How the Law Approaches the Problem of Distinguishing a Hobby from a Business in Australia - Coursework Example

Name Course Lecturer Introduction Determining which activity is termed as a business for taxation issue is a contentious issue in many tax jurisdictions. In Australia, the situation is further compounded by the lack of a precise description of a business in Australian law. Any tax system must be fair in the way it demands taxation and at the same time make sure as much revenue as possible is collected from the citizenry. The distinction of whether a business or a hobby is significant as taxpayers have been able to take advantage of two loopholes in the distinction to avoid taxes. First, the Australia tax office cannot tax income made through a hobby activity. Secondly, when some individuals make losses they claim their hobbies are businesses thus were able to claim deductions for losses they had made. Both ways the Australia tax office's losses considerably from this two tax avoidance tactics. This paper analyzes how the law approaches the problem of distinguishing a hobby from a business in Australia. What constitutes a Business Subsection 995-1 (1) of the Income Tax Assessment Act 1997 (ITAA 1997) considers a business to be a trade, profession, calling, vocation, employment, excluding where one is engaged as an employee. The income made in the course of businesses is assessable in ordinary circumstances. According to Margaret, Ingraham, and Karlinskya a business is considered to be of a commercial nature if it is organized and systematic (290). Others requirement includes the presence of a profit motive and the scale of the business activity. In taxation the effect of an activity being described as business are threefold, they may either be an advantage or a disadvantage: a) a disadvantage; the income from business transactions is assessable for taxation, b) an advantage; the business expenses are deductable while calculating taxable income, c) an advantage; the business owner may be able to offset it’s losses with other taxable income (Zetler and Bonello, 127). Therefore, a clear definition of what constitutes a business in the Australian tax jurisdiction is needed to ensure the principle of certainty is maintained in the Australian tax system (Margaret, Ingraham, and Karlinskya, 192). In the Australian tax system assessable income is considered any gain that is either money or money’s worth and is referred to as ordinary income (Greg, 21). According s 6-5 of the ITAA 97 proceeds made in the course of doing business are considered ordinary income in Australia. Faced with the need to ensure a fair tax system and avoid tax loopholes that could be detrimental to tax collection efforts, the common law has tried to address the issue of whether an income making activity is a hobby or a business. Through an analysis of cases several indicators to determine whether an activity constitutes carrying out emerge. However, no single indicator can be used to determine what constitutes a business. It is important to analyze the degree to which each indicator applies to the matter under determination (Rick and Watson, 72). In Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922 and Ferguson v. FC of T (1979) 37 FLR 310 at 325, the overall impression of the taxpayer's intention and his activity must be analyzed to arrive at a conclusion whether a business I is a hobby or business. It may be noted that different cases on the issue have used a number of closely related indicators to determine this issue. The indicators can be summarized into following (Zetler, Julie, and Rodney Bonello, 106): a) The degree to which an activity is of commercial character or purpose b) Whether an individual intention goes beyond engaging in business. c) Whether the taxpayer's purpose is profit or there is a prospect of profit. d) Whether the activity is carried out regularly or repetitively. e) Whether the activity has the characteristic of ordinary trade in a certain industry. f) Whether the planning and organizations of the business are directed at making a profit. g) The size, scale and permanency of the activity. h) Whether it can be defined as business, in contrast to hobbies, recreation or sporting activities. It is worth noting that if a business does not satisfy all these indicators it is considered a hobby. On the other hand an activity does not need to satisfy all the indicators to be considered a business. The commercial character of a transaction came into consideration to deal with loss deduction claims of people who engage in businesses in a small way. This indicator requires the taxpayer to provide evidence that the activity is of commercial nature and is a commercially viable undertaking. This indicator avails a means for people who are in the initial stage of business reducing their tax burden if they are making losses. Walsh J in Thomas v. FC of T 72 ATC 4094; (1972) 3 ATR 165 ruled that an activity has to be of significant commercial purpose to be categorized as business. In Hope v. The Council of the City of Bathurst (1980) 80 ATC 4386 the determination of the commercial nature of an activity is closely linked to the scale and size of the undertaking. By comparing an activity with those carried out by taxpayers in that line of business, the commercial character is apparent. The intention of a person in engaging in an activity is an important indicator of whether it can be considered a business. According to Brennan J in Inglis v. FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497 mere intention is not adequate, there must be activity to support the intent. Similar reasoning was expressed in J&R O'Kane & Co v. IR Commissioners (1920) 12 TC 303 at 347. Similarly, this indicator can be used to reduce the tax burden of an individual’s engaged in preparatory activities for a business. The prospect of profits is one of the most important indicators in determining