Edited version of private advice

Authorisation Number: 1052130341434

Date of advice: 23 June 2023

Ruling

Subject: Deductions - carrying on a business

Question 1

Were you carrying on a business for the purposes of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are the employee expenses for group A deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 3

If the answer to question 2 is no, are the employee expenses for group A deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable.

Question 4

Are the employee expenses for the group B deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 5

If the answer to question 4 is no, are the employee expenses for group B deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable.

Question 6

Are the employee expenses for group C deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 7

If the answer to question 6 is no, are the employee expenses for group C deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable.

Question 8

Are the employee expenses for group D deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 9

If the answer to question 8 is no, are the employee expenses for group D deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable.

This ruling applies for the following periods:

20XX

20XY

20XZ

The scheme commenced on:

20XX

Relevant facts and circumstances

You undertook activities to establish a business with XXXXX that would be operating by a certain point in time.

Those activities were undertaken in accordance with your business plan.

You employed people in groups A, B, C and D to carry our day-to-day activities in preparation for the opening of this business.

You subsequently decided to cease your business plan prior to opening the business and lts' XXXXX.

You incurred various employee expenses, including:

•      salary and wages

•      superannuation contributions to complying superannuation funds

•      payroll tax and fringe benefits tax (FBT), and

•      final salary and wages, including paying out of annual leave.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All legislative references in these reasons for decision are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Summary

You were carrying on a business for the purposes of section 8-1.

Detailed reasoning

Section 8-1 states:

(1)  You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2)  However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

(3)  A loss or outgoing that you can deduct under this section is called a general deduction.

Subsection 995-1(1) defines business as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

Whether or not a business is being carried on is a question of fact and is determined by weighing up the relevant indicators.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) explains at paragraph 13 that the courts have held that the following indicators are relevant:

• whether the activity has a significant commercial purpose or character; this indicator comprises many aspects of the other indicators
• whether the taxpayer has more than just an intention to engage in business
• whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity
• whether there is repetition and regularity of the activity
• whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business
• whether the activity is planned, organised, and carried on in a businesslike manner such that it is directed at making a profit
• the size, scale, and permanency of the activity, and
• whether the activity is better described as a hobby, a form of recreation or a sporting activity.

The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impression gained from looking at all the indicators, and whether these factors provide the operations with a commercial flavour. However, the weighting to be given to each indicator may vary from case to case (paragraph 16 of TR 97/11).

Where an overall profit motive appears absent and the activity does not look like it will ever produce a profit, it is unlikely that the activity will amount to a business (paragraph 17 of TR 97/11).

The indicators above are also referred to in Taxation Ruling TR 2019/1Income tax: when does a company carry on a business? (TR 2019/1). It states the following in paragraphs 15 and 17:

There are two categories of legislative provisions and cases where the question is whether a company carries on a business. The first category is concerned with whether a company carries on a business in a general sense - irrespective of what is the actual business...

The provisions this Ruling deal with are concerned with the first category: whether a company carries on a business in a general sense.

Paragraphs 19 and 20 of TR 2019/1 state:

While the indicia set out in the case law are relevant to companies, companies are typically formed for the purpose of carrying on a business. In Westleigh and American Leaf,it was observed that where a company aims to make, and has a prospect of profit, it is presumed that the company intends to, and does in fact, carry on a business. In American Leaf, Diplock LJ observed that this means any gainful use to which a company puts its assets will, on its face, amount to the carrying on of a business. However, this presumption can be rebutted if it can be shown that, on the facts, the company had no aim or prospect of making a profit.

A consideration of the relevant indicia of when a business is carried on in light of the characteristics of a company shows why this presumption arises. It can also assist in determining whether the presumption arises and, if it does, whether it is rebutted on the facts of the case.

By applying the indicia to you it is possible to determine whether this presumption arises, or whether based on the facts such a presumption is incorrect.

