Edited version of your written advice

Authorisation Number: 1013020892509

Date of advice: 15 June 2016

Ruling

Subject: Commissioner's discretion-special circumstances

Question:

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 business activity in your calculation of taxable income for the 2011-12 and 2012-13 financial years?

Answer: No

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on:

1 July 2011

Relevant facts

You are a partner in a partnership which has operated a primary production activity for more than 15 years.

The property suffered drought conditions that ended approximately six years ago which reduced the income earned by the business and increased the expenditure on feed and fodder.

You have suffered from an illness for several years. Due to your illness your spouse has been required to care for you and this affected you and your spouse attending to farming operations and increased the operating costs of the farm as additional labour was required to keep the farm running.

The partnership farming activity has satisfied the tests set out in sections 35-30 (assessable income test), 35-40 (real property test) and 35-45 (other assets test) of the ITAA 1997.

You do not satisfy the income requirement set out in subsection 35-10(2E) of the ITAA 1997.

The business has never made a profit.

You expect that the partnership will make a tax profit from the farming activity in the 2016-17 financial year because you consider:

• Improved environmental conditions will result in a larger number of livestock being able to be sustained, an increase in the size and quality of the livestock born which will lead to higher prices, and higher quantity and quality of product which will lead to increased sales and prices.

• The average market value of the products you sell is increasing.

• Your health is improving which means you and your partner will be able to perform more work on the farm which will reduce the partnership's costs for contracted labour.

• You have recently gained access to an additional market for a product that you previously could not access.

• Expenses will remain relatively stable as improved conditions will mean that the farm requires less maintenance and supplies. There will still be slight increases in most of the other farm expenses, as the scale of the business increases so will the variable costs for running the business.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 35-10(1)

Income Tax Assessment Act 1997 subsection 35-10(2)

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

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

Reasons for decision

Summary

It is accepted that both drought and your illness constitute special circumstances and affected your business. However, this in itself is not sufficient for the discretion to be exercised. The Commissioner must also be satisfied that your activity would have made a profit in the 2011-12 and 2012-13 financial years if these special circumstances had not occurred.

The Commissioner considers that the special circumstances contributed to the extent of the losses but is not satisfied that they were the only factors that resulted in the activity making losses. That is, the Commissioner is not satisfied that but for the drought and your illness, the activity would have made a profit in the 2011-12 and 2012-13 financial years. Therefore, the discretion will not be exercised.

Detailed reasoning

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

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

• the exceptions apply, or

• the Commissioner exercises his discretion.

In your situation, 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 you do not come under any of the exceptions. Your business losses are therefore subject to the deferral rule unless the Commissioner exercises his discretion.

You have requested that the Commissioner exercise the special circumstances discretion as you believe that the drought and your illness were special circumstances that prevented the business from producing a tax profit in the 2011-12 and 2012-13 financial years.

'Special circumstances' are those circumstances which are sufficiently different to distinguish them from the circumstances that occur in the normal course of conducting a business activity, including drought, flood, bushfire or some other natural disaster.

For individuals who do not satisfy the income requirement, the business activity must have been materially affected by the special circumstances, causing it to make a loss. In this context, the Commissioner may exercise this discretion under paragraph 35-55(1)(a) of the ITAA 1997 for the income year(s) in question where, but for the special circumstances:

• your business activity would have made a tax profit, and

• the activity passes at least one of the four tests or, but for the special circumstances, would have passed one of the four tests.

Taxation Ruling TR 2007/6 sets out the Commissioner's interpretation of the exercise of the Commissioner's discretion under paragraph 35-55(1)(a) of the ITAA 1997. The following has been extracted from paragraphs 48 to 53 of this ruling:

Although not limited to natural disasters, paragraph 35-55(1)(a) of the ITAA 1997 refers to special circumstances as including drought, flood, bushfire or some other natural disaster… Cyclones, hailstorms and tsunamis are examples of other natural disasters that would come within the scope of the paragraph.

Further paragraph 54 of TR 2007/6 includes illness of key personnel as an example of the type of circumstances to which the special circumstances limb of the Commissioner's discretion can be applied.

Paragraph 47 of 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.

Paragraph 52 of TR 2007/6 states that the discretion can be exercised in income years after the one in which the special circumstances have occurred if the effects of those special circumstances on a business activity continue such that they prevent the business activity from making a tax profit in those later years.

Your circumstances

Your illness is clearly a special circumstance as it was outside your control and affected you and your partner who are key personnel of the business.

