Edited version of private advice

Authorisation Number: 1052203032928

Date of advice: 7 June 2024

Ruling

Subject: Commissioner's discretion - 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 XXXX to include any losses from the minerals prospecting business activity in the calculation of taxable income?

Answer

No.

This ruling applies for the following period:

year ending xx xx xx

The scheme commenced on:

xx xx xx

Relevant facts and circumstances

You carry on a minerals prospecting business activity.

The minerals prospecting business activity commenced on xx xx xx.

You conduct the minerals prospecting business activities on a number of tenements in xxxxx. A number of personnel/firms are engaged under contract to carry on the mineral prospecting activities.

You do not satisfy the less than $250,000 income requirement set out in subsection 35-10(2E) of the ITAA 1997 for the year ended 30 June xx xx xx.

Due to the difficulty forecasting exploration success together with future global economic and pricing/cost conditions, you state that it is not possible to say with any degree of accuracy when the business is projected to generate a tax profit.

Based on previous experience over the last 10 years, profitability has occurred in 2 of those years as per below:

Table 1: Based on previous experience over the last 10 years, profitability has occurred in 2 of those years as per below:

The nature of mineral exploration businesses is that income receipts are irregular and largely dependent on exploration success, which can result in the deductions attributable to the business activity being greater than the income derived from the business activity.

You describe the activity as a high risk high return activity with no industry 'norm' generally applicable. Exploration 'success' is often a function of global economic and price/cost condition at the time and into the future which are very difficult to forecast.

You have enjoyed exploration success at a far higher rate than is commercially experienced in the exploration industry.

You have sought to find prospective mineral deposits and then apply for tenements in order to explore and develop them.

In xx xx xx, you transferred the majority of your exploration activities to your company, but you retained a number of mining interests personally which you continued to actively explore.

You state that the nature of the mineral exploration industry is one of high risk and high reward. AMEC has stated that 'Exploration is highly speculative, with estimates that only one in 10,000 areas of interest (prospects) will ever be mined'. Whilst this may be the case, a mineral exploration business can still produce assessable income from prospects which ultimately may not proceed to being mined. Other industry sources refer to an extremely low 'success rate' (commonly said to be 3 successes in 1,000 tries, noting that a 'success' is not confined to cases where an exploration discovery leads to mining).

You state that the period of time within which an activity will produce assessable income can be anywhere up to 25 years, being highly dependent on the exploration success of that activity. It cannot be measured by reference to a particular year after commencement of the business; rather it should be measured in terms of a range of years, with the potential some industry participants may never achieve success even over the period of time which is within the industry norm.

The exploration activities have generated profits every 3 to 5 years, well within the industry norm. You state that the mineral exploration losses do not arise from the manner in which the business is conducted, but it is by reason of the inherent nature of such businesses and consistent with what other businesses in that industry.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 35

Income Tax Assessment Act 1997 paragraph 35-10(1)(a)

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

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

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

Income Tax Assessment Act 1997 subsection 35-10(4)

Income Tax Assessment Act 1997 subsection 35-55(1)

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

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

Income Tax Assessment Act 1997 subparagraphs 35-55(1)(c)(i)

Income Tax Assessment Act 1997 subparagraph 35-55(1)(c)(ii)

Income Tax Assessment Act 1997 subsection 35-55(2)

Reasons for decision

Question

Summary

The exercising of the Commissioner's discretion in paragraph 35-55(1)(c) of the ITAA 1997 requires the nature of the business to be taken into consideration when determining if that is the reason for it not producing a tax profit. On the facts of this case it is accepted that it is because of its nature that the business activity has not produced at tax profit.

Secondly, that there must be an objective expectation that, within a commercially viable period for the industry it will produce a taxation profit.

In XXX (your) case, you did not demonstrate that there is a reasonable expectation that your activity will produce assessable income great than deductions attributable to it in any future year. Therefore, the Commissioner is not satisfied that it is unreasonable to apply the rule in subsection 35-10(2) of the ITAA 1997.

The loss is deferred for use in a later year. If the business makes a profit in a following year, you can offset some or all of the deferred loss against this profit, up to the amount of your profit.

