Clifton Hefner and Commissioner of Taxation
[2013] AATA 407
[2013] AATA 407
Division Taxation Appeals Division File Number
2012/4992
Re
Clifton Hefner
APPLICANT
And
Commissioner of Taxation
RESPONDENT
DECISION
Tribunal Senior Member McCabe
Date 18 June 2013 Place Brisbane The objection decision under review is affirmed
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Senior Member McCabe
CATCHWORDS
TAXATION – Private rulings – Non-commercial business activity – Commissioner's refusal to exercise discretion – Objection decision under review affirmed
LEGISLATION
Income Tax Assessment Act 1997 (Cth) Division 35
CASES
Commissioner of Taxation v Eskandari [2004] FCA 8
REASONS FOR DECISION
Senior Member McCabe
The taxpayer is an engineer. He earns in excess of $250,000 a year from his engineering work. In 2009, he established a cattle stud in partnership with his wife. He wants to offset expenses and losses from the stud against his income as an engineer in the year ending 30 June 2011. But there is a problem. The taxpayer’s losses from the agricultural business are regarded as losses from a non-commercial business activity within the meaning of Division 35 of the Income Tax Assessment Act 1997. The losses must be deferred pursuant to s 35-10 of the Act unless the Commissioner exercises the discretion in s 35-55(1)(c) to permit the taxpayer to include the losses in the calculation of the taxpayer’s assessable income in the year of income in question. The Commissioner has refused to exercise the discretion. The taxpayer has asked the Tribunal to take a fresh look at the question.
THE PRIVATE RULING
This is technically a request to review the Commissioner’s objection decision in relation to a private ruling. The taxpayer had applied for the Commissioner to exercise the discretion in s 35-55(1)(c) of the Act to allow the taxpayer to include the losses from the cattle stud in the calculation of his taxable income in the year of income ended on 30 June 2011.
The application for the ruling included a description of the taxpayer’s scheme that was clarified in subsequent correspondence. The ruling is reproduced at exhibit one pp 154ff. It said the taxpayer:
·commenced his cattle breeding business on 1 February 2009 in partnership with his wife;
·proposed establishing a pure bred Charolais herd using the latest scientific technology and management (although the ruling also noted there was also a commercial Brahman herd being run);
The ruling set out a table showing the projected growth in the herd. The herd reaches full size (its maximum production level) in 2013 or 2014 but the ruling notes the taxpayer does not anticipate producing a tax profit until the 2017-2018 year of income when his debt levels were reduced. (The bulk of the debt in question is comprised of a $950,000 loan from a bank used to fund the 2009 purchase of a 100 acre property from for $676,532. The stud operation is conducted from this comparatively small property. The balance of the loan was applied towards working capital.)
The scheme described by the Commissioner is an accurate statement of what was proposed. It was not suggested the taxpayer was asking me to consider any material differences to the scheme upon review. The review has proceeded on that basis, although I was provided with some additional evidence at the hearing from the taxpayer and expert witnesses (including his wife, who is an expert on cattle nutrition) which enabled me to put – dare I say it – some factual meat on the bones set out in the ruling.
THE DISCRETION
Section 35-10(2) effectively quarantines losses from non-commercial activities from the taxpayer’s other income. The provision is designed to protect the integrity of the tax system. There are exceptions to the general rule set out in ss 35-10(1)(a), (b) and (c). Only the exception recognised in s 35-10(1)(b) is potentially relevant here. That sub-section refers to the possibility the Commissioner might exercise the discretion in s 35-55.
This case deals in particular with the discretion referred to in s 35-55(1)(c). That sub-section provides:
The Commissioner may, on application, decide that the rule in subsection 35-10(2) does not apply to a business activity for one or more income years (the excluded years) if the Commissioner is satisfied that it would be unreasonable to apply that rule because:
… (c) for an applicant who carries on the business activity who does not satisfy subsection 35-10(2E) (income requirement) for the most recent income year ending before the application is made-the business activity has started to be carried on and, for the excluded years:
(i) because of its nature, it has not produced, or will not produce, assessable income greater than the deductions attributable to it; and
(ii) there is an objective expectation, based on evidence from independent sources (where available) that, within a period that is commercially viable for the industry concerned, the activity will produce assessable income for an income year greater than the deductions attributable to it for that year (apart from the operation of subsections 35-10(2) and (2C)).
THE TAXPAYER’S ARGUMENT
The taxpayer says he will not produce assessable income until the year ended 30 June 2017 or 30 June 2018 because of the nature of the business: it is a greenfields cattle stud (ie, one that is started from scratch, as opposed to one that taps into existing, readily available bloodlines) that has a long lead time before it becomes successful. I heard evidence from a number of witnesses on this point.
The taxpayer spoke of the careful planning that went into the start-up phase of the venture. He said he and his wife made a conscious choice to buy a relatively small but expensive property because it had a high carrying capacity. He emphasised the importance of establishing a reputation for excellence before the bloodlines they were developing would become attractive to other breeders. Goodwill was crucial, he explained. In his written submissions, the taxpayer was critical of the Commissioner’s approach to the ruling and objection. He said the Commissioner was not allowing for the differences between a commercial beef operation and a stud. The taxpayer said studs took longer to become viable because they had higher costs per animal (most obviously because of the expensive technology required in a breeding operation), higher infrastructure costs and the longer time required to develop a reputation which was the key to premium bull sale prices.
