Private ruling: Non-commercial losses and Commissioner's discretion for special circumstances
Date of advice: 21 December 2016
Published: May 2017
Ruling period: Year ended 30 June 20II | Year ended 30 June 20JJ | Year ended 30 June 20KK | Year ending 30 June 20LL
Date scheme commenced: 1 July 20HH

Ruling: Q1: Did your business activity commence from 1 January 20AA? | A1: No. | Q2: Did your business activity commence when you gained the PCT patent on your invention? | A2: Yes. | Q3: Will the Commissioner exercise the discretion in paragraph 35-55(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses in relation to the product in your calculation of taxable income for the 20HH-II to 20JJ-KK financial years? | A3: No.

Relevant facts and circumstances: In 20AA you formed the idea to create a security device for a building structure that could not be undone externally. This idea was formed from the numerous break-ins in your area of residence whereby assailants were accessing structures by unscrewing and removing external sheeting. At the time you began development there were no other security device products available. The intention around the creation of this invention was for licencing agreements to be sold to building companies so that they could manufacture the product as needed. Throughout 20AA you invented a security device and a provisional patent was acquired. In 20BB you engaged the services of an external company to help commercialise the invention. You were attempting to use their expertise to take the activity to the next level. At the time you engaged the external company, they were a new operation and, in hindsight, were not the right choice to assist with the commercialisation. During 20BB you registered your invention under a trademark in anticipation of the invention being commercialised. Throughout 20BB the external company were engaged to manage investigations of patent, trademark and copyrights. The external company were also to manufacture a functioning prototype of the product to use in business presentations to interested parties. The manufactured prototypes were of insufficient standard which created a significant lag time. By the end of 20BB the external company presented the product to Company A. At the time of the presentation there were no competitors for your product in the market place. Also at this time the provisional patent was upgraded to a Patent Cooperation Treaty (PCT) patent. In early 20CC the decision was made to present to another company as you felt that there was insufficient progress in the negotiations between the external company and Company A. The external company presented to Company B. By late 20CC another presentation was conducted to Company C due to continuing insufficient progress with both Company A and Company B. Negotiations with all three companies were ongoing throughout 20DD and the external company were also engaged to investigate the possibility of having your invention manufactured in another country. By late 20DD you had lost faith in the external company due to their inability to either deliver a function prototype or secure the backing of any of the businesses approached. There was a dispute between yourself and the external company which led to the issue having to be resolved in the Relevant Court. The result of this court action was the external company having to pay you compensation for fault on their part. As you took over negotiations with Company A, Company B and Company C you found that the negotiations that the external company had been in charge of had not been followed through resulting in Company A creating their own security device. Their design was sufficiently different that no patent or copyright infringements would occur. You believed that the differences between your invention and the Company A design meant that your invention was still viable. Over the next XX months you continued to contact businesses over Australia to gauge their interest in your product, but most of them were worried about a potential copyright infringement on the Company A product as they are a rather large competitor. In late 20EE Company D were contacted and negotiations commenced. In early 20FF a confidentiality agreement was signed allowing the exchange of prototypes and drawings of your invention. You liaised with Company D throughout the year and by early 20GG an agreement was reached to enter into a licencing agreement. At this point specialist solicitors were engaged by you to negotiate the distribution rights and licencing agreement. As the negotiations between the solicitors progressed, you applied for a design application in Country A to protect from copyright infringement and allow your invention to be marketed in Country A. In late 20GG a two year licencing agreement was signed with Company D. Over the life of the licencing agreement Company D was able to manufacture your invention to an acceptable standard and at a commercially viable cost. At this time a Company D raised the issue that there was an inability to create a specific tool that would work adequately with your invention. In light of this problem Company D allowed the licencing agreement to lapse so they could negotiate a new licencing agreement. By early 20JJ you suggested to Company D that you would try to manufacture a specific tool yourself, using your knowledge of the original invention to help progress the new licencing agreement negotiations which had appeared to stall. Two appropriate tools were successfully developed by a local engineering firm. In early 20JJ negotiations with Company D for a new licencing agreement recommenced. In mid 20JJ there was a meeting between yourself and the director of Company D to review your invention and the tool and look at the progress of the disputes over the new licencing agreement. Following this meeting Company D requested the prototype and to begin progress on manufacturing. Despite the positivity of the meeting with Company D, by the end of 20JJ you had ended the protracted negotiations with Company D for a new licencing agreement. The belief of your solicitors was that the negotiations were stall tactics by Company D to keep your invention out of the market. At this point there were four products on the market similar to your invention, but with enough differences in design that your invention was still viable. In early 20KK you pursued funding and assistance via a Specific Programme, but you have since found that you didn't qualify for the program. You recently paid to have your patent renewed. While you have not completely abandoned your venture in getting your invention to market, given the issue you have faced thus far, you are reassessing how to continue. You have provided evidence of your extensive research into the market, competitors and the driver behind the invention, which was the upsurge in crime in your area. You have also provided a business plan that outlines several market entry strategies and detailed marketing on the pricing and position of the invention. You satisfy the income requirement set out in subsection 35-10(2E) of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 - Division 35 | Income Tax Assessment Act 1997 - section 35-10 | 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

