.

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 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. The exceptions do not apply in your situation.

There are two types of discretions. These are commonly referred to as the 'special circumstances' discretion and the 'lead time' discretion.

You have indicated that you are not applying for the lead time discretion as your activity is an established activity.

Your only option is to obtain the special circumstances discretion.

Special circumstances

The Commissioner's discretion in paragraph 35-55(1)(a) of the ITAA 1997 may be exercised for the income years in question where the business activity is affected by special circumstances outside the control of the operator of the business activity, that prevent the activity from making a profit in that year.

This is a three step process:

1. You have to show that the circumstances are considered to be 'special' in terms of this legislation;

2. You have to show that the circumstances were outside your control; and

3. You have to show that it was these special circumstances that prevented the activity from making a profit in the applicable years.

You have asked the Commissioner to consider a discretion for a number of years, due to the widespread industry conditions causing the activity to be currently unprofitable. You state that the high Australian dollar has killed off significant export demand and driven prices to unsustainable lows. You have provided forecast figures to show that a profit is forecast for later years.

The Commissioner can only give a discretion in years where there are losses. For the later income years you have forecast a profit. Also at this point in time, based on the facts that you have provided, it is impossible to show that special circumstances prevented you from making a profit in these years. The Commissioner cannot give a discretion for these years under paragraph 35-55(1)(a) of the ITAA 1997.

There is a loss in the current income year and the possible exercise of a discretion in this year will be considered.

Section 35-55 of the ITAA 1997 provides that the Commissioner can decide that section 35-10 of the ITAA 1997 does not apply where he is satisfied that it is unreasonable for it to apply.

Paragraph 35-55(1)(a) of the ITAA 1997 provides that the Commissioner can exercise the discretion where certain special circumstances apply.

Paragraph 35-55(1)(a) of the ITAA 1997 refers to 'special circumstances' outside of the control of the operators of the business activity, including drought, bushfire and other natural disasters. However the list is not meant to be exhaustive. There are a range of other circumstances which may be considered as special.

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 Secretary, Department of Employment, Education, Training & Youth Affairs v. Barrett and Another (1998) 82 FCR 524 '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 and 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.

The operators of the business activity must show that the special circumstances were outside their control. The concept of control was discussed in Secretary, Department of Employment, Education and Youth Affairs v. Ferguson (1997) 76 FCR 426; (1997) 48 ALD 593; (1997) 147 ALR 295 for the purposes of subsection 45(6) of the Employment Services Act 1994 . At 76 FCR 438; 48 ALD 603; 147 ALR 306, Mansfield J said:

'The expression in s45(6)(a) requires that the main reason for the failure was something that the person had within that person's control. The concept of "control" in that context is one of fact, but I think it is intended to mean something which the person could have done something about.'

And at 76 FCR 438, 48 ALD 603; 147 ALR 306:

'It recognises the focus of the expression upon occurrences which the person concerned could not realistically prevent.'

Paragraph 47 of Taxation Ruling TR 2007/6 explains that to qualify as special circumstances the circumstances must go beyond the normal or expected fluctuations in business, weather or market conditions. Ordinary economic, weather or market fluctuations that might reasonably be predicted to affect the business activity as well as trading downs and risks associated with running a business will not be considered to be special circumstances.

It then has to be shown that the special circumstances, in the case of those that do not meet the income requirement, prevented them from deriving a profit from the business activity in that income year. For example, you may have a business that is normally profitable but during a severe drought water supply may be affected to the extent that water allocations are cut and crops cannot be irrigated to the correct level. Assuming normal prices were received in that year, it could be shown that the reduction in yield due to drought (special circumstances) was the reason that a profit was not produced in that year. The Commissioner may exercise the discretion to allow the losses to be offset against other income in that year.

You have stated that:

Because of industry conditions the venture is currently not profitable and is not likely to be so for some time……

Because of widespread industry conditions the activity has struggled to be profitable, in the face of among other things a massive change in the Australian dollar as a result of the mining boom (from US$0.60 to US$1.05 presently). This has killed off significant export demand and driven prices to unsustainable lows.

We need to consider whether these circumstances are considered to be 'special circumstances', whether they were outside your control and whether they prevented your activity from making a profit in this year.

History of production and prices of the industry

The oversupply and subsequent price fluctuation for the product have historically been part of the industry in Australia. In earlier years growers were paid a subsidy under a scheme by the Federal Government to remove crops and not to replant for a period of years.

In essence, the purpose of the assistance is to encourage uneconomic growers who wish to leave the industry to do so and, thereby, to reduce surplus production.

Industry information indicates that in the early years the market price for product doubled which consequently lead to a 50% increase in plantings across Australia. For example, in the period from January 1999 to June 2001 there were product rulings issued for a number of these projects.

Further guidance can be found in reports produced by the relevant government departments, such as the Department of Agriculture, Fisheries and Forestry (Research by ABARES).

Production in Australia increased rapidly over the past 20 years, primarily driven by strong demand for Australian product in export markets. During this period, relatively high prices led to a rapid expansion of Australia's crop area.

However, in recent years the growth in demand for Australian product has slowed considerably, as competition in export markets increased. This has placed downward pressure on prices. In response to increased international competition, the proportion product exports being shipped in bulk has increased, placing further downward pressure on prices.

Continued weak global demand was once again reflected in lower prices buyers offered for product. Data from the industry body about purchases provides estimates of average prices by region. With the exception of one year, real and nominal product prices have been declining annually over the past decade.

The report includes graphs showing a gradual reduction in price over the 11 year period. The average prices dropping to half or less.

In coming years, the Australian industry is expected to continue to face strong competition in both the domestic and export markets. The abundant supply on the world market, the global economic slow down and a strong Australian dollar relative to the currencies of Australia's major export destinations will continue to put downward pressure on demand for Australian product. As a result, prices are expected to remain subdued.

The equivalent report for the projections in earlier years, reported that the Australian industry had expanded rapidly at an earlier time.

In the fifteen years before this report, the production has increased threefold while the value of production has risen tenfold. It noted that the, rapid expansion in production over the past few years has created many challenges for the industry.

Exchange Rates

A review of the history of the exchange rate shows that in 1997-98 the Australian dollar was around US80c, going down to around US50c in 2001-02, going back up to US80c by January 2004. It stayed at this level until January 2007 before going up to just under parity, dipping down to nearly US60c with the global financial crisis, before going back up to parity or slightly above, currently.

Conclusion

Whilst we accept that the fluctuations in market prices are not within your control we consider them to be a normal part of the industry. There has been a gradual drop in prices over the period, not a pronounced sudden drop. This is due to a number of factors including:

· a rapid expansion in the area under crops in Australia

· a slow down in the demand for Australian product, as competition in export markets increased

· the proportion of exports being shipped in bulk has increased, placing further downward pressure on prices

· the value of the Australian dollar.

It is not considered that this variation in prices over the period concerned is considered to be special circumstances in terms of the non-commercial loss legislation. Looked at over this period of time and taking into account the industry history it is not considered to be unusual, uncommon or exceptional. There are a number of normal factors that have contributed in bringing prices down from a high and history shows that this has happened before. The dependency on export markets means that there are a number of factors that can be expected to influence prices.

The circumstances you have outlined that have affected your business activity to prevent it from making a profit are not considered to be special circumstances for the purposes of the non-commercial losses legislation. Therefore the Commissioner cannot exercise his discretion. As stated above, the Commissioner cannot exercise the discretion under special circumstances for a later period at this point in time.