Bills Digest No. 181  1999-2000New Business Tax System (Integrity Measures) Bill 2000

Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details

Passage History

New Business Tax System (Integrity Measures) Bill 2000

Date Introduced: 13 April 2000

House: House of Representatives

Portfolio: Treasury

Commencement: Royal Assent. However, the measures have differing application dates which will be discussed in the Main Provisions section.

Purpose

To:

• deny deductions against income from other sources for business expenditure that is of a non-commercial nature, and
• remove early deductions for investments in certain managed investments where services are performed in the year following the expenditure (the 13 Month Rule).

Background

As there is no central theme to the Bill, the background to the various measures will be dealt with below.

Main Provisions

Non-commercial Activities

As a basic rule, deductions are allowed against all of the income of a taxpayer, including from sources other than the activity which gave rise to the loss, where:

• the costs are incurred in gaining or producing assessable income, or
• are necessarily incurred in carrying on a business to produce or gain assessable income (section 8-1 of the Income Tax Assessment Act 1997).

The Bill addresses the second leg of these deductions.

At the margin, the distinction between carrying on a business and engaging in a hobby or other pursuit of a personal or domestic nature, for which deductions are not allowed, is very difficult to determine. There is no single test, either in taxation legislation or at common law, that can be used to distinguish between the two. In the absence of a definitive test, the courts have had regard to a large number of factors when determining whether a deduction is allowable in respect of a taxpayer carrying-on a business. For example, the Federal Court has stated:

In the absence of a definitive test, the ATO and courts have regard to a number of factors in reaching a decision as to whether a business is being carried on. These include:

• the scale of the operations
• whether employees are involved
• the frequency of acts and transactions
• is there a view to profit or is the activity a hobby
• is conduct continuous or spasmodic
• the amount of capital involved
• whether business records are kept and the nature of any records kept, and
• whether there is advertising and market research or not.⁽²⁾

The absence of a clear test means that each case must be determined on its merits and that decisions are often subject to appeal.

The deductibility of non-commercial losses from other income was examined by the Review of Business Taxation (Ralph Report), which found that there was a 'significant revenue leakage' from unprofitable activities, many of which were unlikely to ever make a profit and 'do not have a significant commercial purpose or character.'⁽³⁾

The Ralph Report noted the difficulties in determining if a business activity was being carried on and recommended that a number of business activity tests be used to determine if a legitimate commercial activity was being carried on. It was further recommended that if one or more of the tests could not be satisfied, deductions in respect of the activity should only be offset against income from the activity and not from other sources.⁽⁴⁾

The recommended tests are:

• Annual turnover for the activity is greater than $20 000. Where the activity has commenced or ended during the year this amount would be on a pro-rata basis.
• If the assets used in the activity are real property, the value of those assets exceeds $500 000 or, if other assets are used, their value, excluding motor vehicles, exceeds $100 000.
• There has been a profit, and therefore an amount included in taxable income, in at least three out of the last seven years that the activity has been conducted.

It was also recommended that if there were special circumstances outside the control of the taxpayer the Commissioner should be given a discretion as to whether losses should be able to be offset against other income in the year incurred. The examples given relate to primary industry activities and include drought, floods and bushfires.

The Ralph Report further recommended that income from the rental of real estate should be exempt from the proposed deferral of claiming losses against other income. No specific reason was given as to why such an investment should be exempt and should be treated differently from other activities.⁽⁵⁾ There is no similar recommendation in regard to investments in shares.

If a deduction is found to be non-commercial, it was recommended that it only be able to offset against income from the same, or similar activity (the example given was a change from sheep to cattle grazing) and any accumulated losses carried forward to future years. If in any of the future years a test is satisfied the accumulated losses would then be able to be offset against income from any source.⁽⁶⁾

The Government's response to the above proposals was announced in the Treasurer's Press Release of 11 November 1999 which dealt with the Stage 2 response to the Ralph Report. The recommendations were accepted with the following changes:

• share investments would also be excluded from the proposals, and
• the test that a profit is made in three of the last seven years is to be reduced to three in the last five years.⁽⁷⁾

In addition, the Bill contains an exemption aimed at certain primary producers.

Major Arts groups are opposed to the potential implications of these proposals (refer to the Concluding Comments Section).

