House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Wayne Swan MP)

Chapter 2 Non-commercial losses

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to tighten the application of the non-commercial losses rules in relation to individuals with an adjusted taxable income of $250,000 or more. These amendments will prevent high income individuals from offsetting deductions from non-commercial business activities against their salary, wage or other income.

2.2 All references are to the ITAA 1997 unless otherwise stated.

Context of amendments

2.3 The non-commercial losses rules were introduced in 2000, following recommendations from the Review of Business Taxation . They are aimed at improving the integrity, fairness and equity of the tax system, by addressing the opportunity for individuals to avoid tax by carrying on unprofitable business activities and claiming deductions for losses arising from such activities against their other income.

2.4 Under the current non-commercial losses rules contained in Division 35 of the ITAA 1997, an individual carrying on a business activity either alone or in partnership has to quarantine losses to the business activity.

2.5 Exemptions exist, however, which allow taxpayers to apply losses from the business activity against their other income in an income year if the business activity satisfies at least one of four objective tests in that year, or if the Commissioner of Taxation (Commissioner) exercises a discretion. The four tests are:

•

assessable income test - the assessable income generated from the activity must be at least $20,000;

•

profits tests - the activity must have produced a profit in three of the last five income years;

•

real property test - the reduced cost base value of real property or interests in real property used on a continuing basis to carry out the activity is at least $500,000; and

•

other assets test - the reduced cost base of any other assets used on a continuing basis to carry on the activity is at least $100,000.

2.6 If a business activity does not pass any of these tests, the Commissioner has a discretion to nonetheless allow a taxpayer to offset the losses against other income, having regard to certain circumstances. For example, if there are exceptional circumstances applicable to the business activity that stop it from meeting one of the four tests. Exceptional circumstances could include adverse weather conditions, such as drought or flood, that prevent a farming business from meeting the assessable income test in a particular year.

2.7 In addition, another exception is available when the taxpayer is involved in a primary production or professional arts business activity, and the taxpayer's total income from other sources is no greater than $40,000.

2.8 Currently, if any of the above tests are met, the taxpayer can deduct all of the expenses from their business activities from both the business and other income. If all of the tests are failed, the deductions are limited to the amount of the income from the business. It does not mean that the costs are not deductible, just that deductions are quarantined to the particular business activity. Quarantined deductions can be carried forward to be used against future income from that business activity or offset against other income once a test is met.

Consultation

2.9 An exposure draft of the proposed legislation was released for public consultation on 26 June 2009. The consultation period closed on 26 July 2009. Seventeen submissions to the consultation process were received.

2.10 Submissions raised concerns around the process for applying to the Commissioner, and the evidentiary burden for taxpayers applying for a discretion, including what constituted 'objective evidence'. The exposure draft has been amended to require applications to be made in an approved form. The form will help the taxpayer work out what information is required to be provided to the Commissioner to assess whether or not to exercise his or her discretion.

2.11 Submissions also raised concerns about the continued status of discretions obtained prior to the changes in this Bill; particularly in relation to 'managed investment schemes'. Transitional provisions now ensure that all previous discretions granted by the Commissioner will continue to apply.

2.12 Consultations also raised the issue of investment allowances under Division 41 of the ITAA 1997 being quarantined to a business activity that is otherwise profitable, but because of the investment allowances makes a tax loss. The exposure draft has been amended to carve-out those investment allowances for owners of otherwise profitable businesses.

Summary of new law

2.13 These amendments recognise that the current non-commercial loss rules apply in a discriminatory way, because taxpayers with high incomes are more able to meet one of the four objective tests. These amendments limit access to the four objective tests to individuals who meet an income requirement.

2.14 These amendments also provide the Commissioner with a new discretion in cases where an individual does not meet the income requirement, but can nonetheless independently demonstrate that their business is genuinely commercial.

