Private ruling: Non-commercial business losses and the Commissioner's discretion
Date of advice: 14 October 2016
Published: May 2017
Ruling period: ● Year ended 30 June 20XX | ● Year ended 30 June 20YY | ● Year ended 30 June 20ZZ
Date scheme commenced: 1 July 20WW

Ruling: Q1: Will the Commissioner exercise the discretion in paragraph 35-55(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from your business activity (the activity) in your calculation of taxable income for the 20WW-XX to 20YY-ZZ financial years? | A1: No.

Relevant facts and circumstances: The arrangement that is the subject of the private ruling is described below. You satisfy the <$250,000 income requirement set out in subsection 35-10(2E) of the ITAA 1997. During the 20WW-XX financial year you commenced an activity primarily concerned with producing artistic items. Your items are couture, in that your collections are unique, singular, and bespoke. Your intention was to grow and develop your profile as a professional until retirement from your full time employment. You would do this by producing complete collections to be exhibited regularly at shows/exhibitions, and undertaking other ad-hoc engagements, and commissions as opportunities arise. You have previously conducted your activity out of your home, however you have been recently utilising a studio space that has been provided to you for free. You have purchased some equipment for manufacturing and displaying your items. However the largest cost is the physical materials needed to make each piece. You advised that the items are extremely costly to make, and take many hours to produce. To date you have produced a large number of items. Whilst you value the items at a particular figure, based on industry advice, current retail prices for similar pieces, and extensive market analysis, you accept that it will take time to become established and to get to the point where profit yielding prices are accepted by the market as fair. You advised that the reasons for this are: 1. the practice of couture art is intrinsically dependent on time both to get up and running and in maintaining the presentation of regular shows and installations 2. the art works are 'products' that are individual; they cannot be readily compared on the basis of price, usefulness, quality or any of the other criteria against which a product can be compared to its competitors. Furthermore, even in the area of art, the business focuses on a different client base. 3. for almost every potential buyer of the items, with the exception of institutions, a purchase is in the nature of highly discretional expenditure; it is not an item or service of 'essential' needs. 4. buyers of the items are more likely to purchase a work if that work meets certain tests: a) the price is considered fair, and b) the work meets their aesthetic expectation. In relation to the price, you advised that 'while a high(er) price for the art will be more likely the product of steady and consistent credibility building, no-one will pay the high prices for albeit unique and high quality and creative items if the creator is unknown, and where no-one before them has paid similar high prices. However a buyer would/should not expect to pay less than the fair retail for a store bought mass produced high end designer/couture item either. The work is so unique, making such a 'fair' price evaluation difficult.' In relation to aesthetic expectation, it is more usual in the arts buying world, which does not necessarily rely on a track record; an impulsive buyer who likes something might confidently pay the asking price. That is every creators dream. For a client who undertakes a commissioned work, it is the shared journey of creating a work that comprises the purchased satisfaction as the completed work itself. The creation of items for show is always a construct of time. A show cannot merely be one or two items or a shop front with new items arriving on the shelf as they are made, it must have significant impact and coherence to attract an audience. The show is planned months, if not years in advance and steadily takes shape with this focus as a body of work. For the 20WW-XXto 20YY-ZZ financial years, you have presented your items or your items have been recognised, on a number of occasions. Your first art show was in 20XX, and was a fully curated show/installation. There were over XYZ attendances, which, according to the events manager, was an extremely good attendance. You are also in the process of coordinating a number of shows in the near future. You have advised that the success of your couture label depends on the progress of presenting shows and exhibitions periodically. Therefore your business plan allows for six to seven years to realise sales and attract commissions from clients. You have provided a letter of support from individual A, who has worked in the Industry for more than 40 years. The letter states the following: '…judging from my own experience and the observations I have made on other artists, the road to success is not necessarily paved by incrementally increasing sales of created items. A period of 10 years is not