Significant commercial purpose

As explained in paragraph 29 of TR 97/11 the significant commercial purpose or character indicator is closely linked to the other indicators and is a generalisation drawn from the interaction of the other indicators. It is particularly linked to the size and scale of activity, the repetition and regularity of activity and the profit indicators.

Size, scale, and permanency of the activity

Paragraph 46 of TR 2019/1:

The size and scale of the activities in question are relevant, but not necessarily conclusive, of whether they amount to the carrying on of a business. Where the company carries out activities which have a purpose and prospect of making a profit, the amount of capital it has invested in the activities and the scale of its activities, even if limited and small, will carry less weight than it would in the case of an individual or trust.

Repetition and regularity

Paragraph 38 of TR 2019/1

The degree of repetition or regularity of the company's activities is relevant to determining whether it carries on a business. While there is a need for activity, this may be satisfied even if a company's activity is relatively limited, irregular or has periods of inactivity.

Prospect of profits

The taxpayer's involvement in the activity should be motivated by wanting to make a profit and the taxpayer's activities should be conducted in a way that facilitates this. This will require examining whether objectively there is a real prospect of making such a profit from participating in the relevant activity.

Paragraphs 32 and 33 of TR 2019/1

In determining whether a company has a profit-making purpose, the purposes of those who set up the company, maintain and control it may be considered. The objects as stated in the company's constitution can also be considered, although this is not conclusive of whether a company carries on a business.

If a company is a member of a group of companies, its purpose, and whether it carries on a business, may be determined by reference to its role within the group, the activities of the wider group, and the intended activities of any of its subsidiaries at the time they are set up.

Paragraph 35 of TR 2019/1

A company's activities may have a profit-making purpose, even where on the objective evidence it is expected, and indeed likely, that they will not make a profit in the short term. Where this is the case, the company may still carry on a business, although the other indicia will carry more weight in reaching that conclusion.

Intention of the taxpayer

The carrying on of a business is not a matter merely of intention, it is a matter of activity. It is appropriate to look at when the activities started and whether they add up to more than a mere intention to conduct a business.

This is addressed in TR 97/11:

39. The intention of the taxpayer in engaging in the activity is a relevant indicator: see Thomas. However, a mere intention to carry on a business is not enough. There must be activity. Brennan J in Inglis v. FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497 said that:

'The carrying on of a business is not a matter merely of intention. It is a matter of activity. ... At the end of the day, the extent of activity determines whether the business is being carried on. That is a question of fact and degree.'

See also J&R O'Kane & Co v. IR Commissioners (1920) 12 TC 303 at 347 and Case K9 78 ATC 98 at 103; 22 CTBR (NS) Case 29 at 302.

40. This indicator is particularly related to:

•         whether the activity is preparatory or preliminary to the ultimate activity;

•         whether there is an intention to make a profit; and

•         whether the activity is better described as a hobby or the pursuit of a recreational or sporting activity.

Preparatory activities

41. Sometimes a taxpayer may have incurred expenses before commencing a particular business of primary production. For example, expenses associated with experimental or pilot activities which do not amount to a business and do not result in any assessable income being produced are not deductible: see Softwood Pulp and Paper Ltd v. FC of T 76 ATC 4439; (1976) 7 ATR 101 and Goodman Fielder Wattie Ltd v. FC of T 91 ATC 4438; (1991) 22 ATR 26. Experimental or pilot activities of this nature should be distinguished from the activities in Ferguson, which were found to have a sufficient commercial character to be regarded as a business in their own right. However, where a business has commenced, expenses may be deductible even if no income is derived in the relevant year: see Thomas.

Your activities during the relevant period have a 'commercial flavour' (to quote Ferguson)as they were undertaken to open the business at a point in time. There was more than an intention to carry on a business, as significant activities were conducted in a systematic and organised manner.

Therefore, having considered the indicators of carrying on a business during the relevant period, your activities support the conclusion that you were carrying on a business for the purposes of section 8-1.

Question 2

Summary

The employee expenses for group A are deductible under section 8-1 on the basis that you were carrying on a business and no part of those expenses is excluded by subsection 8-1(2).

