Edited version of your written advice

Authorisation Number: 1012687482526

Ruling

Subject: Non-commercial losses - Commissioner's discretion

Question

Will the Commissioner exercise the discretion in paragraph 35-55(1)( c) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your business in your calculation of taxable income for the years ended 30 June 2013 to 30 June 2015?

Answer

No

This ruling applies for the following periods

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

The scheme commenced on

1 July 2010

Relevant facts

You commenced a breeding business in 2010.

You have been involved in the industry for many years.

Your main income producing activities of the business are breeding stock for sale and to enhance your reputation as a breeder.

The activity is conducted mainly at your property and equipment.

You utilise consultants in the business, some of whom also act as agents for buying purposes.

You regularly use a consultant's property for your activities.

Your business plan states that breeding stock will be maintained focusing on low numbers but high quality'.

Losses were made 2012-13 to 2013-14 financial years and are expected in the 2014-15 financial year due to lack of sale numbers in a start-up business and the high costs associated with the activity.

You have provided livestock trading statements and a breakdown of sales figures.

You have entered into share arrangements or partnerships in the case of some of your stock.

The business has required capital contribution by you to acquire the breeding stock and to cover cost of sales.

You expect that major sales of stock will commence in the 2015-16 financial year.

You expect the business will be profitable from 2015-16 financial year.

You have provided independent evidence from an industry expert of the lead times for your industry for different activities.

Your income for non-commercial losses purposes is greater than $250,000.

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)(c)

Reasons for decision

For the 2009-10 and later financial years, Division 35 of the ITAA 1997 will apply to defer a non-commercial loss (NCL) from a business activity unless:

• you meet the income requirement and you pass one of the four tests

• the exceptions apply

• the Commissioner exercises his discretion.

In your case, you do not satisfy the income requirement (that is, your taxable income, reportable fringe benefits and reportable superannuation contributions but excluding your business losses, exceeds $250,000) and do not come under any of the exceptions. Your business losses are therefore subject to the deferral rule unless the Commissioner exercises his discretion.

The relevant discretion may be exercised for the financial year in question where:

• it is in the nature of your business activity that there will be a period before a tax profit can be produced; and

• there is an objective expectation your business activity will produce a tax profit within the commercially viable period for your industry.

The meaning of 'because of its nature'

For the Commissioner to exercise the discretion you must be able to show that the reason your business activity is producing a tax loss in a year, is because of something inherent to the nature of the business and not something peculiar to your situation. For example, the discretion will not be available where the failure to make a profit is for reasons other than the nature of the business such as, a consequence of starting out on a small scale, the hours worked or the need to build a client base.

For the failure to satisfy one of the four tests or produce a tax profit to be 'because of its nature', the failure must be because of some inherent characteristic that the taxpayer's business activity has in common with other business activities of that type (Federal Commissioner of Taxation v. Eskandari (2004) 134 FCR 569; [2004] FCA 8; 2004 ATC 4042; (2004) 54 ATR 695 (Eskandari)).

Where the activities failure to satisfy a test or produce a tax profit is because of such an inherent characteristic, the requirement will be met for any income year within the period from the time the business activity starts to the end of the last income year in which that characteristic still affects the activity's ability produce a tax profit.

Where the initial period has passed, any continuing failure to produce a tax profit will be for reasons outside of subparagraph 35-55(1)(c)(i) of the ITAA 1997, and the discretion will not be exercised.

The note under paragraph 35-55(1)( c) states:

Paragraphs (b) and (c) are 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.

Paragraph 1.51 of the EM comments:

This arm of the safeguard discretion will ensure that the loss deferral rule does not adversely impact on taxpayers who have commenced activities which by their nature require a number of years to produce assessable income. Examples of activities could fall into this category are forestry, viticulture and certain horticultural activities.

Stone J in Eskandari confirmed this view when considering whether the Commissioner's discretion should be exercised in regard to losses incurred in a migration consultancy business. When looking at the type of activities referred to by the note and the EM, Stone J stated at FCA 31:

Such activities have an inherent characteristic that cannot be overcome by conducting the business activity in a different way but only by changing the nature of the business.

Therefore, the phrase 'because of its nature' refers to inherent characteristics of the type of business activity being conducted by the taxpayer, which are common to any business activity of that type. These inherent characteristics must be the reason why the activity is unable to produce a tax profit. The discretion is not intended to be available where the failure to produce a tax profit is for other reasons.

The decision in Eskandari has been cited in two recent AAT cases, and the application of its principles clarified in relation to the term 'because of its nature' in paragraph 35-55(1)(c)(i). These cases are particularly relevant as they clarify the application of the law after the introduction of the $250,000 income test in determining who may get a discretion under 35-55(1)(c).

In Case 1/2013 [2013] AATA 3; 2013 ATC 1-050; 87 ATR 355 (Case 1/2013), the AAT held that a taxpayer whose vineyard did not reach full production for approximately 10 years was not entitled to the exercise of the discretion in s 35-55(1)(c) of the ITAA 1997 allowing losses from non-commercial businesses to be offset against other income. The AAT found that, although the taxpayer provided convincing reasons why she chose to take a staggered approach, the vineyard could be planted and reach peak production within five years, rather than eight or nine years.