Comparison of key features of new law and current law

Detailed explanation of new law

2.15 The exceptions to the general rules about non-commercial losses are aimed at providing relief for individuals where certain characteristics of the business show that it is likely to be commercial, despite having made a loss in an income year. These amendments improve the integrity, fairness and equity of the non-commercial losses rules by recognising that the current exceptions operate in a discriminatory way because high income individuals are more able to satisfy the objective tests and use these to avoid tax.

2.16 To address this issue, the new law introduces an income requirement that limits those who can access the objective tests that provide an exception to the general rule about quarantining non-commercial losses.

2.17 Division 35 creates four tests to determine whether a business activity may be treated as commercial in nature for the tax laws. The four tests are:

•

the assessable income test - the assessable income generated from the activity must be at least $20,000;

•

profits tests - the activity must have produced a profit in three of the last five income years;

•

real property test - the reduced cost base value of real property or interests in real property used on a continuing basis to carry out the activity is at least $500,000; and

•

other assets test - the reduced cost base of any other assets used on a continuing basis to carry on the activity is at least $100,000.

Income requirement

2.18 The income requirement prevents individuals with an adjusted taxable income of $250,000 or more from accessing the existing four tests.

2.19 The income requirement is met when, in a given income year, the sum of an individual's taxable income, reportable fringe benefits, reportable superannuation contributions and total net investment losses is less than $250,000. The four amounts that make up the income requirement, when referred to together, are also known as an individual's 'adjusted taxable income'. The four amounts that make up the income requirement are defined in subsection 995-1(1). [Schedule 2, item 5, subsection 35-10(2D)]

2.20 When working out if an individual has met the income requirement, the individual must disregard any excess deductions from any non-commercial business activity that has excess deductions that are subject to Division 35. [Schedule 2, item 5, subsection 35-10(2D)]

2.21 Subsections 35-10(1) and (2A) are amended to allow for the introduction of the income requirement. [Schedule 2, items 3 and 4, paragraphs 35-10(1)(a) and (2A)(a)]

Example 2.1

Jane received $150,000 income from her salaries and wages in 2009-10, but then a promotion increased her salaries and wages income to $250,000 for 2010-11. She also had $50,000 in reportable superannuation contributions in both years. She did not have any reportable fringe benefits or total net investment losses.

She also owns a party planning business, that mostly plans parties for her friends and family, which had an assessable income of $30,000 in 2009-10 and 2010-11, but which also had $45,000 of deductions in both years. It has never made a profit. Jane's party planning business, therefore, had excess deductions of $15,000 in 2009-10 and 2010-11. She does not apply for a discretion.

In 2009-10, Jane can apply the losses from her non-commercial business against her other income. For 2009-10, the total of Jane's salaries and wages income and her reportable superannuation contributions was $200,000, so she met the income requirement. Jane's party planning business had excess deductions, but it had an assessable income in excess of $20,000, so it met the assessable income test, so she does not have to quarantine her losses from her party planning business. For 2009-10, Jane applies the $15,000 excess losses from her party planning business against her other income.

For 2010-11, Jane cannot apply the $15,000 of losses from her party planning business attributable to the 2010-11 income year because she does not meet the income requirement. For 2010-11, the total of her salaries and wages income and her reportable superannuation contributions is $300,000, so she fails the income requirement. The $15,000 of excess deductions from 2010-11 are quarantined, and can only be applied against assessable income from her party planning business in future income years.

Applying to the Commissioner

2.22 Individuals who meet the income requirement for the most recent income year ending before the date of making the application and whose business does not meet one of the four objective tests, but who can nonetheless objectively demonstrate that their business is commercial, can apply to the Commissioner to exercise a discretion and not apply the non-commercial losses rules. That is, the existing rules continue to apply to taxpayers with an adjusted taxable income below $250,000.

2.23 Section 35-55 is amended to provide another discretion to the Commissioner for taxpayers who do not meet the income requirement for the most recent income year before the date of making the application, but who have excess deductions from a business that - based on an objective assessment - is a commercial business. [Schedule 2, items 9 and 11, paragraphs 35-55(1)(b) and (c)]

2.24 Individuals who do not meet the income requirement, but who can nonetheless objectively demonstrate that their business is commercial, can apply to the Commissioner to exercise a discretion to not apply the non-commercial losses rules.

