Private ruling: Non-commercial losses
Date of advice: 29 September 2015
Published: September 2015
Ruling period: Year of income ended 30 June 2013 | Year of income ended 30 June 2014 | Year of income ended 30 June 2015 | Year of income ended 30 June 2016 | Year of income ended 30 June 2017 | Year of income ended 30 June 2018
Date scheme commenced: 1 July 2012

Ruling: Q1: Are the interest expenses of the Partnership 'amounts attributable to the business activity' in terms of subsection 35-10(2) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of ITAA 1997 to allow you to include your share of the losses from the business in your calculation of taxable income for the years of income ended 30 June 2013 to 30 June 2015 inclusive? | A2: Yes | Q3: Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of the ITAA 1997 to allow you to include your share of the losses from the business in your calculation of taxable income for the years of income ended 30 June 2016 to 2017 inclusive? | A3: No | Q4: Will any losses deferred by subsection 35-10(2), which are not otherwise deducted in a subsequent year, be deductible against any assessable income (which could include a net capital gain) realised by you on disposing all or part of your interest in the partnership as a result of certain specified events happening? | A4: Yes

Relevant facts and circumstances: The Partnership commenced running a business in 200X. Since commencement of the business, and in accordance with the business plan, the Partnership has incurred significant expenses in developing the necessary infrastructure required for the business activity. The business activity has been financed by the initial injection of capital by the partners as well as by debt financing.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 35 | Income Tax Assessment Act 1997 subsection 35-10(2) | Income Tax Assessment Act 1997 subsection 35-55(1)(c)

Reasons for decision: Summary: The interest expenses incurred by the Partnership are 'amounts attributable to the business activity' in terms of subsection 35-10(2). | Detailed Reasoning - Detailed reasoning: Under subsection 35-10(2), if the amounts attributable to the business activity for a year of income that otherwise could be deducted (apart from Division 35) exceed the assessable income (if any) from the business activity, the excess (i.e., the non-commercial loss) is treated for the purposes of the ITAA 1997 as though it: (a) were not incurred in that income year; and (b) instead, were an amount attributable to the business activity that is deductible in the next income year in which that *business activity is carried on. Under section 8-1 a taxpayer can deduct against assessable income any expenses necessarily incurred in carrying on a business for the purposes of deriving assessable income, unless that expense is of a capital, private or domestic nature or incurred in relation to gaining or producing exempt income or non-assessable non-exempt income, or is otherwise specifically excluded from deduction. As stated by the Full Federal Court in Watson v DFC of T (2010 ATC 20-167): s 35-10(2) speaks of "amounts attributable to the business activity for that income year that you could otherwise deduct ... for that year". Clearly, the relevant deductions must be both attributable to business activity for the relevant year and allowable as deductions for that year. … The better view is that the deductions referred to in s 35-10(2) are those which are both attributable to business activity in the relevant year and allowable as such "for" that year. …" As the interest expense incurred by the Partnership is in relation to financing its business activity, and would be deductible under section 8-1 in the year it is incurred, the interest expense is 'attributable' to the business activity being carried on by the Partnership in terms of subsection 35-10(2). Accordingly, the interest expenses incurred by the Partnership are 'amounts attributable to the business activity' in terms of subsection 35-10(2). | Summary: For those rulees who meet the income requirement set out in subsection 35-10(2E), the Commissioner will not be required to consider the exercise of the discretion under subsection 35-55(1). For those rulees who do not meet the income requirement for the relevant income year, the Commissioner will exercise the discretion under subsection 35-55(1) for the income years ending 30 June 2013 to 30 June 2015 inclusive. Thus, the relevant share of losses from the business activity will not be subject to the loss deferral rule in subsection 35-10(2) for those years. However, for those rulees who do not meet the income requirement for the relevant income year, the Commissioner will not exercise the discretion under subsection 35-55(1) for the income years ending 30 June 2016 and 30 June 2017 inclusive. Thus, the relevant share of losses from the business activity will be subject to the loss deferral rule in subsection 35-10(2) for those years. | Detailed Reasoning - Detailed reasoning: For the 2009-10 and later income years, Division 35 will apply to defer a non-commercial loss from a business activity unless: • you meet the income requirement and you pass one of the four tests: • assessable income test (section 35-30) • profits test (section 35-35) • real property test (section 35-40) • other assets test (section 35-45) • the exception in subsection 35-10(4) applies; or • the Commissioner