Edited version of your private ruling

Authorisation Number: 1012550888085

Ruling

Subject: Non-commercial losses - Commissioner's discretion

Question 1

Were you carrying on a business of producing and selling digital material in the relevant financial year?

Answer:

No

Question 2

Can 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 losses from your activity in the calculation of your taxable income for relevant financial year?

Answer:

No.

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts

You are producing and plan to sell digital material.

You currently conduct the activities by yourself and you plan to employ others as necessary.

You plan to sell in Australia and overseas. You have conducted market research and you have had some interest.

You have self-funded the activity to date but other sources of funding are being investigated.

You have developed some materials which are currently being trialled.

The product is not yet ready for sale.

Once ready for first sale the operational costs will be ongoing to keep the material up to date and relevant.

You have provided business projections.

You have experience in an area relating to the subject of the digital content and you have had a long term plan of starting a business.

You claim that it is inherent in the nature of your activity that it takes time for material development as the product needs to be ready before sale.

You expect that assessable income from your activity will exceed $20,000 in the 2013-14 financial year and that you will make a profit in the 2014-15 financial year.

Your income for non-commercial loss purposes was less than $250,000 during the 20XX financial year.

Relevant legislative provisions

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

Reasons for decision

Summary

The Commissioner will not exercise his discretion under paragraph 35-55(1)(b) of the ITAA 1997 to allow you to apply your business losses against your assessable income in 2012-13 financial year.

We consider that your activity had not yet commenced as a business in the relevant income year, therefore you will not have any deductible business loss to which the non-commercial loss rules could apply.

Detailed reasoning

Business losses from activities that do not meet any of the four tests under Division 35 of the ITAA 1997, or the exception in subsection 35-10(4) of the ITAA 1997, will be subject to the loss deferral rule in subsection 35-10(2) of the ITAA 1997, unless the Commissioner exercises a discretion under section 35-55 of the ITAA 1997 that it would be unreasonable to defer the loss.

In order for Division 35 to apply, a taxpayer must have commenced business. In determining when a business commences, there are three indicators that must be present before it can be said that a business has commenced. These are:

• purpose, intention and decision;

• acquisition of a business structure; and

• commencement of business operations

We must examine the above indicators in light of the characterisation of your business activity. In Goodman Fielder Wattie Ltd v. Federal Commissioner of Taxation 29 FCR 376; (1991) 22 ATR 26; 91 ATC 4438, Hill J stated:

Critical to the resolution of the present controversy, is the characterisation of the business activity itself which is said to have commenced. It was conceded properly by the applicant that if the business claimed to be carried on by it was to be characterised as one of manufacturing and selling monoclonal antibody products, then that business did not commence until around November 1982...

For example, for a primary production activity involving the planting and cultivating of trees, then the planting of the trees could be seen as the commencement of that business. Alternatively, if your business activity is characterised as a trading activity, involving conducting services in return for a fee, the business would generally be considered to have commenced once you begin conducting the services for a fee.

The information which you have provided indicates that your intended business activity is best characterised as a trading activity. Your intention is to develop digital materials and receive income in the form of sales of these products.

Purpose, intention and decision:

The chain of events leading to the commencement or start-up of a business activity often begins with a mere intention to establish the business activity. This is developed by researching the proposed business and, in some instances, by experiment. This process culminates in a final decision on whether to commence business. However, not all businesses commence in such an orderly manner.

It is clear from the information you have provided that you had decided the form of that business and had shown some commitment to it by conducting market research and trials and investing time in developing the materials that will become your product.

Acquisition of a business structure:

For a business activity to commence, an appropriate business structure should be in place. As to what this structure will consist of, and its size, this will be a question of fact and degree, and depend on the nature of the business activity. It is usually a collection of capital assets. What the particular capital assets are will depend on the particular business activity.

In Calkin v. CIR [1984] 1 NZLR 440 Richardson J said at 446-447:

Clearly it is not sufficient that the taxpayer has made a commitment to engage in business: he must first establish a profit-making structure and begin ordinary business operations.

In your case, you had not actually acquired all of the business assets that you needed to commence your business activity, including a finalised product to sell.

Commencement of Business Operations:

As noted by Brennan J in Inglis v. Federal Commissioner of Taxation (1979) 10 ATR 493; 80 ATC 4001, the level of activity is important in deciding whether a business is being carried on.  Brennan J stated at ATC 4004-4005;  ATR 496-497 that:

The carrying on of a business is not a matter merely of intention.  It is a matter of activity.  Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted.

In your case, you had not begun ordinary business operations during the relevant financial year. At that point in time you did not have your product ready for sale.

We consider that, up to this point, your activities were preliminary to the carrying on of your intended business. The costs associated with the establishment of a trading entity are capital in nature as they relate to the structure of the business rather than the daily activities from which the business gains its assessable income (see Federal Commissioner of Taxation v. Maddalena 71 ATC 4161; (1971) 2 ATR 541).

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.

Alternatively, even if you had commenced business, you have not produced any objective evidence to show that there is an inherent or innate characteristic preventing a business of producing and selling digital material from producing assessable income for any period of time: F C of T v Eskandari [2004] FCA 8; 54 ATR 695. On the contrary, some digital products may be successful soon after they are available for sale.