Example 2.2

In the 2009-10 income year, Jack has a taxable income of $200,000, reportable superannuation contributions of $50,000 and reportable fringe benefits of $20,000. Jack also owns a vineyard that is valued at $750,000. The vineyard has excess deductions of $50,000 this year.

Jack does not meet the income requirement because the sum of his taxable income, reportable fringe benefits, and reportable superannuation contributions is $270,000. The vineyard has never made a profit. Despite that his non-commercial business activity is being carried on with real assets worth more than $500,000, he must now apply to the Commissioner if he wants to apply his non-commercial losses against his other income.

Jack has obtained an independent assessment that the vineyard will make assessable income greater than deductions within seven years. Jack applies to the Commissioner to exercise a discretion. The Commissioner decides that there is an objective expectation, based on an independent assessment, that the vineyard will produce assessable income greater than available deductions in a given year in a period that is considered commercially viable for the industry concerned, and that Jack can apply the $50,000 against his other assessable income in this income year.

2.25 Before considering whether to exercise a discretion, the Commissioner must be satisfied that, because of its nature, the business does not or will not meet one of the four tests (only applicable for taxpayers that do not meet the income requirement) and has not produced a profit. For taxpayers with an adjusted taxable income less than $250,000, they must demonstrate that, because of its nature, the business activity does not meet any of the four of the objective tests. For individuals with an adjusted taxable income of $250,000 or more, they must demonstrate that the reason they do not or will not make a profit is because of the nature of the business and not for some other reason which is peculiar to that individual's particular business.

Example 2.3

Sergio and his bother 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.

Approved form

2.26 To obtain the exercise of the Commissioner's discretion, an individual will need to complete a form approved by the Commissioner. The form will assist the Commissioner in determining whether the discretion should be exercised, by requiring the individual to provide certain information that will support the exercise of the discretion. [Schedule 2, item 13, subsection 35-55(3)]

Objective evidence

2.27 The application form will require relevant information (including, where available, evidence from independent sources) to be provided by the applicant. In particular, the information required by the form may include:

•

details of the nature of the business activity, including when the business activity commenced to be carried on;

•

objective evidence from independent sources demonstrating that, because of the nature of the business activity, it does not or will not satisfy the tests that are available to the taxpayer, or does not produce assessable income greater than available deductions in a given income year (whichever is applicable); and

•

objective evidence from independent sources that, despite the business not meeting the available test or tests, the business does not or will not satisfy the tests that are available to the taxpayer, or does not produce assessable income greater than available deductions in a given income year but will nonetheless meet the tests or produce assessable income greater than available deductions (whichever is applicable) in a period of time that is considered commercially viable for the industry concerned.

2.28 The individual is required to establish objectively the commercially viable period for the industry concerned. Evidence of what the commercially viable period for the specific industry is may include:

•

current or projected information about the market for the goods or services (prices and demand) that the business activity produces;

•

evidence such as industry articles, statistics, analyses and market forecasts that support the proposals or projections made in any business plan;

•

evidence on the suitability of the particular business activity to the location where it is undertaken, such as soil and climate conditions, markets for the products or services and transport requirements;

•

scientific research or other papers on relevant industries; and

•

evidence supporting the yield and price forecasts.

2.29 The information relating to the period of time before the business can make a profit is relevant because the discretion is intended to be available where there is some inherent feature that the taxpayer's business activity has in common with other business activities of that type that prevent it from making a profit in the short term.

2.30 The taxpayer is required to establish objectively that the business is commercial in nature and will become profitable in a commercially viable timeframe. Objective evidence from independent sources can include evidence from an individual or organisation experienced in the relevant industry, such as industry or regulatory bodies, tertiary institutions, industry specialists, professional associations, government agencies or other independent entities with a similar successful business activity. Evidence from independent sources can also include evidence from business advisers (such as business plans), financiers and banks.