exercises his discretion (section 35-55). Taxpayers' meet the income requirement where their taxable income, reportable fringe benefits and reportable superannuation contributions (less their business losses) does not exceed $250,000. In the current case, some of the rulees are stated to have satisfied this income requirement for a number of the income years for which the ruling has been sought. Further, the business activity undertaken by the Partnership would meet at least one of the four tests listed above in all of the years for which the ruling is sought. Consequently, those rulees who meet the income requirement will not be subject to the non-commercial loss deferral rules in Division 35, and the Commissioner is not required to consider the application of his discretion under section 35-55. Equally, however, a number of the rulees do not satisfy the income requirement in some or all of the income years for which the ruling is sought. Further, these rulees are not covered by the exception in subsection 35-10(4). These rulees' share of the Partnership's business losses are therefore subject to the deferral rule in subsection 35-10(2), unless the Commissioner exercises his discretion pursuant to subsection 35-55(1). In accordance with subsection 35-55(1), the Commissioner may exercise his discretion to determine that it would be unreasonable for the loss deferral rule in subsection 35-10(2) to apply under certain circumstances, as set out in the: • Special circumstances limb (paragraph 35-55(1)(a)); and • Lead time limbs (paragraphs35-55(1)(b) and (c)). The rulees have advised that there are no special circumstances to which paragraph 35-55(1)(a) could be applied. Paragraph 35-55(1)(b) provides for the Commissioner's discretion to be exercised where the taxpayer does satisfy the income requirement in subsection 35-10(2E) and the business activity does not meet at least one of the four tests. As some of the rulees satisfy the income requirement for a number of the relevant years, and the business activity will meet at least one of the four tests mentioned above in the years for which the ruling is sought, the Commissioner's discretion pursuant to paragraph 35-55(1)(b) will not need to be exercised. However, where the income requirement is not met by a rulee in all or some of the income years for which the ruling is sought, the discretion can only be exercised pursuant to paragraph 35-55(1)(c). Accordingly, the rulees have requested the Commissioner exercise his discretion pursuant to this particular paragraph. | Detailed Reasoning - Lead time limb - paragraph 35-55(1)(c): In part, subsection 35-55(1) states that: The Commissioner may, on application, decide that the rule in subsection 35-10(2) does not apply to a * business activity for one or more income years (the excluded years ) if the Commissioner is satisfied that it would be unreasonable to apply that rule because: …. (c) For an applicant who carries on the business activity who does not satisfy subsection 35-10(2E) (income requirement) for the most recent income year ending before the application is made - the business activity has started to be carried on and, for the excluded years: (i) because of its nature, it has not produced, or will not produce, assessable income greater than the deductions attributable to it; and (ii) 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 subsections 35-10(2) and (2C)). A note to paragraphs (b) and (c) states that: 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. Taxation Ruling TR 2007/6 Income tax: non-commercial business losses : Commissioner's discretion discusses the pivotal concepts for consideration in paragraph 35-55(1)(c) which are: • the meaning of 'because of its nature'; • the 'objective expectation' that the activity will produce a profit within a 'period that is commercially viable for the industry concerned'. (para 4) Consideration will first be given to the 'objective expectation' that the Partnership will produce a profit within a period which is commercially viable for the industry concerned. Consideration will then be given to the meaning of 'because of its nature'. Objective expectation of profit in commercially viable period Paragraph 20 of TR 2007/6 states that: The Commissioner must be satisfied that an objective expectation exists, for each of the year(s) 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. The objective expectation must be based on independent information, where such information is available. Paragraph 21 then states that: The period that is commercially viable for the industry concerned 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 satisfy one of the tests or produce a tax profit. It is not determined having regard to best practice in the industry concerned. It is not sufficient that the activity is commercial in purpose and is likely to return a profit at some indefinite point in the future. The activity has to return this profit within '…a period that is commercially viable for the industry concerned…' Thus, the fact that the activity undertaken by the Partnership is a genuine activity operated with a clear view to future profit will not be sufficient in itself to guarantee the exercise of the discretion under paragraph 35-55(1)(c) if there is no commercially realistic expectation of a profit. For example, if the extent of the infrastructure expenditure meant that the Partnership would never be able