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PCG 2022/D2 gives you a safe harbour for non-commercial business losses.
Safe Harbour for Non-Commercial Business Losses
In this episode, Ben Miller of Wolters Kluwer will walk you through PCG 2022/D2. This PCG gives you a safe harbour for non-commercial business losses when the business fails all four tests.
Here is what we learned but please listen in as Ben explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
Safe Harbour for Non-Commercial Business Losses
Usually, you need the Commissioner’s discretion to tax deduct a business loss against other income when failing all four tests. But PCG 2022/D2 gives you a safe harbour. With PCG 2022/D2 you basically self-assess the deductibility of business losses. Looks like special circumstances apply? If yes, you can assume that you got the Commissioner’s discretion. No need to apply for a private ruling.
“Sole traders and partners in a partnership may be able to utilise a safe harbour to deduct non-commercial losses against other assessable income. The PCG bypasses the Commissioner’s discretion under the non-commercial loss rules, where a business has been directly affected by floods, bushfires or the COVID-19 pandemic. They will need to show necessary evidence to support using the safe harbour. The safe harbour applies for the 2019–20, 2020–21 and 2021–22 income years.”
Ben Miller of Wolters Kluwer
Non-commercial losses
The non-commercial losses regime sits in Division 35 of the Income Tax Assessment Act 1997. When an individual incurs a business loss, they must defer the loss unless the loss is exempt.
Division 35 ITAA 97
So the default position is that losses are’non-commercial’ per Div 35 unless an exemption applies. An exemption applies if you meet the income requirement (< AUD 250,000) and pass one of the four tests.
Companies and Trusts
Losses in companies and trusts are a completely different kettle of fish, ie siloed within the entity. However, companies and trusts also received some concessions re losses.
Companies got a temporary loss carry-back provision. A company can apply for a refund of prior tax paid through a carry back of losses up to 30 June 2023. Trusts can only claim and deduct tax losses in limited circumstances, ie. family trust elections etc. In this episode we just focus on individuals.
Individuals
Division 35 only covers individuals in sole traders and partnerships. There are additional rules for individual partners, which we will cover in a separate episode.
Income Requirement
An individual needs to meet an income requirement. Their other income in that income year must be less than $250,000. If the individual’s income is higher – bad luck. You don’t even need to look at the four tests.
Income for this threshold consists of four components: Taxable income + Reportable Fringe Benefits + Reportable Super Contributions + Total Net Investment Losses
In theory, you could ask for the Commissioner’s discretion if your income is too high. But in practice don’t bother. It is extremely hard to get the Commissioner’s discretion if your income is AUD 250,000 or higher. See one of the private rulings further down under examples.
So once you pass the income requirement, you move on to the four tests – with one exception – primary production and professional arts.
Primary Production and Professional Arts
There is one small variation to all this. And that is primary production and professional arts. If your other income is less than AUD 40,000, then you can claim the business loss no matter what. Whether you pass one of the four tests or not. So the four tests become irrelevant. But only for primary production and professional arts.
But for all other industries, you need to pass at least one of the four tests.
Four Tests
Once you have ticked off the income requirement, you need to pass one of four tests.
1 – Assessable income test (>AUD 20,000)
2 – Profits test (> AUD 0 in three out of past five years)
3 – Real property test (> AUD 500,000)
4 – Other assets test (> AUD 100,000)
If you pass the general income requirement but fail all of the four tests, you can apply to the Commissioner’s discretion if special circumstances apply. And this is where PCG 2022/D2 will come in shortly.
Special circumstances
The Commissioner’s discretion is only for special circumstances. The Commissioner will usually grant special circumstances when the business activity is ordinarily expected to be commercial but wasn’t in a particular income year because of a relevant factor that occurred to either the business or the individual themselves.
To get special circumstances, an individual must apply through the ATO’s Private Binding Ruling system. This can be a difficult process for some taxpayers. Before the Commissioner gives discretion for special circumstances, they will want to know a lot of information about an individual’s business activity.