unreasonable and (is) usual for an artist in this area to become successful.' Further you have advised: 'An expert accountant related in the field individual B has put the length of time that will generally elapse before an artist can expect to give up a full-time job is from four to six years, although an artist looking to make a reasonable income may well wait from ten to fifteen. Indeed, many artists have to die before their works fetch good prices; not a course I intend to take!' You have not earned any business income during the 20WW-XX to 20YY-ZZ financial years, and have therefore made losses in each period. During this period the activity relied significantly on financial support from your full time employment. However your position was made redundant in the 20YY-ZZ financial year, and as such you could no longer sustain the losses. Further you no longer have the capital available to buy materials to build up stocks for your own creative wishes, and for potential clients. You sought extensive direction, mentoring and support, as well as thoroughly researched the business and tax circumstances which are pertinent to you current circumstances. Based on this advice, you have changed the direction of the activity beginning from the 20ZZ- AA financial year. You have changed your business plan to shift the emphasis on your works towards being presented as performance or installation art, with the net income being derived from client subscription, ticket entrance, or commissioning fees, as well as from sales. This business model will very likely seek grant support and collaborative business/community funding support, such as support schemes for small business start-up, emerging artist support, community event funding, and disadvantage/education group funding. During the 20ZZ-AA financial year the activity has earned assessable income of less than $5000 from the sale of a number of pieces. Further for the 20AA-BB and 20BB-CC financial years you have projected income generation, and anticipate profits in both years. Income will be from sales of your items, grants and ticket sales from shows. For the 20WW-XX to 20YY-ZZ financial years your gross income from other sources was greater than $40,000.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 35 | Income Tax Assessment Act 1997 subsection 35-10(1) | 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 sections 35-30 | Income Tax Assessment Act 1997 sections 35-35 | Income Tax Assessment Act 1997 sections 35-40 | Income Tax Assessment Act 1997 sections 35-45 | Income Tax Assessment Act 1997 paragraph 35-55(1)(b) | New Business Tax System (Integrity measures) Act 2000 Explanatory Memorandum Tax Laws Amendment (2009 Budget Measures No.2) Bill 2009 Explanatory Memorandum

Reasons for decision: Summary: Carrying on a business If an activity is not carried on as a business, and cannot reasonably be expected to produce assessable income, for example, it is carried on as a hobby, then you cannot claim general deductions in relation to it, regardless of the operation of Division 35 of the ITAA 1997. Taxation Ruling TR 2005/1 provides guidance on the principles to be applied in determining whether an artist is carrying on business as a 'professional artist'. It states that common law has identified a number of indicators that are relevant in determining whether a taxpayer's activities constitute the carrying on of a business. The question whether a taxpayer's activities should be characterised as a business is primarily a matter of general impression and degree ( Ferguson ATR 884; ATC 4271). As noted in the Federal Court decision in Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922, no single indicator is determinative; rather all of the indicators must be considered. Whether a business is being carried on is based on the overall impression gained after looking at the activity as a whole and the intention of the taxpayer undertaking it. In your case, you have indicated in your application that your activity is carried on as a business. This ruling has, therefore, been determined on the basis of accepting your statement that you were carrying on a business from the 20WW-XX financial year. Overview of Division 35 For the 2009-10 and later financial years, subsection 35-10(2) of the ITAA 1997 will apply to defer a non-commercial loss from a business activity unless: ● the exceptions in subsection 35-10(4) applies ● you satisfy the income requirement and you pass one of the four tests in sections 35-30 (assessable income test), 35-35 (profits test), 35-40 (real property test) or 35-45 (other assets test), or ● the Commissioner exercises his discretion. In subsection 35-10(4) of the ITAA 1997 it is outlined that the rule in subsection 35-10(2) of the ITAA 1997 does not apply to a business activity for an income year if: a) the activity is a primary production business, or a professional arts business, and b) your assessable income for that year (except any net capital gain) from other sources that do not relate to that activity is less than $40,000. As your assessable income for the financial years in question were greater than $40,000, the