Division 35 of ITAA 1997 prevents losses from non-commercial business activities carried on by individuals being offset against other assessable income in the same year. The rules apply to an individual either operating alone or in a partnership, but special rules apply where a partnership is involved.
The general rule is that where deductions in relation to the non-commercial business activity for a year exceed the assessable income from the business activity for that year, the excess cannot be deducted in the income year in which it is incurred. The excess is treated as being deductible from the assessable income from the business activity in the next income year in which the business activity is carried on.
The general rule applies unless the business activity satisfies one of 4 threshold tests for the income year, being:
- The assessable income test — at least $20,000 in assessable income in the income year.
- The profits test — the business activity makes a profit in 3 of the past 5 income years.
- The real property test — the reduced cost bases of real property in the activity must be at least $500,000.
- The other assets test — certain assets used on a continuing basis in the business activity in an income year must be at least $100,000.
Sitting above these business activity tests is an income requirement which restricts individuals earning above $250,000 in other income from accessing the 4 threshold tests.
Also, the Commissioner may exercise a discretion to allow the loss to be offset against other income, and 2 other exceptions apply for primary producers and professional arts businesses.
How Div 35 applies to partnerships
Division 35 applies to business carried on by individuals, either alone or in a partnership. Therefore, a partnership that carries on a business activity and consists of at least one individual as a partner will fall within the Div 35 rules.
When applying the assessable income test, the real property test and the other assets test to a business activity that is carried on by an individual in partnership with an entity, only the individual partners allocation of income or assets is taken into account. The income or assets of non-individuals are ignored in applying these tests.
Example 1 — Horse stud business activity
Jane and Andrew operate a horse stud in an equal partnership of 2 individuals. For the relevant income year, the horse stud operation has assessable income of $24,000 and a loss of $27,000.
ITAA 1997 s 35-10(2) requires that the assessable income of the business activity be examined separately for each individual. For each individual, their share of assessable income for the horse stud is $12,000, which is under the $20,000 limit and therefore would need to be deferred.
However, under ITAA 1997 s 35-25(a), the individual partners only have to ignore the amounts that relate to non-individual partners when determining whether the assessable income test can be applied. In the situation of Jane and Andrew, as they are both individuals, the entire $24,000 is counted as assessable income under s 35-25(a) and both partners would be able to use their loss against other assessable income.
Example 2 — Let’s add a company
Jane, Andrew and JA Investments Pty Ltd operate the horse stud in an equal partnership, with assessable income of $24,000 and a loss of $27,000.
ITAA 1997 s 35-25 requires the non-individual interests to be ignored when applying the assessable income test. As JA Investments Pty Ltd has a share of $8,000, this would be removed from the partnership’s assessable income of $24,000 when applying the test. The balance of $16,000 is under the $20,000 threshold and in this instance, Jane and Andrew must defer the horse stud loss to a later income year.
Other adjustments for partnerships
Income derived or assets owned or leased by a partner otherwise than as a member of the partnership are also ignored in applying the tests.
In relation to the profits test, an individual partner in a partnership that carries on a business activity will pass the test and the loss deferral rule will not apply if, for at least 3 of the past 5 years (including the current year), the individual’s assessable income from the activity is greater than the individual’s deductions from the activity.
Taxation Ruling 2003/3 — The interaction of multiple business activities and the partnership rules
This Ruling considers the operation of Div 35 of ITAA 1997 and Div 5 of Pt III of ITAA 1936, where an individual carries on business activities in partnership with others.
Where an individual taxpayer carries on multiple business activities in partnership, the correct application of ITAA 1997 s 35-10(2) is not one that looks at the result for the partnership as a whole. Therefore, s 35-10(2) should not be applied to such cases simply by using the amount of assessable income, or of the allowable deductions, the individual partner would otherwise calculate under s 92 of ITAA 1936.
Example 3 — Adding a second activity to Example 2
Jane, Andrew and JA Investments Pty Ltd carry on 2 business activities, a computer software consulting business and a small horse stud. Computer software has assessable income of $210,000 and profit of $150,000. The horse stud has assessable income of $24,000 and a loss of $27,000.
The net income of the partnership under ITAA 1936 s 92 is $123,000, or $41,000 for each partner. However, ITAA 1997 s 35-10(2) requires the partnership to look at each business activity separately, unless it can be grouped. Therefore, the 3 partners would include the computer software profit and Jane and Andrew would defer the loss from the horse stud (as per Example 2).
The partnership rules are therefore important as they deal with the gap between what appears in Div 35 of ITAA 1997 and Div 5 of Part III of ITAA 1936. The rules in the 1936 Act allow the partnership to calculate net income of the partnership as if it was a resident taxpayer. This contrasts with the intention of Div 35 to treat a business activity involving an individual separately from all other activities.
Without ITAA 1997 s 35-10(2), the loss deferral rules could only operate in a situation where the overall net profit or loss from all business activities in a partnership is taken into account. This would allow an opportunity for some taxpayers to game the system in order to allocate losses against other income throughout time.
Grouping of business activities
As s 35-10(2) intends to stop taxpayers gaming the system by including multiple business activities under the one umbrella for tax purposes, s 35-10(3) allows taxpayers to group similar business activities.
Taxation Ruling 2001/14 goes into detail about the approach the ATO uses in determining whether similar business activities may be grouped. In that ruling, the ATO states 5 factors which can be used to determine, on a subjective scale and not necessarily in equal weighting, whether similar activities can be grouped together for the purposes of Div 35. They are the:
- Location of the multiple businesses.
- Assets used in the businesses.
- Goods or services produced.
- Interdependency of the activities, and
- Commercial links of the activities.
For example, an individual who operates a retail flower shop and a delivery service for the items sold in the shop can group those businesses together. However, a rural landowner who operates a grapevine business on that land cannot group that business with a contracting service that provides rural spraying, mowing and weeding to other external landholders.
Exception for primary producers and professional artists
Section 35-10(4) operates as an exception to the loss deferral rule in s 35-10(2) where the business activity carried on by the individual taxpayer is either a primary production business or a professional arts business and the taxpayer’s assessable income from other sources is less than $40,000.
For the purposes of s 35-10(4), where the other sources of the taxpayer’s assessable income consist only of income-producing activities carried on in partnership, the assessable income of the individual partners is calculated as their interest in the net income of the partnership, ie the amount included in their assessable income under s 92(1).
However, this will not be the case where both the primary production business/professional arts business (ie the loss-making activity) and the activities producing assessable income not related to that activity are all carried on in the same partnership. In this case, the assessable income from other sources is calculated by disregarding any assessable income from, and allowance deductions attributable to, the loss-making activity.
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