A new Division 35, titled Deferral of losses from non-commercial business activities, will be inserted into the Income Tax Assessment Act 1997 (ITAA97) by item 3 of Schedule 1.

Proposed section 35-10 contains the general rule that if none of the exemptions is satisfied any losses will only be deductible from income related to the same activity and that any excess may be carried forward to future years to be offset against future income from the same activity (any carried forward loss is to be reduced by the amount of any exempt income which has not already been taken into account to reduce the claimable losses under existing rules). Business activity will include activity of a similar kind. The measures will not apply to a taxpayer engaged in a primary production business (this is defined by reference to the current definition contained in the ITAA97) where their income from sources other than primary industry businesses is less than $40 000.

The exemptions are:

• Assessable income: The proposals will not apply to a business activity which has income of $20 000 or more or, if an activity has been started or stopped during a year, a reasonable estimate of the income for the year equals or exceeds $20 000 (proposed section 35-30).
• Profits: Where the sum of the deductions, not having regard to any losses carried forward, is less than the amount attributed to income from that activity (ie a profit is made and included in assessable income) for at least three of the past five years. If the activity is carried out in partnership with others, the deduction and income amounts will be those applying to the individual under consideration (proposed section 35-35).
• Real property: Where the reduced cost base (this is a value used for capital gains tax purposes) or market value of real property used on a continual basis in the activity for the year is at least $500 000. Dwellings and any attached land used for private purposes are not to be included in the calculation (proposed section 35-40).
• Other assets: Where the value of other assets used continually in the activity during the year is at least $100 000. The assets that may be used in this calculation are: those for which depreciation may be claimed, trading stock, a lease from another entity and trademarks, patents, copyright and similar rights. Interests in real property that are taken into account for proposed section 35-40 are not to be included (this seems to imply that lease interests in real property may be included in this calculation). Also, the value of cars, motor vehicles and similar assets are not to be included (proposed section 35-45).
• Where an asset is used partly for the activity and partly for other purposes, only that part of its value attributable to the activity is to be included for the purposes of the real property and other assets tests (proposed section 35-50).

The Commissioner of Taxation will also be given a discretion to decide that it would be unreasonable that the proposed general rule should apply. Such a decision may be made where:

• the activity was affected during the year by circumstances beyond the control of those conducting the activity, such as a natural disaster; or
• there is a reasonable expectation, based on evidence (including from independent sources where available), that one of the tests will be met, or the activity will be profitable, during a year that is within a commercially viable period having regard to the industry (proposed section 35-55).

Application: To assessments for the 2000-01 and later years of income (item 4).

13 Month Rule

The 13 month rule refers to deductions that are allowed in the current year even though the services to which they relate will be performed within the next 13 months (section 82KZM of the Income Tax Assessment Act 1936 (ITAA36)). The availability of bringing forward the deduction for businesses, other than small businesses, was reduced by the New Business Tax System (Integrity and Other Measures) Act 1999 (IOM Act) which apply from 21 September 1999. That Act provides a reduced deduction in the year of expenditure and a phasing-in period so that for expenditure incurred after 21 September 2002 the expenditure will only be deductible in proportion to the amount of the service provided during the year.

In addition to these changes, the Review of Business Taxation (Ralph Report) examined investment schemes that provide for deductions at the end of a financial year although expenditure would be incurred during the next year and commented:

While transitional arrangements were recommended, and implemented, for general business arrangements as noted above, the Ralph Report recommended that immediate deductibility be denied for such schemes, including:

• projects or arrangements managed by another in which an individual participates, or
• prepayments by eligible small businesses that relate to services or products provided over a period exceeding 12 months or ending after the next year of income

without transitional arrangements.⁽⁹⁾

The Government's response to these measures was announced in the Treasurer's Press Release dated 11 November 1999 dealing with the Phase 2 response to the Ralph Report. The response is consistent with the recommendations described above. In particular, it stated that the proposals would not apply to 'standard' negatively geared investments made outside a business (ie by an individual) or by small business taxpayer, such as rental properties or shares. ⁽¹⁰⁾

The general rule is that expenditure which would be deductible, except for changes contained in the IOM Act, for service to be provided within 13 months will be apportioned (see below) where the expenditure is incurred after 1 pm on 11 November 1999 (the time the measures were announced) and is under an agreement for activity to be performed outside the year of the expenditure (proposed section 82KZME).

