Private ruling: Asset deductibility and Commissioner's discretion for non-commercial business losses
Published: May 2012
Ruling period: 1 July 2012 to 30 June 2013

Ruling: Q1: As a small business entity, will the taxpayer be entitled to an immediate deduction pursuant to section 328-180 of the Income Tax Assessment Act 1997 (ITAA 1997), for the 'cost' of an asset (costing less than $1,000 each) at the time they are installed ready for use in the business? | A1: Yes | Q2: Will the Commissioner exercise the discretion at paragraphs 35-55(1)(b) and 35-55(1)(c) of the ITAA 1997 to allow the taxpayer to include any losses from their business activity in their calculation of taxable income for the income year ending 30 June 2013? | A2: Yes

Relevant facts and circumstances: Overview and Background All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified. The taxpayer is contemplating becoming an investor via membership in a consortium of parties grouping together to fund, operate and actively trade the output from an income generating business (the "Scheme"). The taxpayer proposes to acquire assets for participation in the aspect of the business, which involves the production of a saleable output. Other parties will be appointed by the investors to fund and operate other aspects of the business known as the Balance of Plant, as well as the trading of the saleable output produced from the business. The taxpayer proposes to acquire a number of assets for use in generating saleable output. Each asset is expected to cost under $1,000 and comprise the functional elements sufficient to produce the saleable output. Each asset will comprise an interest in the Scheme, which carries with it a right to have the asset installed and connected to the Balance of Plant ("BoP"). The investors will appoint a Responsible Entity ("the RE") who will be responsible for a number of aspects of the scheme, including to pool the collection of their saleable output for sale to market as well as entering into arrangements that ensure the ongoing servicing and maintenance of the BoP. The BoP will include a number of supporting structures and elements, which are ancillary to the production of the saleable output. Each asset will be able to produce saleable output independently of the BoP. The assets will be chattels at law owned by the investors and the investors can physically remove them from the business premises on the giving of reasonable notice to the RE. The Scheme transaction documents will specifically permit their removal, subject to a predetermined notice period. Once removed, the assets are capable of being sold or deployed into alternative applications. The assets are expected to have a useful life of 25 years, which is equivalent to the term of the Scheme. The key business activities to be carried out for the asset owners by the RE will be prescribed under the Scheme constitution and will fall under two main categories: · Operation and Maintenance ("O&M"); · and Sales The RE and the investors will appoint a manager to undertake the above functions. The Manager will undertake these functions in its capacity as subcontractor and the RE remains ultimately responsible for the performance of these functions. The investor's entitlements to net revenue will be distributed by the RE to the investors in proportion to the number of assets they own. Non-commercial business losses The taxpayer's business activity is part of a Managed Investment Scheme (MIS) that will be covered by a Product Disclosure Statement (PDS) and MIS Constitution. The nature of the taxpayers business activity is for cash flows to be heavily negative in the year of installation and thereafter to be cash flow positive (i.e. producing net assessable income) for each and every year of the likely 25 year life of the system. This business activity involves an extensive upfront capital cost in the initial year of installation (i.e. purchasing and installing the equipment) and then very little in the way of on-going operating costs in subsequent years. The taxpayer provided evidence to show that a business should become commercially viable in the first year after its year of installation.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 35 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Section 40-30 | Income Tax Assessment Act 1997 Subsection 40-30(1) | Income Tax Assessment Act 1997 Subsection 40-30(4) | Income Tax Assessment Act 1997 Subsection 40-425(2) | Income Tax Assessment Act 1997 Subdivision 328-D | Income Tax Assessment Act 1997 Section 328-110 | Income Tax Assessment Act 1997 Section 328-180 | 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(4) | Income Tax Assessment Act 1997 Section 35-30 | Income Tax Assessment Act 1997 Section 35-35 | Income Tax Assessment Act 1997 Section 35-40 | Income Tax Assessment Act 1997 Section 35-45 | Income Tax Assessment Act 1997 Section 35-55 | Income Tax Assessment Act 1997 Paragraph 35-55(1)(b)

Reasons for decision: Summary: As a small business entity, will the taxpayer be entitled to an immediate deduction pursuant to section 328-180 of the ITAA 1997, for the 'cost' of the asset (costing less than $1,000 each) at the time they are installed ready for use in the business? Yes Section 328-180 allows the taxpayer to deduct the taxable purpose proportion of the adjustable value of a depreciating asset for the income year in which the taxpayer starts to use the asset, or have it installed ready for use, for a taxable purpose if: · the taxpayer was a small business entity for that year and the year in which the taxpayer started to hold it; and · (ab) the taxpayer chose to use subdivision 328-D for each of those years; and · the asset is a low-cost asset. The taxpayer is a small business entity under section 328-110 and will therefore meet the requirement under paragraph 328-180(a). If the taxpayer chooses to calculate their deductions under subdivision 328-D instead of Division 40 they will then need to satisfy that the asset is a low-cost asset under paragraph 328-180(b). A low-cost asset is defined under subsection 40-425(2) as a depreciating asset (except a horticultural plant) whose cost as at the end of the income year in which you start to use it, or have it installed ready for use, for a taxable purpose is less than $1,000. Subsection 40-30(1) states that a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except: · land; or · an item of trading stock; or · an intangible asset. According to subsection 40-30(4) whether a collection of items is a single depreciating asset or whether its components are separate individual assets is a question of "fact and degree", which can only be determined by considering all the relevant circumstances of the taxpayers particular case. If the collection of items is the depreciating asset, the decline in value is calculated by reference to the composite item. Otherwise, the individual components are depreciated separately. Paragraph 1.15 of the Revised Explanatory Memorandum (EM) to the New Business Tax System (Capital Allowances) Bill 2001 (the EM) indicates that the functionality test should be applied when identifying particular depreciating assets. Paragraph 1.15 of the EM: Taxpayers will be required to exercise judgement in identifying the depreciating asset where the asset itself is made up of different parts and components. In doing this, the 'functionality' test that is used as a basis of identifying a 'unit of plant 1 ' in the existing plant depreciation rules can be used. | Detailed Reasoning - Functionality test: Taxation Ruling TR 94/11 contains some guidelines about the functionality test and how it must be applied to the facts of each case. Some of these guidelines include: The 'functionality test' applies to determine whether a composite item is a single depreciating asset or whether the components are separate depreciating assets. Where a unit is made up of a number of components, the function of each component and the larger composite item should be considered when deciding which is the relevant 'unit of property'. The function of the item being considered need only be separately definable or identifiable and capable of performing its own intended discrete function ( FC of T v Tully Co-operative Sugar Milling Assoc. Ltd. 83 ATC 4495; (1983) 14 ATR 495 (Tully case)). The function depends on facts of the case and the relevant function is the function the item is to serve in the context of the taxpayer's income-producing activity. More specifically, the relevant function is the function of the item in the particular circumstances of its use, as opposed to a hypothetical use. Paragraph 5 of Taxation Ruling TR 94/11 provides further guidance on the functionality test, at this paragraph it says: An item of plant can consist of a number of separate units, each performing a definable and identifiable function. When considered in isolation each of these units might be a separate unit of property. However, where such separate units are integrally linked so as to create a single (larger) unit having its own individual function then that larger integrated unit may be the relevant unit of property. This is a question of fact and degree. Further guidance on the functionality test may also be obtained from the decision in various court cases. In the case of Tully , the Federal Court held that in determining whether an item is a unit of property it is relevant to look at the intended function or purpose of that item. In this case, the pumping station that comprised an electric motor, starter and other parts was held to be a single unit of property. In reaching his judgment, Fitzgerald J said (ATC at paragraph 4506; ATR at paragraph 506): ...there is, ...a unit of property if it is capable of independent existence, not necessarily self contained, e.g., it may require power from an external source, not necessarily separately used, e.g., it may be incorporated into an operating system such as a machine or complex of machinery in a manufacturing process, but capable either of separate function, or of function in conjunction with different parts, or in a different context, from its current user. In Tully , Fox J in reaching his decision said (ATC at paragraph 4500; ATR at paragraph 500): Several items, each of which at some stage could be regarded as a unit, can be combined or linked, or associated so as to form a larger unit. When one looks to see whether there is a unit, one normally looks to see whether there is a whole something. Whether there is a whole will normally be judged by the intended function or purpose of that which is being looked at. In Ready Mixed Concrete (Vic) Pty. Ltd. v FC of T 69 ATC 4038; (1969) 1 ATR 123 (Ready Mixed Concrete case) his honour Kitto J said at ATC 4042: Notwithstanding the mode and degree of annexation, the truck and the mixer are functionally separate and independent units of property. The function of the delivery belongs to the truck. The use of the mixer is for mixing, as a step in the production of concrete in the condition required for pouring... These cases make it clear that a separate unit of property is one which has an identifiable or definable separate function. If the function of the item is essentially the permanent means used to produce the income, the item generally qualifies as plant, whether it is fixed or movable. This approach was developed by the courts in Yarmouth v. France (1887) 19 QBD 647 and has been consistently applied (see for example J Lyons & Co Ltd v. The Attorney General (1944) 1 All ER 477 and Dixon (Inspector of Taxes) v. Fitch's Garage Ltd (1975) 3 All ER 455 ). The taxpayer will buy the asset as a whole system (each system is expected to cost less than $1,000). The asset produces a saleable output. The overall functionality of the Scheme is to produce a saleable output. The function of the Scheme is therefore to earn the taxpayers business assessable income. The asset is capable of independent existence; it can perform the discrete function of producing saleable output on its own, when interfaced with the BoP it allows the saleable output to be readily delivered to market. The asset can be removed by the investors and used in alternative uses. The asset and the BoP are functionally separate, the asset produces the saleable output (an identifiable and separate function) and the BoP performs the separate function of delivering the saleable output to market for sale. Under the Scheme, a larger unit is created when the asset is interfaced with the BoP to deliver the saleable output to market. This larger unit function is in