Detailed reasoning

You incurred employee expenses for the income years 20XX and 20XY. Although you decided to cease your business plan prior to opening any XXXXX, some employees were required to continue employment during the income year 20XZ in respect of which you also incurred employee expenses.

Under paragraph 8-1(1)(b), you may deduct any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income.

You were carrying on a business, during which you had employees engaged in activities in A.

Salary and wages and other amounts relating to labour are ordinarily outgoings that satisfy subsection 8-1(1). However, an analysis of the relevant facts is still required. In Commissioner of Taxation v Star City Pty Limited [2009] FCAFC 19, Jessup J stated at [263]:

...Likewise, while wages are ordinarily a revenue expense, wages paid to employees engaged wholly upon the installation of new capital equipment should not be so regarded. Merely to look at the legal rights and obligations which existed as between the payer and the payee (ie the employer and the employee) would be of no assistance in the task of characterisation.

Positive limb

The requirements of subsection 8-1(1) are satisfied (through paragraph 8-1(1)(b)) for the following reasons:

• The employee expenses for group A are an outgoing because they involved money flowing out of you.
• You incurred the amount of the employee expenses for group A because you either paid them or you had a presently existing liability to pay them (paragraph 6 of Taxation Ruling TR 97/7).

An outgoing can be incurred before it is paid if you are definitively committed and completely subjected to it during the relevant income year.

• You necessarily incurred the employee expenses for group A in carrying on a business for the purpose of gaining or producing assessable income.

In Commissioner of Taxation v Day [2008] HCA 53 at [21], the majority judgment of the High Court stated (albeit in the context of an individual claiming a deduction under paragraph 8-1(1)(a) which uses the similar but simpler expression 'incurred in gaining or producing your assessable income'):

The words "incurred in gaining or producing ... assessable income", appearing in the section [8-1], have long been held to mean incurred "'in the course of' gaining or producing" income, as was observed in Payne [footnote 34 refers to FCT v Payne (2001) 202 CLR 93 at 99 [9] per Gleeson CJ, Kirby and Hayne JJ]."

In John Fairfax & Sons Pty Ltd v Commissioner of Taxation (Cth) [1959] HCA 4 (John Fairfax), Menzies J stated:

Disregarding the application of the section to losses and considering the alternative head solely in its application to outgoings, there must, if an outgoing is to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think it necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations.

The use of the word 'purpose' in paragraph 8-1(1)(b), is different to its use in paragraph 8-1(1)(a).

Paragraph 8-1(1)(b) requires, in relation to the purpose of the business (as opposed to the purpose of the outgoing), that the purpose be one of gaining or producing assessable income (Magna Alloys & Research Pty Ltd v. Commissioner of Taxation of the Commonwealth of Australia [1980] FCA 180).

Deductibility under paragraph 8-1(1)(b) does not depend on whether the business derived assessable income, that is, upon "success or failure of what the outlay was intended to achieve", but rather on the purpose of the business (John Fairfax, per Menzies J; Esso Australia Resources Ltd v the Commissioner of Taxation of the Commonwealth of Australia [1998] FCA 851.

The concept of a loss or outgoing being necessarily incurred in carrying on a business was analysed by Deane and Fisher JJ in Magna Alloys at 205:

The requirement that the claimed outgoing be "necessarily" incurred in carrying on the relevant business does not, in the context, mean that the outgoing must be either "unavoidable" or "essentially necessary". Nor does the word "necessarily" import a requisite of logical necessity. What is required is that the relevant expenditure be appropriate and adapted for the ends of the business carried on for the purpose of earning assessable income (see Ronpibon Tin NL v Federal Commissioner of Taxation [(1949) 78 CLR 47 at 55 - 56]; Federal Commissioner of Taxation v Snowden & Willson Pty Ltd [(1958) 99 CLR 431 at 437 and 444]). For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily to be incurred (Federal Commissioner of Taxation v Snowden & Willson Pty Ltd [(1958) 99 CLR 431 at 444]). It is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically. "The Act must operate upon the result of a taxpayer's activities as it finds them" (per Williams J in Tweddle v Federal Commissioner of Taxation [(1942) 7 ATD 186 at 190]; see also Ronpibon Tin NL v Federal Commissioner of Taxation [(1949) 78 CLR 47 at 56 - 57]; Cecil Bros Pty Ltd v Federal Commissioner of Taxation [(1962 - 1964) 111 CLR 430 at 434 and 441]; Inland Revenue Commissioner v Europa Oil (NZ) Ltd (No 1) [[1971] AC 760 at 772]; Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd [(1978) 140 CLR 645 at 653 - 654].

This passage in Magna Alloys was referred to with approval by the joint judgment of the High Court in Spriggs v Commissioner of Taxation [2009] HCA 22 (Spriggs) at [75]:

In Ronpibon Tin, the overlap between the limbs of the predecessor section to s 8-1 of the ITAA [Income Tax Assessment Act 1936 (Cth), s 51(1)], which often renders the second limb otiose, was noted [(1949) 78 CLR 47 at 56]. It was held that a loss or outgoing will be "necessarily incurred in carrying on" a business if it is "clearly appropriate" or "adapted" for the carrying on of the business [(1949) 78 CLR 47 at 55-56]. Restating the test another way, the loss or outgoing will be "necessarily incurred" if it is "reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business" [Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 11 ATR 276 at 295-296; 33 ALR 213 at 235 per Deane and Fisher JJ. See further Federal Commissioner of Taxation v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 437 per Dixon CJ; at 443-444 per Fullagar J].

Therefore, Spriggs has settled that an outgoing will be necessarily incurred in carrying on a business under paragraph 8-1(1)(b) if it is:

(a)  clearly appropriate or adapted for the carrying on of the business; or

(b)  reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business.

In Spriggs the High Court also referred to Federal Commissioner of Taxation v Snowden and Willson Pty Ltd [1958]HCA 23, in which Dixon CJ stated that the word 'necessarily', in this statutory context, meant "dictated by the business ends to which it [the expenditure] is directed, those ends forming part of or being truly incidental to the business".

The requirement that expenditure be shown to be appropriate and adapted necessarily involves an examination of all the business operations carried on over time and the whole course of events relevant to the expenditure at issue (Day at [33]).

This requirement is satisfied because the employee expenses for group A were appropriate and adapted for the carrying on of your business. They were part of the cost of operations, in that they rewarded employees for their service to you, and included other outgoings connected to, or flowing from, their employment.

In relation to the period after your decision not to continue, expenses are deductible where the occasion of the expenditure can be found in the employees' employment.

In Day at [30], the majority judgment of the High Court stated (once again noting that it was in the context of an individual claiming a deduction under paragraph 8-1(1)(a) which uses the similar but simpler expression "incurred in gaining or producing your assessable income"):

Payne directs attention to the statement made in Ronpibon Tin, as to the question posed by a provision such as s 8-1(1)(a), as correct and appropriate to be applied. The question, as restated in Payne, is: "is the occasion of the outgoing found in whatever is productive of actual or expected income?" That inquiry will provide a surer guide to ascertaining whether a loss or expenditure has been "incurred in [the course of] gaining or producing ... assessable income".

The employees in A were hired prior to your decision and were required to continue their duties until they were made redundant.

Negative limb

However, pursuant to subsection 8-1(2), you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature. In those cases where a direct link is established between an employee or contractor and the creation of a capital asset, some or all the outgoings in relation to the employee or contractor may be of a capital nature and hence not deductible.

