The ATO Commissioner has the discretion to ensure certain individuals who carry on genuine commercial business activities are not disadvantaged by the non commercial loss provisions due to particular circumstances that stop them from satisfying the relevant tests. Broadly, how might this work?
IN THIS ARTICLE
- The Four Objective Tests
- The Commissioner’s discretion
- Categories of discretion
- Examples of the Commissioner’s discretion
Since the 2000/21 income year, the income tax legislation has contained provisions that prevent individual taxpayers who carry on a business from immediately deducting losses from that business against other income in certain circumstances. The individual can be conducting the business either alone or via a partnership.
These rules are contained in Division 35 of the Income Tax Assessment Act 1997 (ITAA 1997). The objects of Division 35 are to improve the integrity of the taxation system by:
- Preventing losses from non commercial activities that are carried on as businesses by individual (alone or in partnership) being offset against other assessable income; and
- Preventing pre-business capital expenditure and post-business capital expenditure by individuals (alone or in partnership) in relation to non commercial activities being deductible under section 40-880 ITAA 1997. (Section 40-880 is the section that deals with the deductibility of so-called “black-hole” expenditure).
However, there are a number of exceptions that apply to the general objectives, and this is where the complexity of this legislation lies.
Broadly, the non commercial loss rules are directed at individual taxpayers that conduct business activities that will probably never generate positive taxable income. These people are sometimes referred to as “Pitt Street farmers” or “Collins Street farmers”. These are examples of people that have substantial income from another business activity or employment but also have a business activity from which they obtain enjoyment that makes losses. The mischief these rules are directed at is stopping such people getting a tax deduction for what is, ostensibly, a hobby.
But others are caught!
Yet the problem with the non commercial loss rules is that too many genuine commercial activities can be caught within their ambit. New business ventures often make losses in their initial phases while the business gathers customers and for other reasons. These can include the type of business or venture that the taxpayer is conducting.
Note, the non commercial loss provisions only apply to business activities. These provisions do not apply to the receipt of passive investment income from activities which do not constitute carrying on a business – for example the receipt of rent from real property, dividends from shares or interest on financial securities.
The four objective tests and the $250,000 limit
The non commercial loss rules will not apply where one of four objective tests are met and these tests will only apply to an individual where the sum of the following is less than $250,000 for an income year:
- The taxable income of the individual (ignoring non commercial losses), and
- The reportable fringe benefits total for the year, and
- The reportable superannuation contributions for the year, and
- The total net investment losses for that year.
If that sum is $250,000 or greater, there is still an ability to deduct losses under the Commissioner’s discretion, as later discussed.
The four tests, and their broad application, are:
1. The assessable income test: The taxpayer must demonstrate that the assessable income derived from the business activity is $20,000 or more for the income year. For those carrying on business activities in partnership, there is a requirement to determine the proportion of assessable income that is attributable to each partner for the purpose of the test.
2. The profits test: The taxpayer must have earned positive taxable income in any three of the past five income years. For partnerships of individuals, an individual partner aggregates their share of income and deductions from the business activities conducted in the partnership with any income and deductions applicable in their own hands.
3. The real property test: The taxpayer must satisfy that the value of real property, which is used on a continuing basis in carrying on the business activity, is $500,000 or more at the end of the income year.
4. The other assets test: This test deals with assets used on a continuing basis in carrying on the business activity, excluding real property. This test is satisfied when the value of those assets is $100,000 or more. Assets included under the real property test cannot be used when evaluating compliance with this test.
Only one of these tests needs to be passed for the operation of the non commercial loss rules to be avoided.
The Commissioner’s discretion
As the four tests are objective tests, the Commissioner has been given a discretion (section 35-55) to stop the non commercial loss rules from applying in situations where it would be unreasonable for those rules to apply.
The discretion is important and provided to ensure that certain individuals who carry on genuine commercial business activities are not disadvantaged due to particular circumstances which prevent them from satisfying the four tests.
Following are some tips for making an application for the Commissioner’s discretion:
Time and cost
It will often be the case that, apart from the operation of the Commissioner’s discretion, none of the four objective tests will be passed. However, if you think that you are genuinely trying to make a profit from the business activity, you should seriously consider making an application for the Commissioner’s discretion in the approved form.
Depending on the complexity of the business, this may take considerable work. So, the time or money involved in requesting the Commissioner to exercise his discretion must be weighed against the tax savings that could accrue from a successful application.
As soon as a business activity begins to make losses, it is a far better “look” if an application for the Commissioner’s discretion swiftly follows the making of the losses. This sends a message to the Commissioner that you consider the business activity should be, or will be, making profits in the future.
Taxation Ruling TR 2007/6
There is a taxation ruling that is solely on the topic of how the Commissioner exercises his discretion under section 35-55. If you are going to make a request for the exercise of the Commissioner’s discretion, this ruling is compulsory reading.
The ruling states that the discretion is intended to be available for a commercial business activity that has failed, or objectively is expected to fail for a period of time, to satisfy any of the tests in Division 35 for certain reasons outside the control of the operator.
This ruling splits the discretion into two broad categories:
- The special circumstances limb.
- The two lead time limbs.
These limbs are not mutually exclusive.
1. The special circumstances limb
The Commissioner can decide not to apply the non commercial loss provisions if he considers it would be unreasonable to apply them because the business activity was or will be affected by special circumstances outside the control of the operators of the business. Drought, flood, bushfire or some other natural disaster are mentioned as examples.
There is also a note to this limb that says it is intended to provide for a case where a business activity would have satisfied one of the tests if it were not for the special circumstances.