You can also claim the deferred loss against other income in a following year if during that year:

• you meet the requirements set out for non-commercial losses, or
• the Commissioner has exercised the discretion to allow you to claim the loss.

Detailed reasoning

Division 35 of the ITAA 1997 prevents losses from a non-commercial business activity carried out by an individual taxpayer (alone or in partnership) from being offset against other assessable income in the year in which the loss is incurred, unless:

•         the individual meets the income requirement and the business activity satisfies one of the 4 stipulated tests (paragraph 35-10(1)(a)) of the ITAA 1997

•         an exception in subsection 35-10(4) of the ITAA 1997 applies, or

•         the Commissioner exercises the discretion in subsection 35-55(1) of the ITAA 1997 for the business activity for one or more income years.

In your situation, you do not satisfy the income requirement in subsection 35-10(2E) of the ITAA 1997 and you do not come under any of the exceptions. Your losses are therefore subject to the deferral rule unless the Commissioner exercises the discretion.

Discretion in paragraph 35-55(1)(c)

In the context of taxpayers who do not satisfy the income requirement under subsection 35-10(2E) of the ITAA 1997 (that is, because their income for non-commercial loss purposes is $250,000 or more) for the most recent income year ending before the application is made, pursuant to paragraph 35-55(1)(c) of the ITAA 1997 the Commissioner may, on application, decide that the deferral rule in subsection 35-10(2) of the ITAA 1997 does not apply to a business activity for one or more income years (the excluded years) if the Commissioner is satisfied that, for the excluded year:

•         because of its nature, the business activity has not produced, or will not produce, assessable income greater than the deductions attributable to it, and

•         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 subsection 35-10(2) and (2C)) of the ITAA 1997.

Paragraph 1.51 of the Explanatory Memorandum to the New Business Tax System (Integrity Measures) Bill 2000 (the EM) comments in relation to the lead time discretion:

This arm of the safeguard discretion will ensure that the loss deferral rule in section 35-10 does not adversely impact on taxpayers who have commenced to carry on activities which by their nature require a number of years to produce assessable income. Examples of activities which could fall into this category are forestry, viticulture and certain horticultural activities.

The 'particular circumstances' referred to are those that would result in some unfairness or injustice if the loss deferral rule were to apply to the business activity.

Example 1.6 of the EM provides an example of such an activity. In this example, the Commissioner exercises the discretion for an activity that was established as a commercially viable operation and is expected to be highly profitable. However, as it is an agricultural activity that requires time for growth and harvesting before becoming profitable it cannot satisfy any of the tests, (specifically, either the Assessable income test, or the Profits test) until such time as the impact of that inherent restriction passes.

Division 35 of the ITAA 1997 was amended in 2009 to include subsection 35-10(2E) of the ITAA 1997, the income requirement. Section 35-55 of the ITAA 1997 was also updated to expand the Commissioner's discretion to include cases where the income requirement was not met.

The note under paragraph 35-55(1)(c) of the ITAA 1997 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.

However, the wording of the provision is not limited to 'lead time' cases. The Explanatory Memorandum that accompanied the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 at paragraph 2.25 provides as follows:

Example 2.3

Sergio and his b[r]other are partners in a successful yacht building business on Sydney Harbour that makes competition yachts that are mostly used for an international race that is held every four years. Sergio does all the design, and his brother does most of the construction. Sergio is highly regarded,and has another job as a designer that pays him salaries and wages that are more than $250,000 every year.

Because the boats are only paid for when they are finished, the business, in common with other businesses of this kind, generally makes a loss for three out of every four years. Over the four year period the business makes a profit. Sergio wants to apply the losses from the business activity against his other income, and he applies to the Commissioner for a discretion.

The Commissioner decides that because of the nature of the business activity - not the manner in which Sergio and his brother run the business - it does not produce assessable income greater than available deductions in a given income year, but, that based on an objective expectation, it will produce assessable income greater than available deductions in a given income year within a timeframe that is commercially viable for the business concerned. The Commissioner exercises a discretion.

Stone J in Commissioner of Taxation v Eskandari (2004) 134 FCR 569; [2004] FCA 8; 2004 ATC 4042; (2004) 54 ATR 695 (Escandari) 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.