to return a profit on the venture, the discretion should not be exercised. The Partnership first returned an accounting profit in the year ended XXXX, and the rulees first expect to return a taxable profit from the business activity in their income tax return for the year of income ended 30 June 2018. The net taxable income from the Partnership's business activity is projected to be $X for that year rising to $Y in several years after that. Accordingly, it is accepted that there is a realistic expectation of a profit into the future. That is, that 'the activity will produce assessable income for an income year greater than the deductions attributable to it for that year'. However, as indicated above, sub-paragraph 35-55(1)(c)(ii) further requires that there be an 'objective expectation, based on the evidence from independent sources' that this profit will occur 'within a period that is commercially viable for the industry concerned'. Thus, it is necessary to consider the meaning of these terms. As discussed in TR 2007/6 (paragraphs 99 to 102), it is necessary to identify a collection of businesses which are carried on in a commercially viable manner. In particular, paragraphs 100 and 101 explain: 100. 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. The first factor is relevant to satisfaction of the Assessable income test and the second to satisfaction of the Profits test of the production of a tax profit. 101. As such, geographical or other differences which materially affect the measures of performance paragraphs 35-55(1)(b) and (c) 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. TR 2007/6 further explains at paragraph 104: 104. In order to demonstrate that the objective expectation exists, a business operator should produce evidence showing that the business activity will satisfy one of the tests or produce a tax profit, showing the period within which a commercially viable business would do so. ....... the evidence that the business activity will satisfy one of the tests or 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 relation to the Partnership the relevant industry is considered to be XXX. The applicant has provided evidence to support their contention that the lead time for this type of business should be approximately X to Y years. The Commissioner has considered the evidence provided and is satisfied that for the purposes of sub-paragraph 35-55(1)(c)(ii), for the industry concerned the commercially viable period to produce a tax profit is approximately X years. Because of its nature However, as stated above, it is not sufficient for the exercise of the discretion under paragraph 35-55(1)(c) that a business produce a profit within a 'period that is commercially viable for the industry concerned'. The failure of the business activity to produce assessable income in excess of its deductions must also be 'because of its nature.' Paragraph 17 of TR 2007/6 states that in order for the failure of a business activity to make a profit under paragraph 35-55(1)(c): …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 (see Federal Commissioner of Taxation v. Eskandari (Eskandari )). As further stated by Stone J at paragraph 29 in Eskandari: It would seem clear from comments in the Explanatory Memorandum to the New Business Tax System (Integrity Measures) Bill 2000, which introduced Division 35 into ITAA 97 , that in making these amendments, the legislature was concerned with common features of business activities not with features that are peculiar to the way in which the individual taxpayer runs his business. In relation to s 35-55(1)(b) the Explanatory Memorandum says at [1.51]: ``This arm of the safeguard discretion will ensure that the loss deferral rule in 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.'' Thus, paragraph 78 of TR 2007/6 states that: 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 subparagraphs 35-55(1)(b)(i) and (c)(i) being met. (Refer to Example 9 at paragraph 139 of this Ruling). Accordingly, even though a particular business expense may ordinarily be deductible under section 8-1, it may be the case that the expense is not because of some inherent characteristic of the business activity for the purposes of paragraph 35-55(1)(c). In the case of the Partnership, there are several reasons why the Partnership's business activity has not yet produced a tax profit (where the assessable income is greater than the deductions attributable to it for the income year): • Specific industry factors • Infrastructure setup costs • Financing (Interest) expenses Infrastructure setup costs The Partnership has incurred significant expenditure on infrastructure set up costs. The applicant submits that the decision to implement a significant program of infrastructure development is not merely a business choice in the context of the business activity generally, but an essential characteristic of the business activity being undertaken. Further, the applicant can point to specific factors which required the spreading of the infrastructure development activities over an extended period. Documentation provided by the applicant supports the contention that the requirement for the implementation of a significant program of infrastructure is integral to this type of business. Accordingly, the Commissioner accepts that the infrastructure development costs are inherent to the 'nature' of the Partnership's business activity. Thus, to