The outdated small business and non-commercial loss limits Paul Kenny

Former regime ITAA defines a 'business' to include 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee', this definition does not provide any detailed guidance as to what constitutes a business. s ITAA Case law though provided a means of answering this question. The determination of whether a taxpayer is carrying on a business is the result of a process of weighing up of a number of relevant factors. self assessment system of income taxation certain employee taxpayers took advantage of the uncertainty of what constitutes a business and claimed deductions for losses Treasurer’s press release “There is significant revenue leakage from unprofitable activities carried out by individual taxpayers claiming deductions for so-called business activities. Many of these activities are more like hobbies and/or lifestyle choices.”

Rationale “The non commercial losses measure will improve the integrity of the tax system by limiting the extent to which losses from an individual's non commercial business activities are used to reduce the tax paid on other income such as salary or wage income. “ “The current tax law is complex and resource intensive to administer. The measure seeks to simplify current tax law, remove uncertainty and prevent a significant leakage of revenue from deductions of losses from non-commercial activities.”

Overview of the original Div 35 The non commercial loss provisions apply to each and every income year in which an individual taxpayer (whether alone or in partnership) carries on a relevant business activity. The provisions though do not extend to restricting losses from negatively gearing passive investments such as property or shares. The main operative provision provides that a loss from the business activity will only be deductible in the income year in which it arose if it satisfies one of the following requirements: (a) the individual's business activity meets one of the four tests; (b) the individual comes within the Exception; or (c) the individual is covered by an exercise of the Commissioner's discretion in relation to that business activity, If these requirements do not apply the loss is quarantined and can only be offset against future profits from the business activity

Literature Review In 2002 the Board of Taxation completed its post-implementation review of the quality and effectiveness of the NCL legislation, and found that the provisions were highly effective and that the compliance and tax administration costs were manageable. Differing views have been offered by leading commentators, professional bodies and other government bodies The quarantining of losses under the NCL provisions will hinder certain loss making business activities that do not require lead times and that are carried on in a very small scale. The generous exclusions from Div 35 allow high income taxpayers to sidestep the NCL provisions. Commentators also noted the great complexity of Div 35.

Amendments Section was introduced in 2001 to provide deductions for blackhole capital expenses otherwise no deductible. Consequently, from 1 July 2005 Div 35 was amended to cater for the treatment of business related capital costs Federal Budget introduced an income test into Div 35 so that high income individuals would not escape loss deferral in their NCL activities. From the income years to avoid the loss deferral rule a taxpayer must pass the income test - a taxpayer’s adjusted taxable income must be less than $250,000

RESEARCH METHODOLOGY perspective of four well accepted tax policy criteria: fiscal adequacy, economic efficiency, equity, and simplicity

Economic efficiency NCL provisions would enhance economic efficiency if they restricted departures from the taxation of economic income. This will lead to a more efficient allocation of resources away from such private pursuits into productive assets. Many lifestyle type activities are not affected given the generous exemptions. Small primary producers and artists carrying on a business with a significant lifestyle element but with other income of less than $40,000 are also exempted. Moderately sized lifestyle type activities that can satisfy one of the four tests are not caught. rules are not targeted at lifestyle activities, many genuine micro businesses that ought to be able to offset losses are restricted, yet other genuine larger scale businesses are unaffected. passive investors, primary producers and artists having less than $40,000 of other income are not affected. Additionally, the quarantined losses are lost where a business restructures from a loss making individual to a corporate structure. Overall the NCL measures work to deter taxpayers from starting new businesses or expanding an existing business into a new area.

Equity The NCL provisions generally promote horizontal and vertical equity. But the NCL rules are not targeted at specific lifestyle activities. Small primary producers and artists carrying on a business but with other income is less than $40,000 are exempted. Also, moderately sized lifestyle type activities that can satisfy one of the four tests are not caught. The four tests greatly favour high income earners and wealthier taxpayers. Harsh impact on genuine micro businesses Taxpayers Australia considered that the measure was “…punitive and drastic to some owners of genuine small businesses caught by this legislation.”

Simplicity Div 35 clearly fails simplicity, as, the issue of whether a business is being carried on still needs to be resolved. The NCL measures introduce a new layer of complexities, such as the need to determine what businesses are of a similar kind. Where an activity consists of two or more businesses that are of a different kind then the taxpayer must produce separate profit and loss statements for these activities. the Commissioner need to exercise the discretion in para 35-55(1)(b) and taxpayers must complete a lengthy and technical application form and evidence provided to demonstrate that the activity will meet one of the four tests

Fiscal Adequacy Estimated to provide a small quantum of tax revenue. some commentators are sceptical about such tax revenue savings given the opportunities for taxpayers to manipulate the NCL exemptions

Conclusion the new rules are too complex for many micro business taxpayers to follow and thus considerable costs are being incurred in obtaining advice from tax professionals. Div 35 has impeded economic efficiency by placing excessive loss limitation rules on genuine micro businesses. This discourages small business. the requirements to separate business activities will stymie business expansion and diversification. Div 35 has not effectively achieved its main goal of limiting of lifestyle activity losses since the provisions do not affect many of these activities. the measures are highly inequitable in their application, with many genuine micro businesses greatly impacted by the loss limitations whilst other loss making taxpayers including hobby lifestyle activities are unaffected. The old out of date dollar limits need to be indexed, these work to make Div 35 increasingly irrelevant