And further at FCA 32:

... In my view, the phrase 'because of its nature' in s 35-55 indicates that the failure must be a result of some inherent feature that the taxpayer's business activity has in common with business activities of that type.

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 produced assessable income greater than the deductions attributable to it. The discretion is not intended to be available where the failure to produce more assessable income than attributable deductions is for other reasons.

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 and would not result in the requirements of subparagraph 35-55(1)(c)(i) of the ITAA 1997 being met.

Where both an inherent characteristic and some other factor are identified, this in itself will not mean that the requirement in subparagraph 35-55(1)(c)(i) of the ITAA 1997 is no longer met. It is only where it is clear that the reason the activity is unable to produce a taxation profit is not because of any inherent characteristic, but because of some other factor, that this requirement will not be met.

Objective expectation

The Commissioner needs to be satisfied that there is an objective expectation that the business activity will produce a tax profit in some future income year falling within a period that is commercially viable for the industry concerned. If the business activity is not expected to produce a tax profit within this period then the discretion may not be exercised.

The objective expectation does not have to be held by, or attributed to, a particular person. The Commissioner need only be satisfied that, based on the available supporting material, an objective expectation exists.

Whether the required objective expectation exists can be affected by decisions about how a particular activity is operated. For example, the extent of debt finance used (and as a result the level of allowable deductions for interest attributable to the business activity) can affect the time within which the activity can produce a tax profit.

The objective expectation about future performance of the business activity must exist for each particular year and as such may change from year to year.

The 'period that is commercially viable for the industry concerned'

Subparagraph 35-55(1)(c)(ii) of the ITAA 1997 requires that there is an objective expectation that, within a period that is commercially viable for the industry concerned, the activity will produce a tax profit.

The EM at paragraph 1.47 refers to there being an objective expectation, 'that it will either satisfy a test or produce profit within a reasonable time'.

This approach was taken in the Administrative Appeals Tribunal (AAT) in the case of Eskandari v. Commissioner of Taxation [2003] AATA 295 which concluded at paragraph 23 that:

...there is other material pointing to an objective expectation that, within a reasonable period, Mr Eskandari's business activity will become profitable or pass one of the four tests in Division 35.

In the decision on appeal to the Federal Court in Eskandari Stone J did not find that there was an error of law in this aspect of the decision by the AAT, but rather that despite the expression used, the AAT was referring to the objective expectation being within a period that is commercially viable for the industry concerned as stated in subparagraph 35-55(1)(b)(ii) of the ITAA 1997.

Generally, Division 35 of the ITAA 1997 involves an enquiry into whether the business activity in question will produce a tax profit within the time frame in which other business activities in the same industry, which behave in a commercially viable manner, do so. (Refer Scott v. Commissioner of Taxation [2006] AATA 542 at paragraphs 30 and 32.) Any business activity in the industry behaving in a commercial manner, reflecting normal industry practices and behaviour, is expected to be able to satisfy one of the tests or produce a tax profit within this time frame.

In practice, when calculating this time period within which any business activity in the industry could produce a tax profit, it may be necessary to ignore one off profits that can occur in some industries.

The reason provided for the repeal of former subsection 35-55(2) of the ITAA 1997 which prevented the discretion being exercised after the first time a test is satisfied or a tax profit produced supports this practice. As discussed previously, the intention of Division 35 of the ITAA 1997 as a whole should be taken into account when deciding whether to exercise the discretion.

Accordingly, the time frame available for a business activity to satisfy a test or produce a tax profit should not be shortened by the occurrence of a one off satisfaction of a test or production of a profit. As noted already, the question posed by subparagraph 35-55(1)(c)(ii) of the ITAA 1997 only concerns the time by which the business activity is objectively expected to make a tax profit.

Similarly, the independent evidence may not always allow for the identification of any one year in which business activities in the industry concerned, operating in a commercially viable manner, are typically expected to produce a tax profit. Instead, this evidence at best may point only to the period that is commercially viable for the industry concerned, for the purposes of subparagraphs 35-55(1)(c)(ii) of the ITAA 1997, being a range of years.