That means disclosing a lot of confidential business data. And taking up a lot of your time. And also consider that at worst you defer the loss and claim it as soon as you make a profit again. So asking for the Commissioner’s discretion and claiming special circumstances might not always be worth the time it takes.
PCG 2022/D2
PCG 2022/D2 is about the need to apply for the Commissioner’s discretion when a business fails all four tests.
The ATO is expecting a large number of applications for the Commissioner’s discretion. The COVID-19 pandemic, floods, and fires affected many. Most faced special circumstances.
As a result, the ATO has recently released the Draft Practical Compliance Guideline (PCG) 2022/D2. The draft guideline outlines a safe harbour that, provided the individual satisfies the relevant conditions, allows an automatic granting of special circumstances.
The draft guidelines list the COVID-19 pandemic as well as other major events like floods, fire and storms.
Safe Harbour
If an individual is below the $250,000 income requirement and made a loss from their business activity and otherwise didn’t pass the 4 main tests, then the safe harbour will apply when the business activity or the individual has been affected by one or more of the following events:
- There was a flood – including where the individual received ATO flood support
- They were affected by a bushfire – including individuals that qualified for an ATO bushfire lodgment and payment deferral, and
- The business was affected by a government-imposed lockdown, business closure or some other restriction due to the COVID-19 pandemic.
These events include not only a situation where the business was directly affected, but also in a situation where the business’s customers were not able to access your client’s business activity due to one of these events.
The safe harbour applies for the years ending 30 June 2020, 2021 and 2022. Therefore, an individual has the option to go back and amend a previous year’s return and receive an additional tax refund.
Always keep in mind that the tax rates for individuals were higher in the 2019-20 income year, as recent tax cuts applied from 1 July 2020.
Overall, the draft practical compliance guideline provides an easier alternative for individuals than attempting to sway the Commissioner that special circumstances apply, as this can be tricky based on research of the past few years.
Recent Private Rulings
Two recent examples of real private binding rulings that can make it otherwise difficult for a practitioner to understand how the Commissioner applies the special circumstances discretion.
1. Special circumstances not allowed – loss to be deferred
The individual’s business activity focused on home maintenance projects. On commencement of the business, the individual incurred some start-up expenses including a commercial vehicle, multiple tools and other equipment.
The business activity incurred a loss but had assessable income over $20,000 – satisfying one of the 4 main tests for deductibility. The individual is required to obtain special circumstances as their other income was above the $250,000 income requirement.
Effectively, the net loss of the business activity was due to large tax concessions available for small businesses where an immediate deduction was available for the purchase of assets, otherwise known as the instant asset write-off provisions. The taxpayer didn’t have a choice in deferring the instant asset write-off and claim depreciation.
Result
No special circumstances. Loss to be deferred. The Commissioner stated that they wouldn’t apply special circumstances for reasons such as increased tax benefits. The ATO stated that taxpayers knew that the immediate deduction rules were available and hence it would have been factored into their normal decision-making for the business.
2. Special circumstances allowed – social media backlash
An individual was already running a business and was contemplating commencing a second business activity. The second business activity was considered viable after some informal market research.
The activity was to schedule and run two events in two different cities which coincided with a large national event. The annual event was to include sports and cultural activities, and the taxpayer was to provide some activities for the event attendees. It was anticipated that more than a thousand people would be attending the annual event.
But then all went to custard. There were significant delays. And attendees moved on to other venues, warning others via social media not to come. The events in both cities generated a small amount of revenue but not enough to meet the threshold test of $20,000. The taxpayer also sought damages from the venue operator, however, the operator had since gone out of business.
Result
The ATO saw special circumstances and allowed the deduction of the loss. The Commissioner agreed that the circumstances were outside of the taxpayer’s control.
Main takeaway from PCG 2022/D2
With the safe harbour, you can now use your professional judgment to help a client to self-assess for non-commercial losses in the COVID-19 pandemic and other major disasters.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 16 November 2022
Tax Talks spoke to Ben Miller - Senior Editor at Wolters Kluwer - for more details.