its entirety to deliver saleable output to market. As the only function of the Scheme is to produce saleable output and therefore the permanent means to produce the taxpayers business income, and as the assets on their own can also produce saleable output to be used in other functions to produce the taxpayers business income, the asset and the BoP as a larger combined unit do not have a separate function. The asset has an existence and function apart from the larger system (when interfaced with the BoP) and accordingly would satisfy the definition of a 'depreciating asset' in section 40-30. As the taxpayer is a small business entity, the cost of each asset is less than $1,000 (qualifies as a low-cost asset) and the asset is considered a separate depreciating asset, under section 328-180 the taxpayer qualify for an immediate deduction for the asset in the year first used or held ready for use in the Scheme. | Detailed Reasoning - Question 2: Will the Commissioner exercise the discretion at paragraphs 35-55(1)(b) and 35-55(1)(c) of the ITAA 1997 to allow the taxpayer to include any losses from their business activity in their calculation of taxable income for the income year ending 30 June 2013? | Detailed Reasoning - Answer: Yes The discretion at paragraphs 35-55(1)(b) and 35-55(1)(c) only apply where you are carrying on a business. | Detailed Reasoning - Division 35: Division 35 of ITAA 1997 applies to losses from non-commercial business activities incurred from the 2000-01 income year. Under Division 35, for the non-commercial business losses rules to apply: · The taxpayer must be an individual; · The taxpayer carries on a business activity and · The taxpayer made a loss from that business activity. Under the rule in subsection 35-10(2), a deduction for a non-commercial loss incurred by an individual from certain business activities in an income year will not be allowable in that income year unless: · you satisfy subsection 35-10(2E) (2009-10 and later income years only) and one of tests in section 35-30, 35-35, 35-40 or 35-45; or · the Commissioner exercises the discretion in section 35-55; or · the exception in subsection 35-10(4) applies. The exception in subsection 35-10(4) applies where (a) the activity is a primary production business and (b) the assessable income of the taxpayer that does not relate to that activity is less than $40,000. This Commissioner's discretion requires that the business activity must be 'carried on' and it is the nature of the business that dictates that one of the four threshold tests under section 35-30, 35-35, 35-40 or 35-45 has not been met. The third test for the exercise of the discretion is where the taxpayer must be able to demonstrate to the Commissioner that there is an objective expectation their business activity will meet one of the four tests (section 35-30, 35-35, 35-40 or 35-45) or produce a tax profit within the time that is within a period that is commercially viable for the industry in which the taxpayer conducts their business. The objective expectation must be based on evidence from appropriate independent sources, where available. The basis of the taxpayer's application for the Commissioner's discretion was 'the nature of your activity'. The nature of the taxpayer's business is such that it requires a substantial upfront capital cost in order to install the plant. Once installed, the business has relatively low ongoing operational costs in comparison to other businesses. This indicates that the taxpayer has applied for the Commissioner's discretion under paragraphs 35-55(1)(b) or 35-55(1)(c). The relevant discretion is paragraph 35-55(1)(b), being: The Commissioner may decide that the rule in section 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 the rule because: (b) for an applicant who carries on the business activity who satisfies 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 satisfied, or will not satisfy, one of the tests set out in section 35-30, 35-35, 35-40 or 35-45; 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 either meet one of those tests or will produce assessable income for an income year greater than the deductions attributable to it for that year… The relevant discretion contained in paragraph 35-55(1)(c), being: 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)). The taxpayer provided evidence from industry experts that their type of business would not be expected to produce a tax profit until the year after installation. The taxpayers business activity meets the requirements of subparagraphs 35-55(1)(b)(i) or 35-55(1)(c)(i) as there are inherent characteristics that prevent business activities of this type from satisfying the tests during the year/s of installation of the plant. Once the plant is installed, similar businesses are able to immediately earn income. For both subparagraphs 35-55(1)(b)(ii) and 35-55(1)(c)(ii), the main issue is whether the taxpayer's business activity will produce a profit within a commercially viable period for their industry. Paragraph 92 of Taxation Ruling TR 2007/6 says: Division 35 does not require that a determination be made as to how long it will take a business activity to become commercially viable. Rather, it involves an enquiry into whether the business activity in question will satisfy a test or produce a tax profit within the time frame in which other business activities in the same industry, which behave in a commercially viable manner, do so. (Refer Scott v. Commissioner of Taxation [2006] AATA 542 at paragraphs 30 and 32.) The taxpayer provided evidence, which is based on industry experts in their industry and from independent sources that shows that this type of business, conducted in a commercially viable manner, should be able to make a tax profit by the year after installation of the plant. As there is sufficient information (based on evidence from independent sources) for the Commissioner to be satisfied that there is an objective expectation that, within the period that is commercially viable for a business of this type, the taxpayers business activity will produce a tax profit, the Commissioner will exercise the discretion in paragraph 35-55(1)(b) and 35-55(1)(c) of the ITAA 1997 for the year ending 30 June 2013.

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