Edited version of private advice

Authorisation Number: 1052316016709

Date of advice: 8 November 2024

Ruling

Subject: Commissioner's discretion - non-commercial loss

Question

Will the Commissioner exercise the discretion in paragraph 35-55(1)(b) 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 2023-24 and 2024-25 financial years?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2024

Year ending 30 June 2025

The scheme commenced on:

3 June 2024

Relevant facts and circumstances

You satisfy the less than $250,000 income requirement set out in subsection 35-10(2E) of the ITAA 1997.

You are a qualified for the activity you are engaged in.

You have 3 years' experience working in this field with another firm.

You carry on practice as a sole practitioner.

You are carrying on your practice from your home address but have also set yourself up to take online appointments and assist clients from any location.

You offer a standard range of services for the industry within which you are practicing.

You commenced business operations late in the first relevant year. You began taking paying clients shortly after this date.

In your first month of practice you spent from 150-180 hours on the following activities;

•         Business setup

•         Reaching out to prospective clients and following leads

•         Marketing and promotion

•         Meeting the registration and compliance requirements of government and professional bodies.

•         Setting up software and appointment booking systems

•         Building client forms

In the first month you were engaged in this activity you spent 7 to 8 hours a day on weekdays on these activities, and additional time on the weekends. The time you spent in this activity on weekends in the following months increased.

You have completed the business registration, insurance, setup, quality control and compliance requirements necessary for your activity.

You have also met the requirements for registration as a practitioner in your field.

You invoice your clients after your services are provided. Completing the services you provide may take additional time as you wait for the return of additional information and documentation.

The evidence you have provided indicates that the time required in the industry in which you are engaged for a start-up business to build the clientele required for commercial viability is 18 months.

You have submitted your income and expenses, actual and expected, for the relevant financial years.

You believe that you will have completed the 18 months required in your start up practice to build a commercially viable client base at that time.

Relevant legislative provisions

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

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

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)(a)

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

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

Reasons for decision

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));

•         an exception in subsection 35-10(4) applies; or

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

In your situation, none of the exceptions would apply and although you satisfy the income requirement, you do not meet any of the four tests in the years under consideration. Your business losses are therefore subject to the deferral rule, unless the Commissioner exercises his discretion.

You have requested the Commissioner to exercise his discretion under paragraph 35-55(1)(b) of the ITAA 1997 in the 2023-24 and 2024-25 financial years.

Under paragraph 35-55(1)(b) of the ITAA 1997, the Commissioner's discretion can be exercised where:

•         the business activity has started to be carried on but because of its nature, it has not satisfied, or will not satisfy one of the 4 tests; and

•         there is an objective expectation that within a period that is commercially viable for the industry concerned, the activity will meet one of the tests or will produce assessable income for an income year greater than the deductions attributable to it for that year.

This 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.

A business has commenced for taxation purposes when it is capable of beginning ordinary operations and has begun ordinary business operations. In Calkin v. CIR [1984] 1 NZLR 440 Richardson J said at 446-447:

Clearly it is not sufficient that the taxpayer has made a commitment to engage in business: he must first establish a profit-making structure and begin ordinary business operations.

For a business activity to commence, an appropriate business structure should be in place and begin ordinary business operations.

As to what the business structure will consist of, and its size, will be a question of fact and degree, and will depend on the nature of the business activity.

The Commissioner's approach to exercising the discretion under section 35-55 of the ITAA 1997 is outlined in Taxation Ruling TR 2007/6 Income Tax: non-commercial losses: Commissioner's discretion.

TR 2007/6 states that the lead time discretion provided by paragraphs 35-55(1)(b) and (c) of the ITAA 1997 is available for a business activity if there is an initial period from when the activity commenced where the nature of the activity prevents one of the four tests from being met (paragraph 35-55(1)(b)), or a tax profit from being made (paragraph 35-55(1)(c)).

For the Commissioner to exercise the discretion you must be able to show that the reason your business activity is not satisfying one of the 4 tests or making a profit is inherent to the nature of the business and is not peculiar to your situation.

The phrase ''the nature of the activity'' as it is used in section 35-55 of the ITAA 1997 was considered in some length in FC of T v Eskandari 2004 ATC 4042. In his discussion on the matter Stone J stated:

The definition of "nature" relied on by the applicant is an "essentialist" definition, incorporating the concept of a fundamental or essential character created by an "inherent and inseparable combination of properties". An instrumentalist definition might incorporate the concept of "defining characteristics". Either way, a decision as to the "nature" of a business activity requires not just an understanding of the meaning of the word but a judgment as to which characteristics are "essential' or "defining" in respect of the relevant business activity.

In this case the court ruled that asking for the greater part of a client's fees on the successful grant of their visas was not in the nature of an immigration agent's business, but it was a business choice peculiar to that agent's business model. An argument that the business was in a developmental stage and required more time to build its client base was also dismissed, as this could apply to almost any new business.

The lead time discretion is not intended to be available where the failure to make a profit or to meet a test is for reasons other than the nature of the business, such as, a consequence of starting out small, needing to build up a client base, or business choices made by an individual (for example, the size and scale of the activity, the hours of operation, and or the level of debt funding) that are not consistent with the ordinary or accepted practice in the industry concerned.

Your activity consists of providing services to clients for a fee. While you kept working to consolidate your business structure by meeting registration and compliance requirements, setting up software and appointment booking systems, and building client forms you were ready to being ordinary operations on 3 June 2024 and began taking paying clients shortly after that date. You continued these activities over the following months, and also undertook various marketing and advertising activities to help build your client base.

Having commenced your business activity late in the first relevant year you will have been providing your services for more than 18 months and are expecting to make a profit and meet the assessable income test in the financial year following the relevant financial years.

You believe it will take you 18 months to build a commercially viable client base so you can make a profit.

You have also chosen to invoice your clients on completion of the services you are providing and you believe this will contribute to the delay in your business activity generating a commercially viable income.

The invoicing model you have chosen for your activity is a business choice you have made and is not an essential or defining characteristic of the industry in which you are engaged.

It is also recognised that you undertook significant activity consolidating your business structure and working to build your client base in the months following the date you commenced your business activity. These activities could be requirements of any new business, however, and are not defining characteristics of the accounting services industry.

The reason you will not make a profit or meet one of the 4 tests in paragraph 35-10(1)(a) of the ITAA 1997 in that 18 month period is a consequence of your starting small, business choices you have made, and the need to build your client base over that period.

Having regard to your full circumstances, it is not accepted that it is the nature of the business activity that has prevented you from making a profit or passing the assessable income test.

Therefore, the Commissioner will not exercise his discretion under paragraph 35-55(1)(b) of the ITAA 1997 for the years in question.