the extent that the Partnership's failure to produce assessable income in excess of deductions was the result of this infrastructure expenditure, the Commissioner would exercise his discretion under paragraph 35-55(1)(c). Financing (interest) expenses As mentioned above, the Commissioner's view, as outlined in paragraph 78 of TR 2007/6, is that interest expenses are not 'inherent' to a business activity and therefore cannot be taken into account for the purposes of sub-paragraph 35-55(1)(c)(i). Since the publication of TR 2007/6, the treatment of interest expenses when applying the discretion in section 35-55 has been addressed in several Administrative Appeals Tribunal decisions. In Heaney and Commissioner of Taxation [2013] AATA 331; (2013) ATC 10-315, Senior Member Egon Fice commented (at 144) that: The level of debt financing of such a business operation is not a factor which goes to its nature. It is not an inherent feature of a taxpayer's business activity and will depend entirely upon the way in which the taxpayer goes about conducting the business. .... In Hefner and Commissioner of Taxation [2013] AATA 407; (2013) ATC 10-319 Senior Member BJ McCabe, in confirming the Commissioner's objection decision not to exercise the discretion said (at 17): .... The evidence establishes a stud could become profitable in advance of 30 June 2017; indeed, depending on the cost structure of the operation, it could become profitable as early as five years after establishment (although I accept it probably would not generate maximum profits until sometime later). The key variable is financing costs. If those costs are high- because the operation is funded wholly or partly by debt - then it will take longer for the operation to turn a profit. But the operation does not suggest debt is an "inherent feature that the taxpayer's business activity has in common with business activities of that type": see Commissioner of Taxation v Eskandari [2004] FCA 8 at [32] per Stone J. A stud business could be conducted in a different way, in the sense that alternative financing arrangements are at least theoretically available. There is nothing inherent in the business activities which demand that they be financed by debt. In Case 13/2011 [2011] AATA 779; 2011 ATC 1-040 Justice Logan commented [at 22] that: .... the facts which comprise the "scheme" for the purposes of the private ruling sought do not support a conclusion that it is in the nature of the activity of beef cattle production that it takes more than two decades or anything like that to produce assessable income greater than the deductions attributable to it. .... what is revealed by the facts comprising the "scheme" is a series of idiosyncratic, managerial choices made by the Applicant as to how to go about the business activity. That he was able to continue the business activity for all of these years and to make these choices was not, on the evidence, because of the nature of that business activity at all but rather because of his ready access either to funding from his own other resources or from external financiers. ... not every managerial reaction to events encountered in the course of a business activity or measure designed to achieve economies of scale is to be regarded as having occurred because of the nature of that activity. (emphasis added). The ruling applicant contends that there is nothing in the decision in Eskandari t o justify an approach of looking at whether the business can be run in another manner that is 'theoretically' possible. Rather, the enquiry should be as to whether the interest expense is on a par with similar businesses. The Commissioner rejects the taxpayer's contention. There is nothing inherent in the business activities of the Partnership to establish that debt financing of such a business operation is a factor which goes to its nature. Accordingly, he is not required to consider whether the Partnership's interest expenses are on par with similar businesses. The Commissioner's view regarding the level of debt funding of a business is expressed in paragraph 78 of TR 2007/6, which is supported by various AAT decisions cited above. Effect of infrastructure and interest deductions on the Partnership's profit For the years of income ended WWWW to XXXX inclusive, the infrastructure expenditure deductions incurred by the Partnership prevented it from producing assessable income greater than the deductions attributable to it, regardless of the amount of the interest deductions. However, in relation to the years of income ended YYYY to ZZZZ, the Partnership's allowable deductions exceeded its assessable income as a consequence of its interest deductions. This is a consequence of the Partnership's level of debt funding, which isn't regarded as having occurred because of the nature of its business activity. Summary For the years of income ended WWWW to ZZZZ inclusive, the Partnership has not produced or will not produce assessable income greater than the deductions attributable to it. However the Commissioner is satisfied that the Partnership's business activity should, within a commercially viable period for the industry concerned, produce assessable income for an income year greater than the deductions attributable to it for that year. Further, as the infrastructure expense deductions: • are considered inherent to the 'nature' of the Partnership's business activity; and • prevented the Partnership from