Paragraphs 60, 61 and 64 of Taxation Ruling TR 2023/2 Income tax: application of paragraph 8-1(2)(a) of the Income Tax Assessment Act 1997 to labour costs related to the construction or creation of capital assets (TR 2023/2) state that:

60. Not all capital asset labour costs will be considered capital or capital in nature. However, where labour is specifically employed or contracted for the construction or creation of a capital asset, it will be on capital account. This is to be distinguished from where employees are employed in the day-to-day and ongoing operations of a business and they engage in activities that are capital in nature (such that their labour costs could be categorised as capital asset labour costs for the purposes of this Ruling) but they engage in those activities infrequently or those activities are considered minor or incidental in the context of their overall activities, duties and functions. The essential character of the capital asset labour costs of those employees is wholly revenue in nature and apportionment will not be relevant.

61. The employment or other contractual arrangements and/or an understanding of the functions undertaken by the employees or contractors will generally demonstrate whether or not persons are specifically employed or engaged for constructing or creating a capital asset. Other circumstances that will assist in ascertaining this include:

•         the nature and scope of the business

•         the corporate structure used to organise, plan, manage and undertake capital activities or activities related to capital assets

•         how the business plans and executes those activities

•         the business practices concerning the use of internal labour and external contractors for those activities

•         the terms of employment, job descriptions, key performance indicators of staff, the pattern of deployment and working profile and practices of internal labour in those activities, and

•         the accounting, control and governance systems you use to record the costs and resources used in those activities.

...

64. Whether a person is specifically employed in respect of the construction or creation of a capital asset will be determined at the time a relevant expense is incurred. Hence an employee cost or contracted labour cost can initially be on capital account and later be on revenue account when the employment or contracting changes (and vice versa).

No employees in group A were involved in creating a capital asset. Consequently, the employee expenses for group A do not fall within subsection 8-1(2).

As you were carrying on a business, the employee expenses for Group A, including those incurred after you decided not to continue with your business plan, are deductible under section 8-1.

Question 4

Summary

The employee expenses for group B are deductible under section 8-1 on the basis that you were carrying on a business and no part of those expenses is excluded by subsection 8-1(2).

Detailed reasoning

As discussed in the reasons for decision to question two, you may deduct any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, pursuant to subsection 8-1(2), you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature.

No employees in group B were involved in creating a capital asset. Consequently, the employee expenses for group B do not fall within subsection 8-1(2).

In relation to the period after you decided not to continue with your business plan, expenses are deductible where the occasion of the expenditure can be found in the employees' employment. The employees in group B were hired prior to your decision and were required to continue their duties until made redundant.

As you were carrying on a business, the employee expenses for Group B, including those incurred after you decided not to continue with your business plan, are deductible under section 8-1.

Question 6

Summary

The employee expenses for group C are deductible under section 8-1 on the basis that you were carrying on a business and no part of those expenses is excluded by subsection 8-1(2).

Detailed reasoning

As discussed in the reasons for decision to question two, you may deduct any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, pursuant to subsection 8-1(2), you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature.

No employees in group C were involved in creating a capital asset. Consequently, the employee expenses for group C do not fall within subsection 8-1(2).

In relation to the period after you decided not to continue with your business plan, expenses are deductible where the occasion of the expenditure can be found in the employees' employment. The employees in group C were hired prior to your decision and were required to continue their duties until made redundant.

As you were carrying on a business, the employee expenses for Group C, including those incurred after you decided not to continue with your business plan, are deductible under section 8-1.

Question 8

Summary

The employee expenses for group D are deductible under section 8-1 on the basis that you were carrying on a business and no part of those expenses is excluded by subsection 8-1(2).

Detailed reasoning

As discussed in the reasons for decision to question two, you may deduct any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, pursuant to subsection 8-1(2), you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of capital, or of a capital nature.

No employees in group D were involved in creating a capital asset. Consequently, the employee expenses for group D do not fall within subsection 8-1(2).

In relation to the period after you decided not to continue with your business plan, expenses are deductible where the occasion of the expenditure can be found in the employees' employment. The employees in group D were hired prior to your decision and were required to continue their duties until made redundant.

As you were carrying on a business, the employee expenses for Group D, including those incurred after you decided not to continue with your business plan, are deductible under section 8-1.