whether an activity is a business. According to Jessell MR in Smith v. Anderson (1880) 15 Ch D 247 at 258, activities “that occupy the time, attention and labour of a man” with the aim of making a profit are business. Therefore, any activity that could ever make a profit is considered a business. According to Bowen CJ in Ferguson at ATC 4264; ATR 876 the whether a business makes a profit in the long or short term is irrelevant. It must be noted that lack of evidence that a business may ever make a profit does not mean the activity in question is not a business. Hope v. The Council of the City of Bathurst (1980) 80 ATC 4386 an activity can be considered a business if it is carried on a repetitive or regular basis. However, the repetitiveness or regularity of an activity is not decisive in determining whether it is a business or a hobby. According to IRC v Livingston and Ors (1927) 11 TC 538 at TC 542 one of the leading cases on distinguishing business activities from hobbies, whether an activity is carried out in the same manner as similar activities in an industry is another important indicator of whether a business can be categorized as a hobby or a business. In Ferguson the question of whether the planning and organizations of a company are directed at making a profit was influential in determining whether an activity is a business. Fisher J said that a venture that is carried out systematically with the aim of making profit is a business. Recordkeeping in a venture shows that the business was carried out systematically. The scale of a venture is another indicator that important in determining the status of an activity. However, this does not mean small scale activities are not considered businesses. In Thomas at ATC 4099 the fact that the venture produced more than the appellant needed for own consumption was accepted as an indicator the undertaking was a business. The Taxation ruling TR 97/11 notes that when the scale of an activity is low, the other indicators are more important in demining what constitutes a business. Finally, whether an activity can be more appropriately defined as a hobby or recreation another indicator of whether an activity can be considered a business. According to Ferguson even where an activity is substantial, it cannot be considered a business if it can be more properly described as a hobby or recreation. Direction of the ATO on determination of whether a business is a hobby or business The Australian Tax Office’s position on this issue is very similar to the position of the common law. According to the ATO in TR 97/11 the indicators of whether a business is a hobby set out in a series of common law cases. The ATO uses the leading common law cases in determining what activities constitute a hobby or a business to articulate its position on the issue. These cases include CTC Resources NL v. FC of T 94 ATC 4072, Ferguson v. FC of T (1979) 37 FLR 310 79 ATC 4261 (1979) 9 ATR 873, Hope v. The Council of the City of Bathurst (1980) 144 CLR 1 80 ATC 4386 (1980) 12 ATR 231 Negative Gearing and Division 35 Division 35 was introduced into the ITAA 97 to limit the number of situations an individual can offset his business losses with other taxable income. Among the business losses that are exempted from the provision in Division 6 are a negatively geared asset (Margaret, Ingraham, and Karlinsky, 143). Negative gearing refers to the purchase of an asset on loan, whose net income is below interest payment and profit can only be realized by selling the asset. Division 35 of the ITAA 97 uses an objective test in determining whether an individual may be able to offset his business losses against other assessable income. The objective test has the following with four limbs. Including a limb that requires that a business to have made a profit for the 3 of the last 5 years. A negatively geared asset cannot pass this test as it never makes a profit at any one time. Conclusion The distinction of whether an activity is a business is a very important issue when it comes to taxation. If the law allows many activities to be defined as a hobby for taxation purpose, the Australian taxman losses as the possible sources of tax revenue are constricted. On the other hand defining a wider range of hobby activities as businesses means they will be able to make a loss deduction meaning a constriction of the taxman sources occurs. Courts must balance the approach they use to define a hobby or a business. The courts must ensure they do not offer people who are not engaged invalid business a chance to offset losses from their fictitious business with their other taxable income. On the other hand, they must ensure the ATO is able to assess the income tax of people who are engaged in business while claiming they are just pursuing their hobbies. References Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922 Ferguson v. FC of T (1979) 37 FLR 310 Hope v. The Council of the City of Bathurst (1980) 80 ATC 4386 Income Tax Assessment Act 1997 Inglis v. FC of T 80 ATC 4001 IRC v Livingston and Ors (1927) 11 TC 538 J&R O'Kane & Co v. IR Commissioners (1920) 12 TC 303 Lacey, Rick, and A. S. Watson. "Economic effects of income-tax law on investment in Australian agriculture: with particular reference to managed investment schemes and Division 35 of the Income Tax Act." 48th annual conference of the Australian Agricultural and Resource Economics Society, February, Melbourne. 2004. McKerchar, Margaret, Laura R. Ingraham, and Stewart Karlinsky. "Tax complexity and small business: a comparison of the perceptions of tax agents in the United States and Australia." Journal of Australian Taxation 8 (2005): 289-371. Smith, Greg. "Taxation in Australia." Tax Policy Conference. 2003 Taxation ruling TR 97/11 Thomas v. FC of T 72 ATC 4094; (1972) 3 ATR Thomas v. FC of T 72 ATC 4094; (1972) 3 ATR 165 Zetler, Julie, and Rodney Bonello. 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