Only individuals, and not companies or trusts, can have a hobby or a private recreational pursuit.
The pursuit of a hobby by an individual may be to supplement wages, create income after having lost a job, test the waters for a new commercial venture or simply follow a passion. The pursuit of a hobby is not the same as carrying on a business for taxation purposes, which means that money derived from a hobby is not income and therefore is not assessable. Conversely, hobby expenditure is not tax deductible.
There is a risk for individuals conducting profitable hobbies that the Commissioner of Taxation will regard them as carrying on business operations.
A hobbyist is not entitled to an ABN and cannot register for GST because private recreational activities, pursuits or hobbies are specifically excluded from the definition of an enterprise.
The Queensland Supreme Court in 1985 concluded that an individual was in the business of primary production after he acquired and used one purebred female angora goat for the purposes of breeding and selling the kids. Afterwards, the Commissioner withdrew his long-standing guidelines on what quantity and land areas were considered necessary for the carrying on of a business operation.
These days there is significant economic activity conducted by taxpayers in cyberspace and for those that conduct such an activity there needs to be a word of caution. For instance, on its website, the Australian Taxation Office (ATO) states that if a taxpayer ‘sets up a shop on an online trading or auction site, you are likely to be carrying on a business – especially if you paid fees to operate the shop.’
The distinction between a hobby and a business is determined by the ordinary meaning of those words as determined by the Courts, although the Income Tax Assessment Act 1997 defines 'business' non- exhaustively as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee.'
Court cases over the years have established the circumstances that generally need to be present before a business is regarded as being operated by a taxpayer. A summary of these business indicators from a primary production perspective is found in the Commissioner’s ruling TR 97/11 which analyses an individual’s activity based on whether:
- They have a significant commercial purpose or character.
- The taxpayer has more than just an intention to engage in business.
- There is a purpose of profit as well as a prospect of profit from the activity.
- There is regularity and repetition.
- The activity is of the same kind and carried out in a manner that is characteristic of the industry.
- The activity is planned, systematic and organised in a businesslike manner.
- They have the necessary size, scale and permanency.
- Whether the activity is better described as a hobby, a form of recreation, or sporting activity.
No one indicator is decisive, and analysis of the indicators must be considered in combination. The conclusion is drawn from the general impression gained during the analysis.
An individual can carry on a business of a limited nature which is preparatory to or in preparation for carrying on another business on a larger scale.
As losses are frequently encountered by startup businesses, it is recommended that a business plan, incorporating cash flow projections and assumptions, be prepared on a realistic basis.
Because of the difficulty involved in determining whether an individual is carrying on a business or a hobby, and the sheer number of individuals making losses from these activities, parliament introduced Division 35 of ITAA 1997 (non-commercial loss rules) during 2000.
Division 35 outlines that a loss made by an individual (including an individual in a general law partnership) from a business operation will not be deductible in the income year in which it arises unless the following conditions are satisfied;
- An individual’s adjusted taxable income is less than $250,000 (after adding back reportable fringe benefits, super contributions, net investment losses and excess deductions from non-commercial business activities that are caught by Division 35), and;
- The exception rule applies where the loss occurs from a primary production business or a professional arts business activity, and where the individual has other assessable income of less than $40,000 (excluding any capital gain).
And, if the exception rule doesn’t apply, one of the following tests is satisfied:
- There is at least $20,000 of assessable income during the relevant year from the business activity.
- The business activity results in a tax profit during any three of the past five income years (including the current year).
- At least $500,000 worth of land and buildings (excluding any private dwelling) are used on a continuing basis in carrying on the business activity in that year.
- At least $100,000 of certain other assets (excluding cars, motorcycles) are used on a continuing basis in carrying on the business activity in that year.
If one of the preceding four tests is not satisfied, you may apply to the ATO for the Commissioner to exercise his discretion.
For the Commissioner to exercise his discretion favorably, it is important that the individual demonstrates that the business activity will, more than likely, satisfy one of the tests or produce a tax profit and outline the period within which a commercially viable business would do so. A business plan and cash flow forecast are necessary, as well as supporting evidence from an independent source. Appropriate independent sources include industry bodies or relevant professional associations, government agencies, or other taxpayers conducting successful comparable businesses.
Any loss denied as a tax deduction will be deferred to future income years and offset against the assessable income from the “non-commercial” business activity.
As a concluding point, once an individual’s activities move from being a hobby to carrying on business, the small business capital gains tax concessions potentially become available. This concession can exempt from tax some or all of a capital gain from the disposal of a capital asset that is used in the individual’s business operations.
Given the complexity of these rules, we recommend that you discuss your specific circumstances with your tax adviser.