In The Tax Institute’s TaxVine email (#37, 7.10.22), their Tax Counsel, Julie Abdalla FTI, examined the non-commercial loss (NCL) rules and how the ATO’s recent Practical Compliance Guideline PCG 2022/1 (PCG) intends to relieve the burden on taxpayers impacted by floods, bushfires or COVID-19. The PCG provides a safe harbour for taxpayers from the 2019–20 to the 2022–23 income years to manage their tax affairs as if the Commissioner had exercised his discretion under the NCL rules, if impacted by these rules. This will be available where (amongst other things) floods, bushfires or COVID-19 meant that the individual was not able to carry on the business activity, or unable to carry it on in the same scale; or some of or all the customers were not able to access the relevant business activity as they usually would. The relief is not as sound as a class ruling, which exercised the Commissioner’s discretion, but this will, no doubt, help many small businesses. If you want to rely on this, though, check all the fine print (especially about having evidence).

 

 

Overview of the non-commercial loss provisions

The NCL rules were introduced in the New Business Tax System (Integrity Measures) Act 2000 (Cth) with effect from 1 July 2000 as an integrity measure to address concerns regarding individuals claiming deductions arising from unprofitable activities. These were broadly that some individuals may have been claiming losses from hobbies and/or lifestyle choices against their assessable income. The NCL rules are contained in Division 35 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and set out a framework for determining whether losses from a business activity that is not related to a taxpayer’s primary source of income should be allowable as deductions in a particular income year. For ATO guidance on the NCL rules, refer to Taxation Ruling TR 2001/14 and the ATO website.

Broadly, if the NCL rules are not satisfied, deductions for expenses attributable to a business activity, that exceed the income from that activity, will be deferred to a later income year when the business activity becomes profitable. Business activities of a similar kind may be grouped together but the rules do not apply to primary production or professional arts businesses where the individual’s assessable income (excluding net capital gains) from other sources is less than $40,000.

The NCL rules apply to each business activity carried on by an individual, either alone as a sole trader, or in a partnership, if:

  • the total of the individual’s taxable income, reportable fringe benefits, reportable superannuation contributions and total net investment loss is less than $250,000 (the income requirement); and
  • the individual meets one of the four tests outlined below.

The four tests

An individual will be able to deduct business losses, against other income that year (rather have it capped and the excess carried forward), even though they meet the (sub-$250k) income requirement, if they can pass any of the following four tests:

  • Assessable income test – this test will be met if the assessable income from the business activity during the income year is at least $20,000. A reasonable estimate may be made if the business activity was occurring for only part of the income year.
  • Profits test – this test will be met if the business has made a tax profit in three of the past five income years (including the current income year). Profits made by a previous owner of the business undertaking the business activity may be counted if the change of ownership did not result in a loss of identity for the business activity.
  • Real property test – this test will be met if the greater of the total market value or total reduced cost bases of real property, including interests in real property, used on a continuing basis in carrying on the business activity is at least $500,000. Dwellings used mainly for private purposes or fixtures owned by the individual as a tenant are not counted towards this total.
  • Other assets test – this test will be met if the total value of other assets is greater than $100,000. This can include assets such as plant and equipment, trading stock, assets leased from another entity and intellectual property rights. However, it does not include assets that could be used towards the real property test, or cars, motor vehicles or similar assets.

If the individual is carrying on the business as a partner in a partnership, the individual should ignore the following for the purposes of calculating the relevant amounts under the assessable income, real property and other assets tests:

  • any part of the assessable income from the business activity for the year that is attributable to the interest of a partner, that is not an individual, in the partnership’s net income or loss;
  • any part of the assessable income from the business activity for the year that is derived from the activity by another partner otherwise than as a member of the partnership;
  • any part of the reduced cost bases, or other values, of assets of the partnership used in carrying on the activity in that year that is attributable to the interest of a partner that is not an individual; and
  • any part of the reduced cost bases or other values of assets owned or leased by another partner that are not partnership assets and used in carrying on the activity in that year.

Commissioner’s discretion

An individual who satisfies the income requirement, but does not meet any of the four tests, can apply for the Commissioner’s discretion. This discretion is limited in scope and available only if either:

  • the business activity would have satisfied one of the four tests, or made a profit, but was, or will be, affected by ‘special circumstances’ outside the individual’s control (e.g. flood, bushfires or other natural disasters); or
  • the business has commenced, but the inherent nature of the business is such that there will be a lead time before the business returns profits.

For further information about the Commissioner’s discretion, refer to Taxation Ruling TR 2007/6.

Safe harbour approach in PCG 2022/1 – 2019/20 to 2022/23 losses due to floods, bushfires and COVID-19

Noting the scope and operation of the NCL rules, a broad range of individuals in business may be affected. The impacts would be particularly felt by those in the early stages of starting a new business or transitioning from a salaried role to being self-employed. The Australian Bureau of Statistics estimates that in the 2021–22 income year alone, almost 220,000 sole proprietors entered into business, bringing the total number of sole proprietors to more than 798,000.

Since 2019, Australians have been impacted by a series of devastating natural disasters and a global pandemic. This string of events was beyond any individual’s control and has affected the Australian economy in unprecedented ways. The economic impacts of the events in this period are likely to have affected many of those businesses, potentially bringing a larger proportion of them within the scope of the NCL rules.

The Practical Compliance Guidance (PCG) provides a safe harbour for taxpayers from the 2019–20 to the 2022–23 income years to manage their tax affairs as if the Commissioner had exercised his discretion under the NCL rules, if impacted by these rules. It is important to note that the PCG contains an administrative approach in the form of a safe harbour. It is not actually an exercise of the Commissioner’s discretion under the tax law. This distinction is important as it goes to the level of reliance taxpayers can attribute to it. The PCG states that, provided taxpayers follow the guidance in good faith, the Commissioner will administer the law in accordance with the approach contained therein. However, PCGs are not legally binding in the same way as public rulings. For further information on PCGs more broadly, refer to PCG 2016/1.

The safe harbour is available to taxpayers who satisfy all the following conditions:

  • the individual meets the income requirement;
  • a loss was incurred from the business activity (excluding losses from prior years);
  • the business activity was impacted by flood, bushfires or a government-imposed lockdown, closure or restriction due to COVID-19;
  • one of the events in the condition above meant that:
    • the individual was not able to carry on the business activity, or unable to carry it on in the same scale; or
    • some of or all the customers were not able to access the relevant business activity as they usually would;
  • the individual has not applied for a private ruling requesting the Commissioner’s discretion be exercised for ‘special circumstances’; and
  • the individual has evidence demonstrating they meet these criteria.

The PCG will likely come as a welcome relief for many impacted taxpayers, potentially reducing their compliance concerns and providing an equitable outcome for affected taxpayers to manage these difficult situations.

Next steps

With the release of the PCG, tax practitioners should be working with their clients to determine if they may need to consider the NCL rules for the purpose of utilising or deferring their losses, and whether they meet the criteria for the safe harbour contained in the PCG. When working through the safe harbour conditions, it is important to ensure that your clients have sufficient evidence to substantiate any position taken. If the client does not meet the criteria for the safe harbour, you may need to consider whether there are sufficient grounds to apply for a private ruling requesting that the Commissioner exercise his discretion in cases involving special circumstances.

Kind regards,

Julie Abdalla, FTI

 

 

[Tax Month – October 2022 – Previous Month, 9.10.22]

Category: Tax Month - October 2022

Author: John Morgan

John Morgan is a tax specialist lawyer of more than three decades experience now practicing at the Victorian Bar - w: www.FJMtax.com e: f.john.morgan@vicbar.com.au