Edited version of private advice

Authorisation Number: 1051578740929

Date of advice: 1 October 2019

Ruling

Subject: Non-commercial losses

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 activity in the calculation of your taxable income?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2018

Year ended 30 June 2019

Year ending 30 June 2020

The scheme commences on:

1 July 2017

Relevant facts and circumstances

Your income for non-commercial loss purposes is over $250,000.

Orchard purchase

You operate an orchard.

You purchased the orchard approximately five years ago.

At the time, the mixed fruit orchard was well-established and being operated as a commercial orchard but you consider that it had been neglected and 'run down'.

The orchard has been operated as a commercial orchard for more than xx years under various owners.

You consider that all of the trees in the orchard had been allowed to grow too large which increases picking and pest management costs, reduces fruit quality and increases the likelihood of damage to trees and machinery.

Most of the Z trees were suffering from disease, drastically reducing their production and making them uneconomical to maintain. They were the original farm plantings, and some trees were over xx years old, which makes them near the end of their useful life. There was also a predomination of the lower value U variety.

Replanting

When you purchased the orchard, there were approximately xxx Z trees, xxx W trees and xxx Y trees. Of the xxx W trees, xxx were trellised and xxx were free standing. The free standing W trees have poor structure, reducing production and making them susceptible to storm damage.

You have removed approximately xxx Z trees and stumped almost all of the remainder. Stumping is where a fully grown tree is cut back to a one to two metre tall stump in order for it to regenerate.

You have removed all of the Y trees, which are a lower value variety.

You have removed xx of the W trees and you have lost xx W trees due to storm damage.

You have replaced these trees with x,xxx new plantings, which are all Ws on trellises.

The majority of clearing and replanting occurred in the 2016-17 and 2017-18 income years.

The Zs produced a small crop in the 2015-16 income year which generated approximately $xx,xxx of the farm's total revenue of approximately $xxx,xxx that year.

In the 2016-17 financial year the Zs only produced $x,xxx revenue after some removals and stumping. There has been no revenue since from the remaining stumped trees which are currently not worth maintaining.

The Y trees were still producing a good crop until you removed them. The decision to remove those trees was due to their size making them uneconomic to farm.

It was decided that planting the higher value W trees on the higher production trellis system was a better financial plan than refurbishing the existing trees.

Financial information

Since you expected to have a period when your orchard would make a trading loss, you have taken additional employment. This employment would normally remunerate approximately $xxx,xxx per year, however, during the 2017-18 income year, you received a discretionary bonus which increased your off farm income above the $250,000 threshold.

You have provided your orchard's total revenue and profit/loss figures for the 2014-15 to 2017-18 income years as follows:

You have provided the following forecasted profits/losses:

Income year 2018-19 Loss of $xx,xxx

Income year 2019-20 Loss of $x,xxx

Income year 2020-21 Profit of $xx,xxx

You expect to make a tax profit in the 2020-21 income year.

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)(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 from a business activity unless:

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

Under subsection 35-55(1) of the ITAA 1997, the Commissioner may, on application, decide that the deferral rule does not apply to a business activity for one or more income years (the excluded years) if the Commissioner is satisfied that it would be unreasonable to apply that rule because:

(c)for an applicant who carries on the business activity who does not satisfy subsection 35-10(2E) (income requirement) for the most recent income year ending before the application is made - the business activity has started to be carried on and, for the excluded years:

(i) because of its nature, it has not produced, or will not produce, assessable income greater than the deductions attributable to it; and

(ii) there is an objective expectation, based on evidence from independent sources (where available) that, within a period that is commercially viable for the industry concerned, the activity will produce assessable income for an income year greater than the deductions attributable to it for that year (apart from the operation of subsections 35-10(2) and (2C)).

Included in Division 35 of the ITAA 1997 is a 'Note' to paragraph 35-55(1)(c) of the ITAA 1997 which states that the particular paragraph is intended to cover a business activity that has a lead time between the commencement of the activity and the production of any assessable income. The note includes an example of 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.

The meaning of 'because of its nature' is explained in paragraphs 17-19 of Taxation Ruling TR 2007/6:

17. For the failure to satisfy one of the four tests (subparagraph 35-55(1)(b)(i)) or produce a tax profit (subparagraph 35-55(1)(c)(i)) 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 (see Federal Commissioner of Taxation v. Eskandari (Eskandari )).

18. Where the activity's failure to satisfy a test or produce a tax profit is because of such an inherent characteristic, the requirement in subparagraphs 35-55(1)(b)(i) or (c)(i) 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 to satisfy a test or produce a tax profit respectively (the 'initial period').

19. Where this initial period has passed, any continuing failure to satisfy a test or produce a tax profit will be for reasons outside of subparagraphs 35-55(1)(b)(i) and (c)(i), and the discretion will not be exercised (unless the special circumstances limb is satisfied).

Paragraphs 77 and 78 of Taxation Ruling TR 2007/6 expand on the discussion of the phrase 'because of its nature' mentioned in the above paragraphs:

77.   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 satisfy any of the tests. The discretion is not intended to be available where the failure to satisfy one of the tests is for other reasons.

78.   The consequences of business choices made by an individual (for example, the hours of operation, the size or scale of the activity, and the level of debt funding) are not inherent characteristics of a business activity...

For the Commissioner to exercise the discretion, you must also be able to show that the reason your business activity is producing a loss is inherent to the nature of the business and is not peculiar to your situation. That is, the reason why the business is making a loss must be due to the inherent features of the industry rather than the way the business is carried on.

Where an operator chooses to carry on the business activities in a manner that does not produce a tax profit within the period that is commercially viable for the industry concerned, paragraph 35-55(1)(c) of the ITAA 1997 may not be satisfied.

As stated further above, the Note to subsection 35-55(1) of the ITAA 1997 states that the lead time discretion is:

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.

In your case, you purchased a commercial orchard. Although you consider the orchard was neglected and 'run down', it was still being operated as a commercial orchard when you acquired it and was still capable of generating significant amounts of income as evidenced by the total revenue figures for the orchard in the income years immediately after you acquired it.

Although some of the Z trees were over xx years old, the trees still produced a crop generating about $xx,xxx of the farm's $xxx,xxx revenue in the 2015-16 income year. You decided to remove xxx Z trees and stumped almost all of the remainder.

You have chosen to remove the Y trees as they are a lower value variety. You decided to focus on W trees, being the higher value variety, and have replanted x,xxx W trees on trellises.

The reason that your business activity will not make a profit until the 2020-21 income year is due to a decision you have made with regards to how you run your business rather than due to any inherent features of the industry.

Therefore, the Commissioner will not exercise the discretion under paragraph 35-55(1)(c) of the ITAA 1997 in relation to your activity.

Further information for you to consider

However, if you do satisfy the income requirement (that is, your taxable income, reportable fringe benefits and reportable superannuation contributions but excluding your business losses, is less than $250,000), in the 2018-19 and 2019-20 income years, you can check if you pass any of the four tests of commerciality. If you pass one of these tests, you can offset the loss in the year in question.

Your forecasted cash flow shows total revenue in 2018-19 of $xx,xxx and 2019-20 of $xxx,xxx. As these amounts show that your potential assessable income will be greater than $20,000, you can offset the loss for the particular year in question, provided you meet the income requirement.