Losses affected by Division 35? Consider PCG 2022/1

In September 2022, the Commissioner of Taxation (“Commissioner”) released Practical Compliance Guideline PCG 2022/1 Non-commercial business losses – Commissioner’s discretion regarding flood, bushfire, or COVID-19 (“PCG 2022/1”).

PCG 2022/1 provides guidance on the circumstances in which the Commissioner will be taken to have automatically exercised his discretion to permit the application of non-commercial business losses under Division 35 of the Income Tax Assessment Act 1997 (“ITAA 1997”).

Overview

It is today more common than ever for individuals to run a side hustle, for example, running a little cake business from your kitchen, growing organic vegetables in your garden, brewing beer in your backyard, or even making crafty wood products in your garage.

Where such activity amounts to the carrying on of a business, but generates a loss, the non-commercial business loss rules contained in Division 35 will generally operate to prevent the loss being offset against the individuals’ other income (instead it must be carried forward to be offset against future assessable income generated from the same activity), unless the following income requirement and one of the following four tests are satisfied, or the Commissioner exercises his discretion¹:

Income Requirement - s35-10(2E)

Individual’s ‘adjusted taxable income’ for the income year does not exceed $250,000

1 - Assessable Income Test - s35-30

Assessable income from the relevant business activity for an income year is at least $20,000, or if the business activity was for less than a year, it can be reasonably estimated that it would have been $20,000 if carried on for the whole year.

2 - Profits Test - s35-35

Relevant business activity generated taxable income for at least 3 of the past income years (including the current income year).

3- Real Property Test - s35-40

Total value of real property continuously used in carrying on the relevant business activity (excluding a dwelling used mainly for private purposes, and adjacent land, or fixtures owned by the individual as tenant) is at least $500,000.

4 – Other Asset Test – s35-45

Total value of other assets (excluding certain assets such as those included in the real property test, cars, motorcycles, etc.) used on a continuing basis in carrying on the relevant business activity is at least $100,000, based on certain assumptions relating to value.

Pursuant to subsection 35-55(1), the Commissioner has discretion to not apply Division 35 to non-commercial business losses where he is satisfied that it would be unreasonable to do so because

“the business activity was or will be affected in the excluded years by special circumstances outside the control of the operators of the business activity included drought, flood, bushfire or some other natural disaster…”.

PCG 2022/2

Recognising the significant detrimental impact that bushfires, floods, and COVID-19 have in recent years had on many businesses operated by individuals, the Commissioner released PCG 2022/1, which expressly sets out the circumstances in which he will automatically exercise his discretion in relation to Division 35, for income years ended 30 June 2020 to 30 June 2023 (the “Safe Harbour”).

Individuals will qualify for the Safe Harbour where:

• They satisfy the income requirement in subsection 35-10(2E);
• They made a loss from their business activity, excluding any amount deferred from a previous year under Division 35;
• Their business activity was affected by one of the following events:
• Flood (including where they received ATO flood support);
• Bushfire (including where they qualified for an ATO bushfire lodgment and payment deferral)
• A government-imposed lockdown, business closure or restriction due to COVID-19.
• The event precluded the carrying of the business activity or reduced its scale (e.g., where some or all customers were not able to access the business activity, or access it in the usual manner);
• They have not applied for a private ruling requesting exercise of the Commissioner’s discretion; and
• They have evidence to support that they are eligible for the Safe Harbour

Where the foregoing criteria are satisfied, taxpayers need not apply for the exercise of the Commissioner’s discretion and can treat themselves as eligible under the Safe Harbour.

Illustrative Examples

Example 1 - Flood - eligible to use the Safe Harbour

Chloe operates a small farm that produces vegetables for her own needs and sells excess produce to the local community. Her business activity generated taxable income in the 2021 income year.

In February 2022, the business activity was impacted by severe flooding resulting in a loss of approximately half her agriculture produce and a taxable loss. In previous years, the average loss of agricultural produce was approximately 7% per year due to pests.

Chloe’s other income remained stable, and she met the income requirement in the 2022 income year. Chloe’s farming business returned a loss in the 2022 income year.

Chloe maintains evidence of the loss of agricultural produce to demonstrate the impact of the flood on her business activity.

In this case, Chloe is eligible to apply the Safe Harbour.

Example 2 - COVID-19 - eligible to use the Safe Harbour for current year's loss only

Jess operates a party planning business that mostly plans parties for her family and friends.

The business made a loss of $8,000 in the 2018 income year. Jess was not eligible to use the loss and it were deferred under Division 35. In 2019 income year, the business generated taxable income of $6,000. Jess offset $6,000 of her carried forward losses against that income; however, the remaining $2,000 was deferred and carried forward.

In response to COVID-19, the government-imposed lockdowns, and restrictions. Jess couldn’t carry on her party planning business on the same scale as she usually can as parties and celebrations are restricted and smaller in size. In the 2020 income year, the business made a loss of $4,000. Jess maintains evidence of the lockdown's impact on her business and was able to meet the income requirement in the 2020 income year.

In this case, Jess is eligible to use the Safe Harbour to offset the $4,000 loss from the 2019-20 income year against her other income but cannot use the Safe Harbour to offset the $2,000 loss previously deferred. 

Key Take-Aways

A few things to remember if the above applies to your circumstances and you would like to review an income tax return that has already been lodged.

1. To apply the safe harbour rules, taxable income must have been made in the preceding year and does not apply to losses quarantined in previous years.

2. The safe harbour rules only allow you to apply business losses made in the following income years:

• 2020
• 2021
• 2022
• 2023

3. Generally, an amendment to a previously lodged income tax return can be submitted within the two-year period from the date the assessment was issued for prior year tax returns. However, if your two-year amendment period has lapsed, not all is lost and you may be able to lodge an objection where a written submission to deal with the amendment as if it has been lodged within the time frame is accepted by the Commissioner.