producing assessable income in excess of its deductions in the Partnership's income years WWWW to XXXX inclusive (regardless of the interest expenses) the Commissioner will exercise his discretion pursuant to paragraph 35-55(1)(c) for the income years ending 30 June 2013 to 30 June 2015 inclusive. Consequently, the rulees' share of the losses from the Partnership's business activity will not be subject to the loss deferral rule in subsection 35-10(2) for these years. However, in relation to the YYYY to ZZZZ years of income for the Partnership, it is the way the business activity is financed and the resulting interest expense deductions that are expected to result in the Partnership's deductions exceeding its assessable income. As the financing of the business activity and the resulting costs are not considered to be inherent to the 'nature' of the Partnership's business activity, the requirements of sub-paragraph 35-55(1)(c)(i) will not be met in these years. Therefore, the Commissioner will not exercise the discretion under subsection 35-55(1) in relation to the rulees' share of the losses relevant to the income years ending 30 June 2016 and 30 June 2017 inclusive. The rulees' share of the losses from the Partnership's business activity will consequently be subject to the loss deferral rule in subsection 35-10(2) for those years. | Summary: Any losses deferred by subsection 35-10(2), which are not otherwise deducted in a subsequent year, will be deductible against any assessable income (including a net capital gain) realised by a rulee partner on disposing all or part of his or her interest in the partnership as a result of certain specified events happening. | Detailed Reasoning - Detailed reasoning: Under subsection 35-10(2), if the amounts attributable to the business activity for a year of income that otherwise could be deducted (apart from Division 35) exceed the assessable income (if any) from the business activity, the excess (i.e., the non-commercial loss) is treated for the purposes of the ITAA 1997 as though it: (a) were not incurred in that income year; and (b) instead, were an amount attributable to the business activity that is deductible in the next income year in which that *business activity is carried on. Therefore, if a partner disposes of part or all of their interest in the Partnership, any losses deferred under subsection 35-10(2) will only be deductible against any future assessable income (including a capital gain) received on disposal of that interest if that income is 'from' the 'business activity'. In Watson v. Deputy Commissioner of Taxation [2010] FCAFC 17; (2010) 182 FCR 104; 2010 ATC 20-167; (2010) 75 ATR 224 ( Watson ) the Full Federal Court was concerned with whether income protection policy payments were assessable income 'from the business activity' for the purposes of subsection 35-10(2). The Court held that the meaning of the word 'from' in subsection 35-10(2) should have its ordinary dictionary meaning. As such it indicates the starting point, source or origin of the assessable income. In Watson, the Court found that the income from the income protection policy payments were not 'from' the taxpayer's business activity, but rather were derived from his incapacity to conduct his business activity. In Taxation Ruling TR 2001/14 Income Tax: Division 35 - non-commercial business losses the Commissioner accepts that withdrawals from a Farm Management Deposit account will be income from the business activity if the initial deposit was funded from a primary production business activity and the withdrawal occurs whilst that same business activity is being conducted. In Kidston Goldmines Ltd v. Commissioner of Taxation (1991) 30 FCR 77, 91 ATC 4538, ( Kidston Goldmines ) Hill J was concerned with whether particular income was 'income, ..., derived from the working of a mining property ...' for the purposes of the former subsection 23(o) of the Income Tax Assessment Act 1936 . During the course of his decision, Hill J commented that such income could extend to a 'profit made on the sale of plant used directly on the mining property to work the mine'. In ATOID 2003/288 (withdrawn), the Commissioner confirmed that a balancing adjustment amount included in assessable income following the sale of a depreciating asset used in the taxpayer's business activity would be income 'from' the business activity for the purposes of Division 35. The withdrawal notice for ATOID 2003/288 states that it was withdrawn because 'the meaning of 'from the business activity' is discussed in TR 2001/14'. TR 2001/14 however, does not specifically address the issue of whether any profits on the sale of assets used in a business activity constitutes income 'from that business activity' for the purposes of Division 35. As ATOID 2003/288 was not withdrawn because the Commissioner considered that the view it expressed was incorrect, and, taking into account the comments by Hill J in Kidston Goldmines it is accepted that 'income from a business activity' can include profit on the sale of an asset which is actually used in the business activity. Therefore, any losses deferred by subsection 35-10(2), which are not otherwise deducted in a subsequent year, will be deductible against any assessable income (including a net capital gain) realised by a partner on disposing all or part of his or her interest in the partnership as a result of certain specified events happening.