The agreement must:

• result in the taxpayer being able to claim deductions greater than the income from the activity (ie be negatively geared)
• result in the taxpayer not having day to day control of the operation of the investment, and
• have more than one participant or be arranged or promoted by a person who has similar arrangements with other taxpayers.

Exemptions to the general rule are:

• Interest on money used to acquire an interest in real property, listed shares or a widely held unit trust with at least 300 beneficiaries, and a premium for building, contents and rent insurance, where:

• the taxpayer can reasonably be expected to receive rent, dividends or trust income
• other than a capital gain or an insurance payment, the taxpayer will not receive any other type of assessable income from the investment, and
• the agreement relating to these activities has been reached at arms length (proposed subsection 82KZME(5).

• Interest for which a tax concession is received due to an investment in infrastructure borrowing under the Development Allowance Authority Act 1992 (proposed subsection 82KZME(6)).
• The expenditure by the taxpayer is excluded expenditure, ie principally that it is less than $1 000 or is required to be incurred by a court or law (proposed subsection 82KZME(7)).
• The expenditure is required under a contract or agreement entered into before 1 pm on 11 November 1999 which requires payment before the agreed act is done and which cannot be escaped from by unilateral action of the taxpayer (proposed subsection 82KZME(8)), or
• The expenditure is the subject of a product ruling by the ATO which allows the deduction and the ruling was either made on or before 1 pm on 11 November 1999 or in response to an application received before that time (proposed subsections 82KZME(9 and 10)).

If the general rule applies, deductions in a year will only be allowed in the proportion of expenditure that is equivalent to the proportion of the services performed during the year (ie the deduction cannot be brought forward) (proposed section 82KZMF).

Part 2 of Schedule 2 will make it clear that proportional deductions under proposed section 82KZMF will apply to all expenditure currently covered by the 13 month rule from 2002.

Application: The general rule and exemptions described above will apply from 1 pm on 11 November 1999, while the amendments contained in Part 2 of Schedule 2 will apply from 21 September 2002 (item 11).

Concluding Comments

The denial of deductions for activities which do not satisfy one of the above tests has the potential to significantly effect individuals who perform non-profitable artistic activities. The practicality of a person not being able to, at the present time, earn a sufficient income from an activity and subsidising that activity from other, tax assessable, income is relatively common in the artistic community.

Currently, losses incurred in pursuit of an artistic activity aredeductible against other income only to the extent that they are incurred in producing, or implementing a procedure which is designed to produce, assessable income. The ability to subsidise other activities, some of which will not meet any of the tests in the Bill, can be an important factor in enabling people to perform other, 'artistic' activities due to their ability to deduct costs from that activity against income from other, assessable income producing sources.

The proposals been opposed by a number of representative groups. For example, a representative of The National Association of the Visual Arts has been reported as stating:

While there are no doubt grounds for introducing tests to deny deductions from non-commercial activities, the targeting of such measures may need to be refined to address the potential problems discussed above.

It may also be interesting to compare the value related tests described above to the exemptions to the 80% rule applying for contractors under the New Business Tax System (Alienation of Personal Services Income) Bill 2000 where the tests have regard to how an activity is performed, rather than the value of the activity.

Endnotes

2. Ferguson v FCT (1979) 9 ATR, 876.

3. Australian Master Tax Guide 2000, 14-015.

4. Review of Business Taxation, A Tax System Redesigned, July 1999, p. 295.

5. ibid., p. 294-5.

6. ibid., p. 296.

7. ibid., p. 295. The matters discussed above are contained in chapter 7.5 of the Ralph Report.

8. Treasurer, Press Release, 11 November 1999, Attachment A.

9. ibid., p. 170.

10. ibid., p. 171-2.

11. Treasurer, Press Release, 11 November 1999, Attachment C.

12. The Sydney Morning Herald, 12 May 2000.

Contact Officer and Copyright Details

Chris Field
5 June 2000
Bills Digest Service
Information and Research Services

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ISSN 1328-8091
© Commonwealth of Australia 2000

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Published by the Department of the Parliamentary Library, 2000.

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