Edited version of private advice

Authorisation Number: 1052283765337

Date of advice: 31 July 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 to allow you to include any losses from your business activity in the calculation of your taxable income for the YYYY to YYYY income years?

Answer

Yes.

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

The scheme commenced on:

DD MM YYYY

Relevant facts and circumstances

Background information

1.      You are undertaking a forestry business.

2.      On DD MM YYYY, you obtained a private ruling where the Commissioner exercised his discretion under lead time in relation to your business losses for the YYYY to YYYY income years.

3.      You initially expected to produce xxx tonnes of wood at xxx years. However, for reasons beyond your control, the estimate has been revised to xxx years.

4.      To date, your business has not had a tax profit.

5.      You have provided information that shows that you will make a tax profit within the commercially viable period for your industry.

6.      Your income for non-commercial loss purposes in the income year prior to the income year this application was received by the Commissioner, was more than $250,000.

Assumptions:

7.      The exception in subsection 35-10(4) will not apply to you in any of the YYYY to YYYY income years as your assessable income (except any net capital gain) from other sources not related to your business of primary production will not be less than $40,000.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Division 35

Income Tax Assessment Act 1997 subsection 35-10

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 subsection 35-10(3)

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

Income Tax Assessment Act 1997 section 35-55

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

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

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

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

Reasons for decision

Question:

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

Summary:

Having regard to your circumstances, it is accepted that it is the nature of the business activity that has prevented you from making a tax profit. It is also accepted that you will make a tax profit within the commercially viable period for your industry.

Consequently, the Commissioner will exercise the discretion in paragraph 35-55(1)(c) to allow you to include any losses from your primary production business in the calculation of your taxable income for the YYYY to YYYY income years.

Detailed Reasoning

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

1.      Division 35 prevents losses from a non-commercial business activity carried out by a taxpayer (alone or

2.      in partnership) from being offset against other assessable income in the year in which the loss is incurred, unless:

•         a taxpayer's income for non-commercial loss purposes is less than $250,000 and the business activity satisfies one of the 4 required tests

•         the exception in subsection 35-10(4) applies for the income year, or

•         the Commissioner exercises the discretion under subsection 35-55(1) to not defer the losses.

Income requirement

3.      The income requirement set out in subsection 35-10(2E) will be satisfied for an income year if the sum of the taxpayer's income for non-commercial loss purposes, comprising income, reportable fringe benefits, reportable superannuation contributions and net investment losses, is less than $250,000 for that income year. Where this requirement is satisfied, a taxpayer may include losses from a business activity in the calculation of their taxable income.

4.      However, if the income requirement is not met in the most recent income year ending before the application is made, any losses from the taxpayer's business will be quarantined and applied only against assessable income from the business, unless the Commissioner exercises the discretion not to apply the non-commercial losses rules.

Exception in subsection 35-10(4)

5.      For an income year in which a taxpayer, carrying on a primary production business, has assessable income of less than $40,000 from other sources (excluding capital gains), an exception in subsection 35-10(4) provides that their losses from non-commercial business activities can be claimed against other income.

Commissioner's discretion - lead time exception

6.      In the context of a taxpayer who does not satisfy the income requirement in subsection 35-10(2E) as their income for non-commercial loss purposes is $250,000 or more for that year, the Commissioner may exercise the discretion in paragraph 35-55(1)(c) for the income years in question for a business activity that has started to be carried on if:

•         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 (if available), that the business activity will produce a tax profit within a period that is commercially viable for the industry.

Meaning of 'because of its nature'

7.      For the failure to 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. 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.[1]

8.      The consequences of business choices made by an individual, such as a consequence of starting out

9.      small and needing to build up a client base, or business choices made by an individual that are not consistent with the ordinary or accepted practice in the industry concerned, are not inherent characteristics of a business activity and would not result in the requirements of subparagraph 35-55(1)(c)(i) being met.[2]

10.   The discretion under lead time is intended to cover business activities which, by their nature, require a number of years to produce assessable income. Examples of activities which would fall into this category are forestry, viticulture and certain horticultural activities.[3]

11.   This is reiterated by the note under paragraph 35-55(1)(c) that states:

Paragraph ... (c) [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.

12.   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 assessable income greater than the deductions attributable to it. The discretion is not intended to be available where a failure to produce a tax profit is for other reasons, such as the way the operator has chosen to carry on their business activity.[4]

13.   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) 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.[5]

Objective expectation

14.   The Commissioner must be satisfied that an objective expectation exists, for each of the years in question, that the business activity will satisfy a test or produce a tax profit 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.

15.   The objective expectation must be based on independent information, where such information is available.[6]

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

16.   The period that is commercially viable for the industry concerned under subparagraph 35-55(1)(c)(ii) is the period in which it is expected that any business activity of that type, which is carried on in a commercially viable manner, would be expected to produce a tax profit. It is not determined having regard to best practice in the industry concerned.[7]

17.   The period to be commercially viable does not require determining how long it takes a product to be available to generate assessable income. This is seen in one case where the commercially viable period for olive growing and production was accepted as 10 years, despite olive trees taking 3-5 years to produce their first harvest.[8]

18.   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.[9]

19.   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) only concerns the time by which the business activity is objectively expected to make a tax profit.[10]

20.   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, being a range of years, for the purposes of subparagraph 35-55(1)(c)(ii).[11]

Meaning of the 'industry concerned'

21.   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 paragraph 35-55(1)(c) will depend largely on the facts. However, the context and purpose of paragraph 35-55(1)(c) does not suggest that an overly broad grouping of comparable business activities is always called for when identifying those making up the 'industry concerned'.[12] For example, in a comparison of the expected future performance of the business activity 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.[13]

22.   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.[14]

Evidence from independent sources

23.   For each income year in respect of which the taxpayer seeks the exercise of the discretion, they 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.[15]

24.   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.[16]

Application to your circumstances

25.   You have not met the income requirement as your income for the purposes of subsection 35-10(2E), in the most recent income year ending before your application was made, was not less than $250,000.