Meaning of the 'industry concerned'

What business activities make up the 'industry concerned' for the purposes of the expression 'the period that is commercially viable for the industry concerned' in paragraphs 35-55(1)(c) of the ITAA 1997 will depend largely on the facts. However, the context and purpose of paragraphs 35-55(1)(c) of the ITAA 1997 do not suggest that an overly broad grouping of comparable business activities is always called for when identifying those making up the 'industry concerned'. For example, Example 1.6 on pages 19 to 20 of the EM refers to a comparison of the expected future performance of the business activity in question, concerning 'cultivating macadamia nuts', with what can objectively be expected in relation to 'the commercially viable period for the macadamia nut industry'. Notably, a broader grouping of businesses, such as the 'nut industry', was not put forward as the relevant industry against which to compare expected future performance.

As the purpose of the provision in this respect is to find an appropriate basis of comparison in terms of the expected future performance of the business activity, it will be important to identify a collection of businesses which are carried on in a commercially viable manner. They will also have broadly similar characteristics in terms of such relevant factors as the assessable income they are typically likely to produce and the type of expenses they are typically likely to incur, which is relevant to the production of a tax profit.

As such, geographical or other differences which materially affect the measures of performance paragraph 35-55(1)(c) of the ITAA 1997 are concerned with may make it appropriate to identify a narrower grouping of businesses as the 'industry concerned' than would otherwise be the case. Alternatively, the very nature of the product being produced may mean a more specific and narrower grouping is appropriate especially where, for example, differences in varieties mean that there are material differences in such things as yield and price per unit, which affect the amount of assessable income to be made.

This does not mean that, where the ability of a business activity to perform in the sense referred to is affected by decisions of the operator, the activity can only be compared with other business activities where the same decisions have been made. Such a narrow grouping of businesses would be likely to defeat the purpose of finding an objectively appropriate basis of comparison for the purposes of paragraphs 35-55(1)(c) of the ITAA 1997.

Evidence from independent sources

For each income year in respect of which the operator of the business seeks the exercise of the discretion, the operator must establish that there is an objective expectation that the activity will produce a tax profit and that this will occur within a period that is commercially viable for the industry concerned. This expectation must be based on evidence from independent sources, where it is available. This is not limited to just the predictive model type of material but can also include relevant historical evidence of how the industry in question has performed in the recent past.

In order to demonstrate that the objective expectation exists, a business operator should produce evidence showing that the business activity will produce a tax profit, showing the period within which a commercially viable business would do so. Preferably, this evidence will be documented at the time, and the evidence that the business activity will produce a tax profit within a certain time will be consistent with evidence from independent sources relating to activities of that type. Appropriate independent sources include industry bodies or relevant professional associations, government agencies, or other taxpayers conducting successful comparable businesses.

In respect of the objective test (referred to in subparagraph 35-55(1)(c)(ii)) of the ITAA 1997, the applicant must discharge the onus of proof that the business activity will produce a tax profit (excluding the operation of the loss deferral rule) within the timeframe customary to the industry in which it operates. For example, an individual may provide independent resources from industry peak bodies in relation to the mineral exploration industry throughout Australia.

Application to your circumstances

The exercise of the Commissioner's discretion in paragraph 35-55(1)(c) of the ITAA 1997 requires consideration of whether, because of the nature of the business activity, it has not produced assessable income greater than the deductions attributable in the relevant year. There must also be an objective expectation that the business activity will produce assessable income greater than the deductions attributable to it in a later income year within a period that is commercially viable for the industry.

In considering whether it was because of the nature of the business that it did not generate taxable income in the there was an objective expectation in the year ended 30 June 2021, we have taken the following considerations into account.

You state that the minerals prospecting business activity commenced on xx xxx 19XX and that the business activity produces assessable income greater than deductions every 3 to 5 income years. From the figures provided the activity has produced this outcome in 2 of the previous 10 income years. You provide that it is a normal attribute of a mineral exploration business to incur losses throughout its life and this may be caused by the difficulty forecasting exploration success together with future global economic and pricing/cost conditions.

This is similar in some respects to example 2.3 from the EM, where a yachting business made losses 3 out of 4 years because of the nature of the business, because of the inherent nature of the business, including its ties to an international yacht race held once in 4 years.