The drought that was declared by the Department of Primary Industries which ended approximately six years ago is also a special circumstance.

In the years after the drought, the business has been subject to periods of average, higher than average and lower than average weather conditions. The periods of low rainfall that were not declared a drought do not constitute special circumstances for the purposes of the paragraph 35-55(1)(a) discretion. Primary production activities are expected to be affected by normal weather fluctuations. It is only if a weather fluctuation is exceptional such that it is considered a natural disaster (for example where a drought is declared) is it considered to be a special circumstance.

Effect on profitability

As mentioned previously, for the Commissioner to be able to exercise the discretion, it is not enough that the business was affected by the special circumstances; the Commissioner must be satisfied that if it was not for the special circumstances, the business would have made a tax profit.

The drought resulted in increased feed expenses and a reduction in revenue.

Your illness affected the business in that higher amounts had to be expended on contracted labour.

It is accepted that the drought in the earlier income years and your illness affected the business in the 2011-12 and 2012-13 income years. However, these effects need to be quantified in order to determine if the business would have made a tax profit if those special circumstances had not occurred.

The business made losses of $XXX,XXX/L and $XXX,XXX/L for the 2011-12 and 2012-13 income years, respectively.

The business incurred feed and fodder expenses of $XX,XXX (2011-12) and $XX,XXX (2012-13); and contracted labour expenses of $XXX,XXX (2011-12) and $XXX,XXX (2012-13). In your projections for 2016-17, you included feed and fodder expenses of $XX,XXX and contracted labour expenses of $XX,XXX. This indicates that the business might have incurred some feed and fodder expenses in 2011-12 and 2012-13 even if it was not affected by drought. Also, the business might have incurred some contracted labour expenses, for example for specialised tasks, even if you and your spouse were available to work on the farm. However, we will give the business the benefit of the doubt and so for the purposes of determining whether the business would have made a profit in 2011-12 and 2012-13, we will remove all the feed and fodder expenses and all the contracted labour expenses.

The business has been operating for more than 15 years and the highest income it has ever earned was $XXX,XXX in the 2014-15 income year. This was five years after the drought so it is not considered that the drought affected the income earned in 2014-15. Therefore, this is the best figure available to estimate the income that the business would have earned in 2011-12 and 2012-13 if not for the drought in the earlier years.

Using the highest income figure the business has ever achieved and removing all the feed and fodder expenses and all the contracted labour expenses, it is estimated that the business would have made a net profit/loss as follows:

As discussed above, we have removed all the feed and fodder expenses and all the contracted labour expenses even though it is quite likely that the business would still have incurred some of these expenses (especially contracted labour expenses) if the special circumstances had not occurred. Therefore, these loss estimates are most likely to be quite conservative.

Our view that the farming activity would still have made a loss even if the special circumstances had not occurred is also supported by the following:

• By 2014-15, some years had passed since the drought so it is considered that the business would be no longer affected or if it was, any lingering effects would be slight. Nevertheless, the business made a loss of $XXX,XXX /L which after removing all the contracted labour expenses to take into account the effect on the business of your illness, still leaves a loss of $XXX,XXX /L.

• You have predicted that the farming activity will make a profit for the first time in 2016-17. The profit you have predicted is quite small but to achieve it, you have estimated an income for the year of $XXX,XXX. This estimate appears to be very optimistic given it is more than five times the highest yearly income the business has ever achieved. If this level of income is required in order for the business to make a profit, it is clear that there are other factors besides the drought and your illness which has caused the business to be unprofitable. In fact you have advised that your predictions are based on improved sale prices in the market and the opening up of a market for one of your products that was previously not available to you. Therefore, it is apparent that the level of market pricing and the inability to access the additional market has contributed to the business making losses. Although these matters are outside of your control they are a normal commercial risk of carrying on a business in your industry and not unusual or out of the ordinary. These circumstances would not constitute special circumstances in the way this term is used in the legislation. As the business required these factors to turn in its favour before it could make a profit, it is clear that it was not only the drought and your illness that have caused the business to be unprofitable.

Although the drought and your illness constitute special circumstances and affected your business, the Commissioner is not satisfied that your activity would have made a profit in the 2011-12 and 2012-13 financial years if these special circumstances had not occurred. These special circumstances contributed to the magnitude of the losses but they were not the only factors that resulted in the activity making losses. Therefore, the discretion will not be exercised.