Offsetting losses for tax purposes can be tricky

Provisions in the tax law prevent losses from so-called non-commercial business activities being offset against income from other sources. A recent case before the Federal Court has highlighted some of the difficulties that a business could face in offsetting losses against other business income.

In Watson v DCT [2010] FCAFC 17, the Federal Court dismissed Watson’s appeal and held that income protection insurance should be excluded from the assessable income of his financial planning business.

In the income year ended June 30, 2004, Watson derived income from two sources: (i) his business as a financial planner; and (ii) payments pursuant to a personal income protection insurance policy.

The insurance policy income was payable because Watson had, since 1996, been partially incapacitated for work. During the 2003-04 income year, his business traded at a loss. The question before the Court was whether or not that loss could, for tax purposes, be set off against the income from the protection insurance policy.

Watson and the Tax Office both agreed that the income from Watson’s business was assessable income, and that his insurance policy income was also assessable income. The point in dispute was whether the policy income was assessable income from his business activity for the 2003-04 income year.

Watson claimed that his policy income was “from” the policy he entered into while carrying on his business in 1995-1996. He submitted to the Court that effecting and maintaining income protection insurance was part of the conduct of his business of financial planning, or at least incidental or related to it. He said his main purpose in carrying on his business was to be financially self-sufficient.

Watson submitted that the policy was an income-producing asset, and that he held the contractual rights under the policy “against loss in his business, as part of his business activity” (although the Court disagreed with this latter contention). His contention was that the policy income was “from” his business activity, just like interest “from” a deposit held as part of the business activity.

His insurance premium payments were allowed as tax deductions and he treated them as an expense of his business.

Under the relevant provisions of the tax law, outgoings attributable to a business activity, which would otherwise be allowable deductions in the relevant year, may, in that year, be set off only against assessable income from that business activity. The Tax Commissioner originally decided that Watson’s insurance policy income was not income from his business activity, and that his business deductions could not be offset against such income for tax purposes.

The Court said the main question to be resolved was the meaning of the word “from” in the expression “assessable income… from the business activity for that year”. Tax law can involve some fine distinctions at times!

The Court said the insurance policy income was received because Watson was unable to undertake the full range of business activity that he would have undertaken had he not fallen ill.

The Court’s view was that the insurance policy income was derived from Watson’s incapacity to conduct business activity, and not from the activity which he actually undertook, ie. his financial planning business. This may seem like splitting hairs, but the distinction is important for tax purposes.

The Court therefore concluded that Mr Watson’s insurance policy income was not “from” his business activity for the 2003-04 income year. Therefore, he could not offset the loss from his financial planning business against the income from his insurance policy.

This case shows that applying simple logic to a tax issue doesn’t always produce the result that “logic” might seem to dictate. The tax law is a finicky and a particular (some might say peculiar) beast and those in business would do well to keep that in mind.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.