Reasons for decision: Summary: For the 2009-10 and later financial years, Division 35 of the ITAA 1997 will apply to defer a non-commercial loss from a business activity unless: ● you satisfy the income requirement and you pass one of the four tests ● the exceptions apply ● the Commissioner exercises his discretion. However, for this division to apply, you must be carrying on a business. Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'. The case of Evans v. Federal Commissioner of Taxation 89 ACT 4540; (1989) 20 ATR 922 stated that whether or not an activity amounts to carrying on business for taxation purposes is a question of fact. There is no exhaustive or determinative definition which can be applied to determine this matter. The facts of each case must be examined. In Martin v. Federal Commissioner of Taxation (1953) 90 CLR 470; (1953) 10 ATD 226; (1953) 5 AITR 548, Webb J said: The test is both subjective and objective: it is made by regarding the nature and extent of the activities under review, as well as the purpose of the individual engaging in them, and as counsel for the taxpayer put it, the determination is eventually based on the large or general impression gained. | Detailed Reasoning - Commencement of business activity: Taxation Ruling TR 97/11 is about whether a taxpayer is carrying on a business. TR 97/11 states the question of whether a person is carrying on a business is determined by the facts in each individual case. This is done by considering the following factors that have been used in court cases: ● the nature of the activities, particularly whether they have the potential of profit making; ● the repetition and regularity of the activities; ● organisation in a business-like manner, the keeping of books or records and the use of a system; ● the volume of the operations; and ● the amount of capital employed. TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' ( Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case. As shown in the legal cases and the views of the Commissioner listed above, the indicators with the greatest weighting are the scale or volume of operations and the repetition and regularity of the activities. The fact of profit making is not a salient indicator (although, as stated in TR 97/11, where an activity looks like it will never produce a profit, the activity will not amount to a business). In your situation, the Commissioner considers you are carrying on a business of attaining licencing agreements for you invention. While you have derived no income from the activity, you have performed most of the activities required for the attainment of licencing agreements and getting your product into the market, we consider that the size and scale of your activities is considered to be extensive enough to amount to a business for tax purposes. | Detailed Reasoning - When does a business activity commence?: The actual date of commencement of a business activity is a question of fact ( Goodman Fielder Wattie Ltd v. FC of T 91 ATC 4438; (1991) 22 ATR 26) ( Goodman Fielder Wattie ). For a business activity to have commenced a person must have: ● purpose, intention and decision to commence the business activity ● acquired a minimum level of business assets to allow that business activity to be carried on, and ● actually commenced business operations ( Calkin v. CIR [1984] 1 NZLR 440). We must examine the above indicators in light of the characterisation of your business activity. In Goodman Fielder Wattie , Hill J stated at 4,447: 'Critical to the resolution of the present controversy, is the characterisation of the business activity itself which is said to have commenced. It was conceded properly by the applicant that if the business claimed to be carried on by it was to be characterised as one of manufacturing and selling monoclonal antibody products, then that business did not commence until around November 1982...' For example, if your business activity is characterised as a primary production activity, involving the planting and cultivating of trees, then the planting of the trees could be seen as the commencement of that business. Alternatively, if your business activity is characterised as the selling of a product, the business would generally be considered to commence once you have begun selling the product. In your case it is considered that the business activity you intend to carry on is characterised as the sale of licencing agreements of a patented invention. We can now consider the indicators set out above to determine whether this business activity has commenced. Purpose, Intention and Decision The intention and purpose of a taxpayer in engaging in an activity is relevant to when a business commences. However, an intention to commence a business will not determine that the business activity has actually commenced. The chain of events leading to the commencement or start-up of a business activity often begins with a mere intention to establish the business activity. This is developed by researching the proposed business and, in some instances, by experiment. This process culminates in a final decision on whether to commence business. However, not all businesses commence in such an orderly manner. It is clear from the information you have provided that you have researched your proposed business activity, decided on the form of that business and have committed yourself to it. Acquisition of a minimum level of business assets to allow that business activity to be carried on Most business activities have a structure that provides the framework of the business. It is usually a collection of capital assets. What the particular capital assets are will depend on the particular business activity. In Calkin v. CIR [1984] 1 NZLR 440 Richardson J said at 446-447: Clearly it is not sufficient that the taxpayer has made a commitment to engage in business: he must first establish a profit-making structure and begin ordinary business operations. For a