2.31 The Commissioner must balance the relative weight given to any evidence provided in support of an application for the exercise of a discretion. Nothing in the law requires an individual to obtain new or additional evidence about their business activity where they believe the existing evidence that is available to them demonstrates the business will meet one of the four tests (applicable for taxpayers that meet the income requirement), or produce a profit within a period of time that is commercially viable for the industry concerned. However, such additional evidence may assist the Commissioner in working out whether to exercise a discretion.

2.32 Owners of business activities that, because of their nature, have a lead time between the commencement of the activity and the production of assessable income are eligible to apply for the exercise of the Commissioner's discretion. [Schedule 2, item 13, note to subsection 35-55(1)]

Exercise of the Commissioner's discretion

2.33 For taxpayers that meet the income requirement, the Commissioner may exercise a discretion after an application by a taxpayer, where the Commissioner is satisfied that the nature of the business means that, the business has not, and will not, meet the four tests, but will nonetheless - based on evidence from independent sources - meet one of the tests or produce assessable income greater than available deductions, in a timeframe that is considered commercially viable for the industry concerned.

2.34 For taxpayers that do not meet the income requirement, the Commissioner may exercise a discretion after an application by a taxpayer, where the Commissioner is satisfied that - based on evidence from independent sources - the business will produce assessable income greater than available deductions, in a timeframe that is considered commercially viable for the industry concerned.

Example 2.4

Karen carries on a business of horse breeding, training and selling horses in partnership. The partnership commenced a breeding program which will, in time, enable the breeding of high quality, sought-after animals.

It is in the nature of breeding and training horses that there will be a lead time before a profit can be expected. Independent evidence from the relevant national association supports the view that the commercially viable period for this industry, in view of the intensive training involved, would be when a horse reaches five to six years of age. This period added to the gestation period of 11 months supports a lead time of six to seven years for the industry.

Provided there is an objective expectation that the partnership business activity will make a tax profit within this commercially viable period, the Commissioner may exercise the discretion to allow losses to be claimed.

Example 2.5

Tracey carries on a business of primary production from breeding and selling cattle. Their profit projections indicate that they do not expect to make a tax profit for six years.

Independent evidence provided by Tracey indicates the lead time period begins from the commencement of the activity and includes the time taken to raise the females to a breeding age, allowing for the gestation period of those animals to finish, and finishes when the progeny have reached a saleable age. On the evidence provided, the period for a typical business activity of breeding and selling cattle to become commercially viable is no greater than three years. Therefore, Tracey will not be able to produce a tax profit within a period that is commercially viable for the industry concerned and the Commissioner will not be able to exercise the discretion to allow the losses.

2.35 The discretion is not intended to be available in cases where the failure to make a profit is for reasons other than the nature of the business, such as, a consequence of starting out 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 - such as the hours of operation, location, climate or soil conditions, or the level of debt funding. [Schedule 2, item 13, note to subsection 35-55(1)]

Example 2.6

Joe earns in excess of $250,000 and has a substantial rural property which he and his wife visit most weekends. The property has a family residence and sheds and, apart from one area of the property where a few goats are kept, is otherwise developed with nut trees.

Joe planted a large number of nut trees on the land in 2007, and has been claiming his losses from this activity, having passed the real property test in prior years. As his income is higher than $250,000, Joe applies to the Commissioner seeking the exercise of the discretion in new paragraph 35-55(1)(c) to allow him to access his losses in 2009-10.

In support of his application, Joe provides a letter from the secretary of the Nut Tree Growers' Association that states that yields from that number and type of trees would ordinarily be sufficient to allow Joe to make a profit within about six years. This is the industry norm for growers of that type of nut tree. However, because the soil on the property is not very fertile and the site does not get a lot of sun, Joe accepts that the lead time for his particular nut-growing activity will be nine years not six years. Joe otherwise manages his nut tree orchards in accordance with industry management practices.