TR 2007/6 states that “special circumstances” are those circumstances which are sufficiently different to distinguish them from the circumstances that occur in the normal course of conducting a business activity. The ATO expects that such circumstances will materially affect the business activity, causing it to not satisfy any of the four tests.
However, the ATO does acknowledge that the business may have failed the four tests because this is what would be normally expected in the industry in which the business operates and the special circumstances may extend the time within which the particular business activity could objectively be expected to pass a test.
Those who don’t satisfy the $250,000 test
The $250,000 test was introduced to stop those with adjusted taxable incomes above that level not being able to access the four tests. However, it is important to understand the ATO states in TR 2007/6 such people can still apply under the “special circumstances” limb for an exercise of the Commissioner’s discretion. This can occur where:
- but for the special circumstances, the business activity would have made a tax profit; and
- the activity passes at lease one of the four tests or, but for the special circumstances, would have passed at least one of the four tests.
If applying for the Commissioner’s discretion under the special circumstances’ limb, you will need to be able to demonstrate that the circumstances are outside the control of the taxpayer.
However, the ATO takes a narrower view of what many might consider to be circumstances outside their control. The ATO states failure for no adequate reason to adopt practices commonly used in an industry to prevent or reduce the effects of special circumstances may point to the special circumstances not being outside the control of the operator. Also, the ATO states that there may be situations where the special circumstances, because of their continued existence, become the ordinary or usual situation and the ATO says it would not be appropriate to exercise the discretion once this occurs.
Although the legislation does mention certain natural disasters as being events that are outside the control of the taxpayer, the circumstances can be any event that is outside the control of the taxpayer.
2. The lead time limbs
The second key part of the Commissioner’s discretion is what TR 2007/6 refers to as the “lead time” limbs. There are two sub-limbs of this second limb.
The first sub-limb is for those taxpayers that have an adjusted taxable income of less than $250,000. The second is for those taxpayers that have an adjusted taxable income of $250,000 or more.
These are referred to as the “lead time limbs” because they look to the nature of the business that is being conducted and whether there is an expectation that losses will be made in the initial phase of the business or that it is normal in the initial phases of the business for such a business not to satisfy one of the four objective tests.
Sub-limb – If the $250,000 test is satisfied
If the taxpayer’s adjusted taxable income is less than $250,000, for the Commissioner to exercise his discretion, it is necessary to show for the most recent year ending before the application is made:
- that the business has commenced, and
- because of the nature of the business, it will not satisfy one of the four tests, and
- broadly, that there is objective evidence that within a commercially viable period for the industry, the business will satisfy one of the four tests or will produce positive taxable income in a future income year, without regard to any losses carried forward under the non commercial loss rules.
Sub-limb – If the $250,000 test is not satisfied
If the taxpayer’s adjusted taxable income is $250,000 or greater, for the Commissioner to exercise his discretion it is necessary to show for the most recent year ending before the application is made:
- that the business has commenced, and
- because of the nature of the business, it has not produced, or will not produce positive taxable income, and
- broadly, there is an objective expectation that within a commercially viable period for the industry, the business will produce positive taxable income in a future income year, without regard to any losses carried forward under the non commercial loss rules.
The key difference for these taxpayers is that there is no ability to consider whether the four tests will be satisfied in the future. It is mandatory to show, objectively, that the business will produce positive taxable income in one future year.
Because of its nature
In both of the sub limbs of the lead time limb, it is necessary to conclude that the ability of the business to either not satisfy one of the four tests or not produce a positive taxable income has resulted from the “nature” of the business. There is no definition in the legislation of what this means.
However, the ATO states in TR 2007/6 that the phrase “because of its nature” means that 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.
Both lead time sub-limbs require an objective expectation that either the four tests will be met, or the business will generate positive taxable income in the future. This expectation must be an objective one, which means that an arm’s length person should be able to draw the relevant conclusions and not base them on personal feelings or opinions.
A period that is commercially viable for the industry
The objective opinion to be reached is one that requires the four tests or the positive taxable income to be reached in a period that is commercially viable for the industry. The ATO says that this means a 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 satisfy one of the tests or produce a tax profit.
Examples of the Commissioner’s discretion
Income greater than $250,000 + COVID-19
This private binding ruling has authorisation number: 1051798181795.
This private binding ruling involved another taxpayer with an adjusted taxable income of greater than $250,000. A business was commenced by the taxpayer in the year ending 30 June 2020 as a sole trader. The nature of the business is not stated.
The taxpayer submitted to the Commissioner that the losses incurred for the business in the year ended 30 June 2020 was due to the impact of COVID-19. Further, the taxpayer predicted that he would make an assessable profit in the year ended 30 June 2021.
The Commissioner exercised his discretion to permit the losses from the business activity to be used against other income. This is confirmation that COVID-19 will be considered by the ATO as a special circumstance for the purposes of section 35-35.
Income greater than $250,000 + long lead time
This private binding ruling has authorisation number: 1051784996599.
Although not detailed in the private binding ruling, it is likely that this ruling request concerned someone setting up a new vineyard and wine manufacturing business. This binding ruling is an example of the use of the lead time limb of section 35-55.
Again, the taxpayer had an adjusted taxable income in excess of $250,000. The taxpayer had apparently engaged in this business in a very serious manner. He engaged an executive team based on this specific expertise to set up and run the business and he also engaged an industry expert to consult on the setup and running of the business.
The taxpayer submitted that it would be a number (redacted) of years before the activity became commercially viable. A report was written by an industry expert that gave the projected yields from the business and there was accompanying information that nominated a particular year as the first year in which the taxpayer would make a tax profit.
The Commissioner decided to exercise his discretion.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.