On 24 August 2018, the Federal Court (recently appointed Steward J) set aside an ATO decision, in a non-commercial loss matter, and referred it back to the ATO for re-determination.
The ‘non-commercial loss’ provisions are found in Div 35 of the ITAA97 and are designed to prevent individuals deducting losses, from a ‘business activity‘, against other income, if the business fails to pass any of 4 specified tests (and thus might be described as ‘non-commercial’). If triggered, s35-10(2) limits the deductions, you can claim, that year, to the assessable income from that ‘business activity’, in the same year. The remaining deductions are deemed to be incurred again, the next year, so they can be carried forward. This limitation applies where the taxpayer earns more than $250,000 (of a modified form of ‘taxable income’) or fails to pass any of these four tests.
- The assessable income, from the business activity, was at least $20,000 (the ‘Assessable Income Test‘ in s35-30).
- There were profits (assessable income exceed decuctions), from the business activity, for at least 3 out of the last 5 years (the ‘Profits Test‘ – s35-35).
- The taxpayer uses ‘real property’ in the business activity, with a (non-indexed) ‘cost base’ of at least $500,000 (the ‘Real Property Test‘ – s35-40).
- The total ‘value’ of ‘other assets’ that the taxpayer uses ‘on a continuing basis’ in the ‘business activity’ is at least $100,000 (the ‘Other Assets Test‘ – s35-45). These assets and the respective values include, the written down value of ‘depreciating assets’ and the end of year value of ‘trading stock’.
The Commissioner can allow losses from a ‘non-commercial business’ to be deducted, if he is satisfied of the following (under s35-55(1)(b) or (c)).
(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 [business] activity will either meet one of [the 4 tests set out above] or will produce assessable income for an income year greater than the deductions attributable to it for that year
This s35-55 exemption was central to this case.
The relevant facts were these.
- The Taxpayer commenced a business of breeding Australian bloodline Arabian horses in the 1998 income year, using the trading name “Mystica Arabians”. The business was not a success.
- Ten years later, in the 2008 income year, the Taxpayer changed things. Instead of breeding Australian bloodline Arabian horses, the Taxpayer purchased, for the first time, Arabian horses from overseas, and commenced breeding from these animals. [para 2]
- This ‘business activity’ continued to produce losses, which she set off against her other assessable income, in the 2012 Year, such that her taxable income was $nil. [para 1]
- In the 2012 Year, the Taxpayer’s business did not pass any of the 4 tests, set out above. [para 10]
- Also, her other income was above the $250,000 limit, so she had to rely on the Commissioner exercising his power to allow deductions, under s35-55. [para 10]
- To that end, the Taxpayer submitted material to demonstrate that her business would be profitable, within the 10 – 15 years appropriate for that industry.
- The Taxpayer, however, took the relevant ‘business activity’ as the one that commenced in 2008, namely: breading overseas (not Australian) bloodline horses. Using 2008 as the start date, she was well within 10 or 15 year industry norm, she asserted, for becoming profitable.
- It was the Taxpayer’s contention that these overseas (not Australian) bloodline horses are greatly superior to those which have been bred domestically. They cost considerably more than domestic Arabian horses. It involved a great deal of additional capital (largely for the purposes of acquiring international stock). Also, it involved the purchase of more land and equipment, a different customer base, and a different method of breeding.
- The Commissioner, however, said that the relevant ‘business activity’ was breading horses, which started in 1998. He considered the move to overseas ‘bloodlines’ was just a change of focus, within the same business activity (or similar groupable business activities). The significance of this was that the Taxpayer’s 10 to 15 year profitablity norm, for that industry, had expired by the 2013 date, on which the Taxpayer lodged her 2012 income tax return. The Commissioner decided that there was no basis on which the s35-55 power should be issued (for that year). [para 12 & 33]
- The Commissioner disallowed the losses, the taxpayer objected, the Commissioner disallowed the objection, and the Taxpayer appealed to the Federal Court under Part IVC of the TAA.
The Court concluded the following.
- For steps in assessing taxpayers, where the Commissioner is required to reach a certain ‘state of mind’ (such as being ‘satisfied’ about the s35-55 matters), the Court is limited to Avon Downs  HCA 26 style judicial review, that looked only for faults in the Commissioner’s decision making process (which is what the Parties had assumed). [paras 13 – 21] This leaves the Commissioner (not the Court) making the actual decision. This is why the matter was sent back to the Commissioner, to be decided again.
- That a ‘business activity’ is not necessarily the same as a ‘business’ – but might, for instance, be just part of a greater business. [paras 22 – 31]
- The Court decided that breading Australian bloodline horses and then overseas bloodline horses, were two separate ‘business activities’. [para 32]
- Section 35-10(3) allowed a taxpayer (but not the Commissioner) to ‘group’ similar ‘business activities’ (and breeding first domestic and later overseas bloodline horses, would, most likely, have been sufficiently similar, to have been grouped). However, the Taxpayer did not group them. [para 33]
- It was this ‘similar’/’grouping’ issue that caused the Commissioner to ask the wrong question. He framed the question incorrectly, by asking: whether the Taxpayer’s “business activities pre and post 2007/08 are of a similar kind and would be grouped together such that they would be considered the same business activity for the purposes of determining the lead time.” And, the Commissioner conceded this error. [para 33]
- But the Commissioner did not concede the objection decision – relying on another passage, which concluded that her pre & post 2008 business activities (breeding Australian, then, overseas, bloodstock horses) was: “much more than related. They are in fact the same business activity that has been carried on continuously from 1998 to today“. The Commissioner’s counsel submitted that being the ‘same’ is more than ‘similar’ and subsumes what is merely ‘similar’.
- The Court was not, however, convinced. At para 37, the Court concluded: ‘I am of the view that asking the wrong question here “could” have affected the determination of the applicant’s objection. Like the error in Haritos  FCAFC 92, the error here cannot be safely “quarantined”.’
- Quoting the Sydney Water case  NSWCA 391, the Court said: “the error goes to the heart of the cognitive and evaluative process and one cannot be satisfied that it did not play a relevant or material part in the decision, then the appellant has established that the decision is vitiated.”
- Accordingly, the Court ordered that the matter be sent back to the Commissioner, to be decided again, in accordance with the Court’s reasons (which included the finding that breading the different bloodlines, were two separate ‘business activities’).
(McGlinn v CofT  FCA 1275, Federal Court, Steward J, 24 August 2018.)
Comprehension questions (answers provided)
- Did the Commissioner disallow the Taxpayer’s primary production losses, on the basis that the ‘non-commercial loss’ provisions quarantined the excess deductions against the assessable income generated from the horse breading ‘business activity’?
- Did the Taxpayer’s horse breading activities pass any of the 4 tests set out above?
- Did the Taxpayer rely on the s35-55 exemption, from the prima-facie application of the Non-commercial Loss provisions, by submitting material designed to show that, in the 2012 Year, she was within the 10 – 15industry time, to become profitable, using 2008 as her start date (ie. the date she moved to breading overseas bloodline horses)?
- Did the Taxpayer start breading Australian bloodline Arabic horses in 1998?
- Did the Commissioner use the 1998 date to say she hadn’t shown profits, even over the 15 year period?
- Were breading Australian bloodline and breading overseas bloodline Arabic horses ‘similar’?
- Can taxpayers group ‘similar’ business activities, when applying the Div 35 deduction quarantining rules?
- Did the Commissioner assume these activities had been grouped, when assuming he could use 1998 as the start date, for the 10 – 15 year industry norm for profitability?
- Was this correct?
- Did this matter?