26.   The exception for primary production business activities in subsection 35-10(4) does not apply to you (as assumed for the purposes of this ruling) as it is expected that you will receive at least $40,000 of non-farm income in each of the YYYY to YYYY income years.

27.   Your business losses are therefore subject to the deferral rule under subsection 35-10(2) unless the Commissioner exercises his discretion in section 35-55(1)(c). For the Commissioner to exercise the discretion, the Commissioner needs to find that you have demonstrated that:

•        the business will not be profitable because of its nature, and

•         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.

28.   Your business of forestry activities commenced in YYYY. Since that time, the business has not produced assessable income greater than the deductions attributable to that income. The business plan initially estimated a tax profit from thinning the plantation in year xxx and year xxx. Over the course of the business, you have engaged experienced local management to oversee the expert advisory and management role.

29.   We accept that it is inherent in the nature of forestry activities that the trees may not reach the desired size at a particular age, and that this has contributed to the losses since commencement of the activity. We have also considered whether factors other than those inherent in the nature of the business activity contributed to the loss. Although there may have been contributing factors, we conclude that the main reason you have continued to produce losses was due to the nature of the business. This is supported by the note under paragraph 35-55(1)(c) and paragraph 1.51 of the Explanatory Memorandum that acknowledges forestry activities, by their nature, require many years before it could reasonably be expected to produce income.

30.   Therefore, it is considered as there are inherent characteristics that prevent your business from making a tax profit until around the time of full yield, the business activity meets the requirements of subparagraph 35-55(1)(c)(i).

31.   Subparagraph 35-55(1)(c)(ii) requires that you demonstrate that your business activity will produce a tax profit within the timeframe that is commercially viable for the industry in which it operates. This should be supported by evidence from independent sources, where available.

32.   The commercially viable period for such forestry activities will be from the commencement of the business activity and includes a time in which such activities as:

•         growing the trees to the desired diameter and quality

•         thinning the plantation to maintain growth and increase diameter

•         maintaining or improving the growth cycle of the trees to reach the desired form and vigour, and

•         harvesting trees that have reached the desired diameter necessary to produce high-value wood products.

33.   As shown by the industry analysis and the independent evidence supplied, plantations conducted in a commercially viable manner would be expected to be able to produce a tax profit over 30 years. A time period of over 30 years is the minimum time the trees can grow to maturity to reach the desired growth and width to produce an optimum proportion of high-quality wood products.

34.   You engaged a third party to prepare the business plan which provides a financial assessment of a forestry estate that you will establish and manage over xxx years showing projected income and expected expenses. The business plan indicates that you should make a tax profit after xxx years but have revised this expectation to xxx years. You have adjusted your projection for the business to make its first tax profit to the YYYY income year as the trees are expected to achieve a suitable size and the economic conditions will allow for a harvest of thinning.

35.   To satisfy the requirements of subparagraph 35-55(1)(c)(ii), there needs to be an objective expectation that your business will make a tax profit within a period that is commercially viable for the industry concerned. The information obtained from the industry body supports a conclusion that the period that is commercially viable for the same industry is from commencement to year 30 of operations. As such, there is sufficient information for the Commissioner to be satisfied that there is an objective expectation that, within the period that is commercially viable for forestry operations, your business activity will produce a tax profit from year 30 when you will have a full commercial harvest, which is within the period referred to in subparagraph 35-55(1)(c)(ii).

36.   Therefore, you have satisfied the criterion in subparagraph 35-55(1)(c)(ii).

37.   Accordingly, it is considered appropriate for the Commissioner to exercise the discretion under paragraph 35-55(1)(c) for the YYYY to YYYY income years as it would be unreasonable to apply the loss deferral rule.

[1] Federal Commissioner of Taxation v. Eskandari (2004) FCA 8.

[2] Paragraph 78 of TR 2007/6 Income tax: non-commercial business losses: Commissioner's discretion (TR 2007/6), and paragraph 2.35 of the Explanatory Memorandum for the New Business Tax System (Integrity Measures) Act 2000 (Explanatory Memorandum).

[3] Paragraph 1.51 of the Explanatory Memorandum.

[4] Paragraph 82 of TR 2007/6.

[5] Paragraph 80 of TR 2007/6.

[6] Paragraph 20 of TR 2007/6.

[7] Paragraph 21 of TR 2007/6.

[8] Bentivoglio v. Federal Commissioner of Taxation [2014] AATA 620.

[9] Paragraph 93 of TR 2007/6.

[10] Paragraph 96 of TR 2007/6.

[11] Paragraph 97 of TR 2007/6.

[12] Paragraph 99 of TR 2007/6.

[13] Example 1.6 of the Explanatory Memorandum.

[14] Paragraph 100 of TR 2007/6.

[15] Paragraph 103 of TR 2007/6.

[16] Paragraph 104 of TR 2007/6.