The following paragraphs from the case are relevant:

15. Can it be said the business 'because of its nature… will not produce… assessable income greater than the deductions attributable to it' during the 9 year period contended for by the taxpayer? The answer to that was clear enough from Mr Greaves' evidence - in particular, from his question to Ms Ford about whether it was possible to have the vineyard up and running within 5 years. He said it was. I accept he thought it was commercially prudent to approach the development in a more gradual way, and he may well be right. But that is not the test. I am required to look at whether the failure to produce sufficient assessable income during a given year of income was a "result of some inherent feature that the taxpayer's business activity has in common with activities of that type". See Federal Commissioner of Taxation v Eskandari 134 FCR 569 at [32] per Stone J.

16. Vines can be planted and become productive within 5 years. The applicant has chosen to take a more gradual approach. No one quibbles with the wisdom of her decision, and I am told it is common practice in the industry. But she is unable to satisfy the first leg of the test in s 35-55(1)(c ). In those circumstances, it would not be reasonable to exercise the discretion in her favour.

Similarly, in Hefner v FC of T 2013 ATC 10-319; [2013] AATA 407 (Hefner), the taxpayer failed to establish that eight years of losses from a cattle stud business were 'because of the nature' of the business. The evidence showed that it was possible for a stud to make a profit within five years and it was the high level of debt that would prevent a profit being made until at least eight years from commencement.

The following paragraphs are extracts from the case.

15. I would add I am satisfied the evidence establishes a stud can begin selling its output within about five years, even though its products will not command premium prices until eight to ten years after establishment. The delay in achieving profitability after the five year mark appears to be attributable to financing costs.

16. The Commissioner points out the decision-maker must address the matters in both limbs of the test in s 35-55(1)(c). Those limbs require that the decision-maker be satisfied:

(i) the business will not become profitable in the period under review (ie, before 30 June 2017) because of its nature: and


(ii) there is independent evidence that justifies an objective expectation that the business will produce assessable income within the period that is commercially viable for the industry concerned.

17. The taxpayer is unable to satisfy the test contained in the first limb, which makes it unnecessary to consider the issues in the second limb. The evidence establishes a stud could become profitable in advance of 30 June 2017; indeed, depending on the cost structure of the operation, it could become profitable as early as five years after establishment (although I accept it probably would not generate maximum profits until sometime later). The key variable is financing costs. If those costs are high - because the operation is funded wholly or partly by debt - then it will take longer for the operation to turn a profit. But the operation does not have to be financed by debt. The fact most businesses are financed at least partly by debt does not suggest a debt is an "inherent feature that the taxpayer's business has in common with business activities of that type": see Commissioner of Taxation v Eskandari [2004] FCA 8 at [32] per Stone J. A stud business could be conducted in a different way, in the sense that alternative financing arrangements are at least theoretically available. There is nothing inherent in the business activities which demand that they be financed for that debt.

What is required to be determined is that essential period of time when 'because of its nature' businesses in the industry cannot derive any assessable income. For breeding activities it is that period of time that it takes to produce offspring that can potentially be sold. If it is a crop, it is that period of time that it takes the crop to grow until it produces its first commercial harvest.

Application to your circumstances

In considering whether to allow a discretion in the 2012-13 to 2014-15 years of income, we need to establish whether there is something inherent in the nature of this type of activity that will prevent you from having assessable income greater than the deductions attributable to the activity in these years.

In your application for a private binding ruling, you provided independent evidence which suggests that different lead times for progeny, depending on when the stock starts being used for breeding.

This is an important distinction as it differs depending on your circumstances.

We would agree with the lead time figures suggested for the different starting points and we also suggest that it could be less in certain circumstances.

This is a key factor to take into account when deciding how to conduct your activity and how many broodmares you may commence a business with, in determining the economics of your activity. There are a number of overhead expenses that are required to be met each year and these can only be met from the sale of offspring.

Some of the factors that have prevented, or may prevent, you making a tax profit in the years in question include:

• death of breeding stock;

• your business decisions;

• fluctuation in sales prices;

• small scale start-up;

• large costs.

These are all possible things that can be expected in this type of activity that may affect profitability, but none of these things are considered to be an 'inherent characteristic' of the activity, in terms of 'because of its nature' for non-commercial losses purposes. The above factors will not only affect your business activity during the 'initial period', when an NCL discretion may be considered, they may impact on your business in each and every year it is conducted. They are not factors that are 'in the nature' of the activity that will prevent you from producing assessable income greater than the deductions attributable to it, for NCL purposes.

You had sales of progeny in the year ended 30 June 2012, one year after commencing your business. You have also sold more in the 2012-13 income year. With sales in both the 2011-12 and 2012-13 income years, you are now outside the lead time period associated with the term 'because of its nature' in the context of the first limb of s35-101)(c) of the ITAA 1997.

The failure of your breeding activity to produce assessable income greater than the deductions attributable to it in the 2012-13 to 2014-15 income years is not (or will not be) because of some inherent characteristics of the business but for other reasons as discussed above.

As in Hefner, it is not necessary to consider whether you will satisfy the second limb of s35-101)(c) of the ITAA 1997 about the expectation of producing assessable income greater than the deductions attributed to the activity within a period that is commercially viable for the industry.

Having regard to the facts presented in your ruling, it is not accepted that it is some characteristic inherent in the nature of the business that will prevent you from making a profit for six years as your breeding activity became productive soon after commencement with multiple sales in the 2011-12 and 2012-13 financial years.

For the reasons stated above, and consistent with the decisions in Hefner and Case 1/2013, the Commissioner will not exercise the discretion available in accordance with subsection 35-55(1) and paragraph 35-55(1)(c) of the ITAA 1997 for the 2012-13 to 2014-15 financial years.