Having examined the case, the Commissioner concludes that, despite the large number of trees on the property and the fact that the business is being conducted in accordance with industry management practices, the discretion should not be exercised in Joe's favour. This is because the lead time for this activity to become profitable is greater than the industry norm: the failure to make a profit within a commercially viable period is due to factors that are peculiar to Joe's local environment. Despite the fact that these factors are out of Joe's control, and the fact that the activities are otherwise carried on in a commercially viable way, the excessive lead time before making a profit for Joe's activities are caused by the poor soil quality and lack of sunlight. The Commissioner does not exercise the discretion in Joe's favour because there is an excessive lead time before making a profit, when compared to other businesses in the industry.

Example 2.7

Erin is growing fruit trees in an area where such trees are not traditionally grown because of the prevailing weather conditions.

Erin's annual assessable income is greater than $250,000 so she seeks the exercise of the Commissioner's discretion under new paragraph 35-55(1)(c). In support of her application, she has discovered some international research that claims new horticultural techniques will improve the commercial viability of growing this type of fruit tree in this type of environment.

There is no general acceptance amongst Australian experts that the new techniques would make growing the trees commercially viable in Australian soils and climatic conditions. Having examined the case the Commissioner concludes that, although Erin has some evidence in the form of a technical article written by an overseas expert, that evidence does not necessarily translate to the specific conditions in Australia, and is insufficient to satisfy the objective expectation requirements of the provision. The Commissioner concludes that there is no objective expectation that the activity will make a profit within a period that is commercially viable for that industry, and declines to exercise the discretion in her favour.

Relevant income year

2.36 When the Commissioner, after an application for a discretion from a taxpayer, is working out what the taxpayer's adjusted taxable income is in order to work out if the discretion under paragraph 35-55(1)(b) or (c) should be applied, the Commissioner must look at the most recent income year that has ended immediately before the application for the exercise of a discretion by the Commissioner. [Schedule 2, item 9, paragraph 35-55(1)(b)]

2.37 The Commissioner may exercise a discretion for one or more income years. [Schedule 2, item 7, subsection 35-55(1)]

Application and transitional provisions

Carve-out for certain investment allowances

2.38 The Income Tax (Transitional Provisions) Act 1997 (IT(TP)A 1997) is amended to not apply the non-commercial losses rules under Division 35 of the ITAA 1997 to a business activity that has greater available deductions than assessable income in a given income year only because of the investment allowances that arise because of Division 41 of the ITAA 1997; which is about the Government's small business and general business tax break.

2.39 Investment allowances for certain new business investment were introduced in 2008 to assist with stimulating economic activity. Where otherwise profitable businesses that are run by individuals or partnerships take advantage of the investment allowances, but are then placed in a tax loss position, the owners being unable to apply the losses against their other income. To remove the potentially anomalous result, the law is amended to allow the application of the losses, despite the non-commercial losses rules.

2.40 The amendment will only allow losses to be offset against other income where the loss arises solely because of the deduction available under Division 41 of the ITAA 1997. [0]In all other cases the normal non-commercial losses rules will apply.

Grandfathering of existing Commissioner's discretions

2.41 To remove any doubt about whether a taxpayer that has obtained a discretion before the commencement of this Bill, the IT(TP)A 1997 is amended to allow any existing discretion to continue to apply, despite the amendments.

2.42 These changes will ensure that any discretion that has been applied by the Commissioner, including about any 'managed investment scheme' (or in any other case), will continue in effect despite the amendments.

Application

2.43 These amendments will commence from the date the Bill receives Royal Assent. [Clause 2]

2.44 The amendments will apply to the 2009-10 income year and later income years. [Schedule 2, item 8]

Consequential amendments

2.45 The guide to Division 35 is changed to reflect the amendment made by this Bill. [Schedule 2, item 5, paragraph 35-55(1)(b)]