The taxpayer’s wife provided additional detail about the business. She holds a doctoral qualification and specialises in the nutritional needs of large animals like cattle. She was raised on a feedlot and provides consulting services to other agricultural businesses. The doctor explained she wanted a greenfields operation because she and her husband wished to breed distinct genetics. She said they did not want a “franchise operation” that dealt with existing bloodlines. She explained the logic behind acquiring a relatively small and expensive property: the higher carrying capacity that resulted from higher rainfall and superior pastures meant lower expenditure on fencing and other infrastructure. She referred to culling rates and other aspects of herd management, and to the academic literature. She agreed it would take 4-6 years from the start of production before cattle are sold (that proposition is contained in the literature reproduced in exhibit one at p 148) but noted that while bulls take five years or so before they start to sire progeny, it would take at least another three years before their commercial potential was confirmed: that proposition is contained in exhibit one at p 131.
Dr Farrell gave evidence on behalf of the taxpayer. He holds a doctorate and has lectured in agricultural economics at the University of New England. He had developed generic business modelling for Charolais studs. He explained the variables in his model, which included the size of the herd, breeding rates, the effects of drought and rainfall, feed costs and the costs of infrastructure. The cost of debt funding was also included as a variable. He said his model suggested a typical greenfields stud operation would become commercially viable in about ten years from the date of establishment.
Mr Andrew Ogilvie also gave evidence on behalf of the taxpayer. He is the president of the Cattle Council of Australia, an industry lobby group that (amongst other activities) provides advisory services to its members. Mr Ogilvie emphasised cattle breeding was a slow process, and that it (a) took time to establish a reputation, which was crucial to commercial success, and (b) was expensive, and the expense typically meant stud owners had to factor in the cost of debt finance.
Mr Marsden, an accountant, was also called by the taxpayer. He was involved in a professional capacity in the establishment of the partnership. He made the unsurprising observation that most businesses like this were financed by debt. I note the taxpayer also provided material from a Mr Forrest, a bank manager with some experience in rural businesses, and Dr Sullivan, a veterinarian. Mr Forrest opined that, in his experience, a breeding operation could take up to five years to show a profit. That evidence does not appear to assist the taxpayer, although the Commissioner suggested I should discount the evidence in any event because the basis of his expertise for the purpose of estimating commercial viability is unclear. Dr Sullivan estimated it could take about eight years to develop consistently profitable products. It was unclear whether Dr Sullivan is an expert in the economics of these businesses.
In summary, the taxpayer says the evidence clearly establishes businesses like his do not start making a profit for at least nine or ten years. I accept that is so if one takes into account the cost of servicing debt: the evidence from Dr Farrell in particular suggests most breeders starting a greenfields operation would take about a decade before they turned a profit because of borrowing costs in particular. I also accept the taxpayer has not taken a casual approach to the operation. He has a clear and apparently sensible business plan that he is executing diligently, and I do not doubt his intention to become profitable within the time frame he has indicated. He is serious about building a viable stud. There is no reason to believe he has taken on unreasonably high levels of debt to finance the property or make extravagant improvements.
I would add I am satisfied the evidence establishes a stud can begin selling its output within about five years, even though its products will not command premium prices until eight to ten years after establishment. The delay in achieving profitability after the five year mark appears to be attributable to financing costs.
SHOULD THE DISCRETION BE EXERCISED?
The Commissioner points out the decision-maker must address the matters in both limbs of the test in s 35-55(1)(c). Those limbs require that the decision-maker be satisfied:
(i)the business will not become profitable in the period under review (ie, before 30 June 2017) because of its nature; and
(ii)there is independent evidence that justifies an objective expectation the business will produce assessable income within the period that is commercially viable for the industry concerned.
The taxpayer is unable to satisfy the test contained in the first limb, which makes it unnecessary to consider the issues in the second limb. The evidence establishes a stud could become profitable in advance of 30 June 2017; indeed, depending on the cost structure of the operation, it could become profitable as early as five years after establishment (although I accept it probably would not generate maximum profits until sometime later). The key variable is financing costs. If those costs are high – because the operation is funded wholly or partly by debt – then it will take longer for the operation to turn a profit. But the operation does not have to be financed by debt. The fact most businesses are financed at least partly by debt does not suggest debt is an “inherent feature that the taxpayer’s business activity has in common with business activities of that type”: see Commissioner of Taxation v Eskandari [2004] FCA 8 at [32] per Stone J. A stud business could be conducted in a different way, in the sense that alternative financing arrangements are at least theoretically available. There is nothing inherent in the business activities which demand that they be financed by debt.
CONCLUSION
The taxpayer was startled by the Commissioner’s arguments about the interpretation of s 35-55, but the decision in Eskandari suggests the Commissioner’s approach is right. I accept there is nothing in the nature of the business that will stop it from becoming profitable at some point before the year of income ending 30 June 2017. It is therefore inappropriate to exercise the discretion in the taxpayer’s favour. The objection decision must therefore be affirmed.
I certify that the preceding 18 (eighteen) paragraphs are a true copy of the reasons for the decision herein of Senior Member McCabe
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Associate
Dated 18 June 2013
Date of hearing 22 April 2013 Applicant In person Counsel for the Respondent Richard Schulte Solicitors for the Respondent ATO Legal Services
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