6th May 2010
ESCAPE THE NEW HORSE LOSS RULES!
Well, what a joy to finally pass on some good news re the new horse loss rules for high income earners. No, they haven’t gone away, unfortunately, but there can be a legitimate way to avoid them if your employer co-operates. These loss rules are part of what is known in the tax world as the “Non-Commercial Loss (“NCL”) rules.
For the uninitiated, individuals (or partners who are individuals) whose adjusted taxable income (“ATI”) exceeds $250,000 will have to quarantine and carry forward this loss unless a successful private ruling is lodged with the ATO. No longer can they refer to other ATO rules as to whether a loss can be deducted. These rules operate from 1 July 2009.
The ATI includes the sum of:
- Taxable income for that year (e.g. wages less work related deductions);
- Reportable employer superannuation contributions (“RESCs”) for that year;
- Total net investment losses for that year; and
- Reportable fringe benefits for that year.
In effect, many high income earners will be forced to seek the ATO’s approval before any loss can be claimed from a business activity (e.g. breeders/owners, wine makers, pastoralists etc) on or after 1 July 2009, i.e. this tax year onwards. In tax speak, the “Commissioner’s discretion” is required for the tax loss to be deductible.
TAX TIP – Employer reimbursement of horse business expenses
An employee who is also carrying on a horse loss-making business can avoid these new NCL rules by having their employer reimburses their horse business expenses under an effective salary sacrifice agreement.
The “employer” can also be a family company that pays significant wages to family members, i.e. your typical “Mum and Dad” company.
The ideal scenario is where the employee has their employer reimburse the entire amount of their business expenses under a salary sacrifice agreement. In these circumstances, the employee effectively obtains the benefit of a deduction and, in addition, the NCL rules have no application because the business is no longer in losses (i.e. as all the expenses have been reimbursed by the employer). There are a number of pertinent points to note in relation to this strategy, as follows:
1. The ATO has confirmed that, where an employer reimburses an employee’s business expenses under an effective salary sacrifice agreement, the reimbursement will not be subject to FBT. This is because the taxable value of each reimbursement will be reduced to nil under the ‘otherwise deductible’ rule (i.e. the ‘otherwise deductible’ rules basically applies where the employee would have been entitled to a deduction under the Tax Act had the expenses not been reimbursed by the employer). This is the case notwithstanding the taxpayer’s business loss would otherwise be quarantined under the NCL rules.
2. The employee will basically end up salary packaging the GST-exclusive cost of the horse business expenses, assuming the employer is entitled to a GST input tax credit in respect of the reimbursement under the GST Act. Note, however, that any business expenses reimbursed by the employer are not also be deductible to the employee (i.e. there is no ‘double dip’ available).
Note also that expenses that are reimbursed under a salary sacrifice agreement are not “reportable fringe benefits”. This is important where an employee is unable to avoid the NCL rules by salary sacrificing all their business expenses (or at least sufficient business expenses to convert the loss-making business into a profitable one) and is not able to satisfy the NCL rules because of the new “$250,000 income” test.
Specifically, when a taxpayer is calculating ATI for the purposes of assessing whether the $250,000 income test is satisfied, any reimbursed expenses are not required to be added back. Therefore, an employee should consider salary sacrificing sufficient business expenses to satisfy the income test.
In these circumstance, if the business activity has incurred a loss (i.e. after adjusting for reimbursed expenses), the loss is deductible against the taxpayer’s other income, provided one of the four “objective” NCL rules are met.
This strategy is complex and hopefully the example below will make the strategy clearer.
Example – reduce ATI to under $250,000 and avoid new loss rules
Bert is a high income earner working for a leading investment bank. His salary is $450,000 p.a. For the purposes of this example, his ATI is the same figure.
Bert is also a keen horse breeder and has bred commercially for many years. For the 2010 tax year, his horse sales income was only $60,000, however his expenses were $220,000, thus his horse tax loss for 2010 is $160,000 ($60,000 income less $220,000 expenses).
Under the new NCL rules, Bert could only claim this $160,000 loss immediately if he successfully applies to the ATO for a private ruling, such ruling having to demonstrate that his horse activity has long term “commercial viability”. This is so as Bert’s ATI is $450,000, i.e. in excess of $250,000.
So, how can Bert still “claim” his horse expenses for 2010?
Bert would approach his employer and ask that all of his $220,000 of horse expenses be paid directly by his employer under a “salary sacrifice” arrangement. Accordingly, his salary income is reduced to $230,000 ($450,000 less $220,000) and he no longer has to meet the new NCL income tests. How do we prove he is in the same tax position as if he’d been able to claim his $160,000 loss against his salary? See calculations below.
|Non-packaging (paying $220,000 of horse expenses from “own pocket”)|
|Less: Horse tax loss||$ (160,000.00)||$60,000 sales less|
|$220,000 business expenses|
|Taxable income after horse loss||$ 290,000.00|
|Less: Tax on $290,000 (excl M Levy)||$ 105,350|
|After tax position||$ 184,650|
|Packaging $220,000 horse “business costs” with employer|
|Salary||$ 230,000||$450,000 less $220,000|
|Add: Horse business sales income only||$ 60,000|
|Taxable income after adding horse|
|income only||$ 290,000|
|Less: Tax on $290,000 (excl. M Levy)||$ 105,350|
|FBT cost||$ –||no FBT applies|
|After tax position||$ 184,650|
|1. In example 2, the employer is paying for Bert’s $220,000 of horse costs via a valid “Salary Sacrifice”|
|arrangement. His salary is reduced to $230,000 to fund this.|
|2. As employer has paid all of the business expenses in example 2, the business “P&L” of Bert will|
|only disclose the $60,000 of sales income.|
|3. There is no FBT payable on this salary sacrifice arrangement, thus Bert is in the same after tax-position|
|as if he had fully funded the $220,000 of horse business expenses.|
|4. Due to Bert’s packaged salary being only $230,000, he need not consider the new loss rules as|
|his ATI is less than $250,000 and a “profit” has been derived on his horse business, i.e. $60,000.|
|5. If the packaging arrangement had still resulted in a loss being derived by Bert, i.e. the employer|
|wasn’t able to package sufficient horse expenses, the loss is still deductible against Bert’s salary|
|income, provided one of the four “objective” NCL tests are met. These “objective tests” are far easier|
|to meet and reliance on a successful (and costly) ATO ruling is not required.|
|6. A n individual partner in a partnership can also take advantage of this arrangement, but only his/her|
|share of the business expenses can be packaged.|
You can contact Paul Carazzo directly if you wish him to clarify or expand upon any of the matters raised in this release.
Any reader intending to apply the information in this article to practical circumstances sho uld independently verify their interpretation and the information’s applicability to their particular circumstances with an accountant specialising in this area.
PAUL CARRAZZO CPA
CARRAZZO CONSULTING CPAs
22 BLACKWOOD ST, NORTH MELBOURNE VIC 3051
TEL: (03) 9329 7044
FAX: (03) 9329 8355
MOB: 0417 549 347
Web Site: www.carrazzo.com.au