exceptions do not apply. Further, although you satisfy the income requirement, you do not meet any of the four tests in the years of income under consideration. Your losses are therefore subject to the deferral rule, unless the Commissioner exercises his discretion. Losses that cannot be taken into account in a particular year of income, because of subsection 35-10(2) of the ITAA 1997, can be applied to the extent of future profits from the business activity, or are deferred until one of the tests is passed, the discretion is exercised, or the exception applies. | Detailed Reasoning - Lead time discretion - paragraph 35-55(1)(b) of the ITAA 1997: You requested that the Commissioner exercise the discretion under paragraph 35-55(1)(b) of the ITAA 1997. This discretion may be exercised for the income year in question where: i) the business activity has started to be carried on, and ii) because of its nature it has not satisfied, or will not satisfy, one of the tests set out in Division 35 of the ITAA 1997, and iii) there is an objective expectation, based on independent evidence, that within the commercially viable period for the industry concerned, the activity will either pass one of the tests or produce a taxation profit. i) The business activity has started to be carried on Your ruling application states that the concept of lead time in your couture business is: ● the earlier years of the activity where you acquire the assets (tangible and intangible) to produce the items; ● present collections as arts installations, shows, and exhibitions; ● build the necessary portfolio of recognition to then produce income from sales, or fees associated with shows, and solicited and commissioned activities, which are credentialed by your acknowledged artistry. Paragraph 98 of TR 2001/14 states for a business activity to have commenced a person must have acquired the minimum level of business assets to allow that business activity to be carried on. Therefore the business is not considered to have commenced while you were acquiring the assets (tangible and intangible) to produce the art. However, the Commissioner has accepted your statement that you were carrying on a business from the 20WW-XX financial year, when you commenced creating a portfolio of art to be displayed at your first exhibition. ii) Because of its nature it has not satisfied, or will not satisfy, one of the tests for commerciality Guidance on what is meant by the phrase, 'because of its nature' is provided by TR 2007/6, which states: 71. …the discretion is intended to be available to a commercial activity which fails to satisfy any of the tests for reasons outside the control of the operator. This is confirmed by the Explanatory Memorandum for the New Business Tax System (Integrity measures) Act 2000 (the 2000 Explanatory Memorandum), which states at paragraph 1.48: The discretion is provided to ensure that certain individuals who carry on genuine commercial businesses are not disadvantaged due to particular circumstances which prevent them from satisfying tests 1 to 4. 72. In addition, paragraph 1.51 of the EM (2000 Explanatory Memorandum) comments: This arm of the safeguard discretion [i.e., that in paragraph 35-55(1)(b)] will ensure that the loss deferral rule in section 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. Secondly, the 'Note' to paragraph 35-55(1)(b) of the ITAA 1997 states: Note: 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. Stone J in Federal Commissioner of Taxation v. Eskandari (2004) 134 FCR 569; [2004] FCA 8; 2004 ATC 4042; (2004) 54 ATR 695, confirmed this view when considering whether the Commissioner's discretion should be exercised in regard to losses incurred in a migration consultancy business. When looking at the type of activities referred to by the note and the 2000 Explanatory Memorandum, Stone J stated at FCA 31: Such activities have an inherent characteristic that cannot be overcome by conducting the business activity in a different way but only by changing the nature of the business. And further at FCA 32: In my view, the phrase 'because of its nature' in s 35-55 indicates that the failure must be a result of some inherent feature that the taxpayer's business activity has in common with business activities of that type. Therefore, the phrase 'because of its nature' refers to inherent characteristics of the type of business activity being conducted by the taxpayer, which are common to any business activity of that type. These inherent characteristics must be the reason why the activity is unable to satisfy any of the tests. The discretion is not intended to be available where the failure to satisfy one of the tests is for other reasons. In your case, it is accepted that a period of time is necessary to create a collection of items to be displayed at an exhibition, and it is not until after the items are displayed and offered for sale that income can be generated. As such, for the 20WW-XX financial year it is accepted that it is in the nature of the business activity that it did not satisfy one of the tests, as the collection was being created and was not available for sale until