business activity to commence, an appropriate business structure should be in place and begin ordinary business operations. As to what the business structure will consist of, and its size, will be a question of fact and degree, and will depend on the nature of the business activity. Your activity is the obtaining of licencing agreements from builders to manufacture a specific tool that you have invented and have a patent and trademark for. You obtained a PCT patent at the end of 20BB. From the date the patent was obtained it could be considered that you have the minimum level of business assets to commence your business activity as you require the patent to be able to obtain licencing agreements. Commencement of Business Operations As noted by Brennan J in Inglis v Federal Commissioner of Taxation (1979) 10 ATR 493; 80 ATC 4001, the level of activity is important in deciding whether a business is being carried on. Brennan J stated at ATC 4004-4005; ATR 496-497 that: The carrying on of a business is not a matter merely of intention. It is a matter of activity. Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted. In Hadlow and FC of T [2002] AATA 1250; (2002) 2002 ATC 2294; (2002) 51 ATR 1197 the Small Taxation Claims Tribunal considered the amounts incurred by a taxpayer to research and develop a book. The question for decision was whether the activities were merely preparatory and preliminary or whether the activity had reached a stage where it was able to be characterised as a business. In concluding that the activity was not carried on as a business in the relevant years, member Mowbray stated at paragraph 26: Clearly Mr Hadlow has the subjective intention to carry on a business, but that is not sufficient. There must be business activity. There is a real question whether the activities to date are merely preparatory or preliminary (see Goodman Fielder Wattie at 4447), and whether the project has reached the stage where it is able to be characterised as a business. There has been much activity but the concept of business does not equate with being busy ( Goodman Fielder Wattie at 4447; 386; 339) Mr Hadlow has researched, undertaken travel, and visited museums, libraries and farms in pursuit of a particularly interesting topic. He has expended money but has made no sales, received no advances nor signed any contracts. It is accepted that you have gone beyond merely having an intention to engage in business and there has been some activity. For example, you have invented the item that you wished to sell, you have researched the crime rates and the need for this product, you have obtained external expertise to assist you in obtaining the licencing agreements and you have engaged multiple businesses to attempt to sell your licencing agreements. However, your aim for inventing this product was to obtain licencing agreements. This means that you would have been unable to obtain these licencing agreements until you had a patent on the invention which you obtained at the end of 20BB. Therefore your activities prior to you obtaining the PCT patent to gain licencing agreements from are considered preliminary to the carrying on of your intended business and are directed at constructing or establishing a business structure. As such you are not considered to be carrying on a business until you obtained the PCT patent. | Detailed Reasoning - The Commissioner's discretion - special circumstances: Where the income requirement is satisfied, the Commissioner's discretion, under paragraph 35-55(1)(a) of the ITAA 1997, can be exercised where a business activity is affected by special circumstances, outside the control of the operators, such that it is unable to satisfy any of the tests. Your income for non-commercial loss purposes is less than $250,000, therefore you satisfy the income requirement under subsection 35-10(2E) of the ITAA 1997. However, your business activity has not/will not satisfied any of the four non-commercial loss tests contained in sections 35-30 (assessable income test), 35-35 (profits test), 35-40 (real property test) and 35-45 (other assets test) of the ITAA 1997 in the 2013-14 to 2016-17 financial years. Special circumstances are those circumstances which are sufficiently different to distinguish them from the circumstances that occur in the normal course of conducting a business activity. For those individuals who do not satisfy the income requirement, special circumstances are those which have materially affected the business activity, causing it to make a loss. In regards to the business markets, the needs and wants of any particular market are expected to fluctuate on a regular and recurrent basis. Also negotiations and expectations that occur between businesses can fail and lead to nil outcomes. This is the nature of business and as such these types of issues would not be considered evidence of special circumstances. Taxation Ruling TR 2007/6 sets out the exercise of the Commissioner's discretion under paragraph 35-55(1)(a) of the ITAA 1997. The following has been extracted from paragraphs 47 to 53 of this Ruling. Special circumstances are ordinarily those affecting the business activity such that it is unable to satisfy a test and it would be unreasonable for the loss deferral rule to apply. Ordinary economic, weather or market fluctuations that might reasonably be predicted to affect the business activity would not be considered to be special circumstances. These fluctuations are expected to occur on a regular or recurrent basis and affect all business within a particular industry. Although not limited to natural disasters, paragraph 35-55(1)(a) of the ITAA 1997 refers to special circumstances outside the control of the business activity, including drought, flood, bushfire or some other natural disaster. Cyclones, hailstorms and tsunamis are examples of other natural disasters that would come within the scope of the paragraph. These events are taken to be special circumstances outside the control of the operators of the business activity. The special circumstances must have affected the business activity. In your case, your unsuccessful attempts to obtain licencing agreements that will produce assessable income through unproductive negotiations with major suppliers in the building industry and ineffective assistance from external expertise and resources are not considered to be special circumstances as it falls within the normal course of business. While we appreciate your situation, the Commissioner is unable to exercise the discretion under paragraph 35-55(1)(a) of the ITAA 1997 in relation to your business activity.