We accept that it is inherent in the nature of minerals prospecting that profits are both uncertain and irregular, and that this has contributed to the loss in the year ended xx xx xx. We have also considered whether factors other than those inherent in the nature of the business activity contributed to the loss. In particular, we considered whether the scale of the business activities that you carry on as a sole practitioner and the resources your put towards it may have also contributed to the loss. Although these may have been contributing factors, we conclude that the main reason the business activity produced a loss in the year ended xx xx xx was due to the nature of the business.

Therefore, the criterion in subparagraph 32-55(1)(c)(i) of the ITAA 1997 has been met.

Subparagraph 35-55(1)(c)(ii) of the ITAA 1997 requires that you demonstrate that your business activity will produce a tax profit within the timeframe customary for businesses which behave in a commercially viable manner for the industry in which it operates. This should be supported by evidence from independent sources, where available. We have considered the following factors when considering this criterion.

•         You have stated that the minerals exploration industry is a high risk industry and that, according to AMEC 'Exploration is highly speculative, with estimates that only one in 10,000 areas of interest (prospects) will ever be mined'. You also refer to other industry sources to establish that the industry has an extremely low success rate, of around 3 successes in 1,000 attempts.

Although this does not address the particular circumstances of your business activity, it establishes that in general, the chances of making a profit in your industry is very remote. It does not provide a basis for determining a commercially viable period for making a tax profit.

•         You further state that it can take a business activity in this industry up to 25 years to produce a tax profit, but that, in line with the speculative nature of the industry, this is highly dependent on the exploration success of the activity. You also note that it is possible that a business activity will never result in success.

Again, this does not address your specific business activity. Like the previous dot point, it suggests that there is no certainty of making a profit in your industry. It indicates that a time period of up to 25 years may be a reasonable timeframe in your industry; however, it does not include sufficient details about how this might relate to your particualr business activity for us to be able to determine whether 25 years is a commercially viable period for your business activity.

•         Historically, you have achieved some measure of success. The data you provided for the 2012 to 2021 income years show that you generated a profit in 2 of those years, even though you did not generate an overall profit over that time. We also have considered the fact that you have reduced the level of activity you maintain as a sole practitioner, having transferred much of your business into a corporate structure in 1995.

However, the past performance of your business activity, in conjunction with the material you have provided establishing the uncertainty of profits in your industry, is not sufficient to establish an objective expectation of a future tax profit nor, if a future profit were expected, when that could arise.

In conclusion, unlike Example 2.3 from the EM, there is no objective expectation that your business activity will produce a tax profit in the future. The nature of the business in that example was cyclical, and as such, there was an objective expectation that, given the business was being carried out in an appropriate manner, it would make a profit in the fourth year. Additionally, it is noted that in the example, an overall profit was expected for the 4 years, adding to the commercial viability of the undertaking.

In contrast, in your case, the nature of the industry is highly speculative. Moreover, you have not provided evidence from independent sources which indicates that your business activity will be profitable into the future. Whilst we accept that in some earlier years you have made tax profits, because of the nature industry, this is no assurance of future successes. Therefore, it cannot be said that there is an objective expectation that the business activity will make a tax profit in any future year. As such, we do not need to consider whether any future profit would be made within a period that is commercially viable for your industry. We note, however, that although you have stated that it can take a business activity in this industry up to 25 years to produce a tax profit, you have not provided evidence from independent sources to establish whether your particular business activity is likely to achieve this nor whether this is in fact a commercially viable period.

Therefore, you have not satisfied the criterion in subparagraph 35-55(1)(c)(ii) of the ITAA 1997.

The Commissioner is not satisfied that it would be unreasonable to apply the rule in subsection 35-10(2) of the ITAA 1997.

In this case, for the income year 'the amounts attributable to the *business activity for that income year' that exceed 'the assessable income from the *business activity for that year', then the excess is treated as though it 'were not incurred in that income year' (subsection 35-10(2) of the ITAA 1997).

The excess is treated as an amount attributable to that activity that you could deduct for the next income year in which the activity or a similar activity is carried on. The amounts attributable to the *business activity are those that you could, apart from Division 35 of the ITAA 1997, deduct under the Act for that income year. They do not include a 'tax loss' (as that term is used in Division 36 of the ITAA 1997) that might be deductible in that year but has arisen in respect of carrying on operations in a previous year.