it was displayed at your first show. However after the collection was displayed and offered for sale during the show in 20XX, there is no inherent characteristic of the business activity that prevented it from satisfying any of the tests. You have stated that the concept of lead time in your couture business is the time needed to: 'build the necessary portfolio of recognition to then produce income from sales, or fees associated with shows, and solicited and commissioned activities, which are credentialed by your acknowledged artistry.' Further, in relation to potential income from the business and lead time, you state: 'These conservative income figures are at least, in theory, able to be realized immediately - any person is free to recognize the value of the works of art and wish to purchase it, or seek the consultative skills, or assess aspects of the art as a peer/grant assessor (for example in a funding application). However in practice, the track record of the artist (their profile) also plays an important part in being able command prices and fees. The lead time for a couture artist to become recognized is an important feature to understand in whether income will be evident during the first years of conducting a couture arts business.' As mentioned above, the note to paragraph 35-55(1)(b) of the ITAA 1997 states that the discretion is intended to cover a business activity that has a lead time between the commencement of the activity and the production of any assessable income (emphasis added). Further, the Explanatory Memorandum for the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 (2009 Explanatory Memorandum) states at paragraph 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. Whilst the track record of an artist (portfolio or profile recognition) may influence when income may be derived by an arts businesses, and this recognition may take time to achieve, the Commissioner considers this characteristic comparable to a retail store needing to build up a client base. As stated above, the 2009 Explanatory Memorandum explains that the discretion is not intended to be exercised for that purpose. iii) Objective expectation and commercially viable period TR 2007/6 states that the Commissioner needs to be satisfied that there is an objective expectation, based on evidence from independent sources where available, that the business activity will satisfy a test or produce a tax profit in some future income year falling within a period that is commercially viable for the industry concerned. If the business activity is not expected to satisfy a test or produce a tax profit within this period then the discretion will not be exercised. The 2009 Explanatory Memorandum states at paragraph 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. In addition, paragraph 2.29 of the 2009 Explanatory Memorandum comments: 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. You have provided statements from individual A stating that “A period of 10 years is not unreasonable and (is) usual for an artist in this area to become successful”, and expert accountant individual B stating “the length of time that will generally elapse before an artist can expect to give up a full-time job is from four to six years, although an artist looking to make a reasonable income may well wait from ten to fifteen.” The above statements are subjective in nature and are not considered objective evidence of the commercially viable period for the industry concerned, they merely confirm that there is often (but not necessary) a time-lag between commencing a career as a professional artist and the realization of financial success. This same characteristic can be said for any retail industry or service provider where a period of time is necessary for a customer base to be established through reputation or profile recognition. However, as stated above, the discretion is not available in cases where the failure to meet one of the tests (or produce a profit) is due to the need to build up a client base or following. For the purposes of paragraph 35-55(1)(b) of the ITAA 1997, the discretion is intended to cover a business activity that has a lead time between the commencement of the activity and the production of any assessable income. In your case, your art works were not available for sale until they were displayed at 20XX show. As you have acknowledged, any person was free to recognize the value of your items and to purchase them at this point. Therefore, it is the Commissioner's opinion that the commercially viable period for the industry ceases once your items are available for sale, which in your case was in the 20XX-YY financial year. As your business activity did not satisfy a test or produce a tax profit in the 20XX-YY (or later) financial year, the Commissioner is unable to exercise the discretion.

The private ruling on which this edited version is based has been overturned on objection. | This notice must not be taken to imply anything about the correctness of other edited versions. | Edited versions cannot be relied upon as precedent or used for determining how the ATO will apply the law in other cases.