Tax Brief - New Corporate Loss Measures
After extended consultation and some modest re-drafting, legislation to enact proposed amendments to the corporate loss rules was introduced into Parliament on 14 September. The gestation of these measures has been protracted: the original proposal was outlined in our Tax Brief [available at http://www.gf.com.au/articles_272.htm] on the Assistant Treasurer’s announcement in April 2004 and draft legislation was released for comment in February 2005.
This Tax Brief details the main effects of the new legislative regime. The new rules will significantly affect the ability of companies to utilise their tax losses and some other tax attributes on an ongoing basis. We will focus our discussion on the effects of the rules for companies with prior year tax losses, but it is important to remember that these same rules also apply to a company with carry forward net capital losses, bad debts and foreign losses, and will affect the amount of losses able to be brought into a consolidated group. These rules also affect the position of corporate limited partnerships and those trusts which head consolidated groups (though not unconsolidated trusts that are taxed as companies).
Background
Under current law, a change to the majority ownership of a company will put its prior year losses in jeopardy unless the company continues to carry on the same business. It is no secret that Treasury is displeased with this position. Indeed, one proposal put to the Review of Business Taxation was that companies should always be denied the ability to carry forward losses after a change of ownership. That proposal did not find its way into the Committee’s final report, but only at the price of a minefield of detailed anti loss-duplication rules.
That outcome proved to be a delay, not a defeat. On Thursday 7 April, 2004, Treasury released its discussion paper, Loss Recoupment Rules for Companies. In it, Treasury argued that:
“companies excessively rely on the [same business test] to recoup prior year losses because of growing concern and cost associated with demonstrating the [continuity of ownership test] has been met.”
That “excessive reliance” comes about because of the difficulties companies, especially listed companies, face in attempting to comply with the rules which require them to identify and track the ultimate owners of the company before losses can be claimed. These rules often require tracing shareholdings through multiple layers of companies and trusts, many of which will be offshore. Being set the implausible task of accurate monitoring, companies often need to rely on the alternative of the “same business test” to support the use of their losses.
The new legislation offers the same trade-off originally proposed: the circumstances where a change of ownership will occur will be somewhat relaxed for large companies, but the same business test will not be available to them. Hence, where a change to majority ownership occurs, any carry forward losses will be extinguished. But in the usual way of things in the tax world, the minefield of detailed anti loss-duplication rules introduced in 1999 remains unaffected even though the reason for the minefield is now less compelling.
Modified continuity of ownership test
The Bill will enact a new slightly less stringent means of determining whether adequate continuity of ownership has been maintained for a select group of companies. Companies which qualify for the new regime will enjoy two benefits:
- the method of determining whether the ultimate owners of a company have changed is modified, and
- the number of occasions on which a company is required to undertake the identification of its ultimate owners is now stipulated.
Companies which qualify
The modified continuity of ownership test [COT] will apply to listed companies, companies with more than 50 shareholders (unless ownership is concentrated in a group of 20 shareholders or less), and companies that are majority-owned subsidiaries of listed companies, non-profit companies, charities, superannuation funds (including some non-resident funds), certain managed investment schemes and some other companies.
Tracing to (and through) owners
The first concession arises from the way in which a company determines whether there has been a change to the owners of the loss company. The legislation adopts two strategies – sometimes, the shares of different people are added together and ascribed to a single fictitious owner, and sometimes the legislation relaxes the need to trace through intermediaries, instead treating the intermediary as the ultimate owner. Either device will usually make it easier to demonstrate continuity of ownership.
The first set of modifications adopts the first strategy. All of the shares held by shareholders holding less than 10% of the issued capital are aggregated and attributed to a single notional shareholder. This rule can also be applied to shares held by a nominee where they can be disaggregated and allocated to various owners. In order to deal with fluctuations in the size of small shareholdings, the size of the small shareholdings is capped at the size at the beginning of the year in which the loss was incurred.
A second set of modifications adjusts the rules for identifying owners with an indirect interest in the company – that is, holding an interest in the loss company via an interposed company, trust or other arrangement:
- The loss company will not be required to trace indirect holdings which represent less than 10% of the loss company. So, for example, if a fixed trust holds 12% of the issued shares of the loss company on trust for two equal beneficiaries, it will not be necessary for the loss company to verify the identity of the beneficiaries. Rather, the 6% of the loss company effectively owned by each beneficiary will be aggregated and the trustee will be treated as the owner of 12% of the loss company. Given that the loss company still has to verify that these are the facts, there is perhaps only a modest saving in effort.
- Where a widely-held company (that is, a listed company or a company with more than 50 shareholders) holds between 10% and 50% of the issued shares of the loss company, it is treated as the ultimate owner of the shares; it is not necessary to trace through the widely-held company to verify the identity of its shareholders.
- It is also not necessary to attempt to trace through some types of interposed entities. Where shares or interests in shares in the loss company are held by a superannuation fund, managed investment scheme, mutual insurance company, trade union or some other special companies, this entity is treated as beneficial owner of the shares or interests, subject to conditions.
The rules also attempt to deal with the problem of tracing through some kinds of offshore vehicles – for example, shares held by intermediaries which have issued bearer interests to their owners, and shares held via depositary arrangements.
Occasions which require testing
The new rules also amend the current requirements with regard to the occasions when a company must test its ownership. A company will be required to test for continuity of ownership by comparing ownership at the start of the loss year with the ownership at:
- the end of each tax year; and
- any occasion on which there is a “corporate change” whether to the loss company, or to a company holding more than 50% of the shares in the loss company. The term “corporate change” is used to refer to events such as takeovers, schemes of arrangement, significant share placements or issues.
Effective date
Prima facie, the modified COT rules apply to losses and other tax benefits incurred in the 2002-03 and subsequent years of income – that is, these rules are operative now, and indeed are backdated to the 2002-03 year of income.
However, this backdating can be reversed for losses incurred in the 2002-03, 2003-04 and 2004-05 years of income. For these years, a company can instead elect to have the former COT rules continue to apply.
Removal of the same business test
The quid-pro-quo for the relaxed COT rules is the removal of access to the same business test [SBT] for large companies.
The Bill will preclude companies (or corporate groups) with total income exceeding $100m from relying on the SBT to maintain their losses. The $100m ceiling applies to the year (or shorter period, adjusted as needed) in which the taxpayer wishes to claim the benefit of the loss and is tested annually. Given that there is a choice whether and when to claim a carry forward loss, and when to write off a bad debt, there may be some scope for affected taxpayers to delay or accelerate the claiming of a loss or bad debt based on the year’s income profile. It is also curious that the $100m ceiling is calculated separately for each individual company – there are no special grouping rules for these purposes, although companies which have elected to form a consolidated group will find their income automatically aggregated. But outside consolidation, the income of related companies is not aggregated.
The calculation of $100m in total income is complex. The rules require the taxpayer to include assessable income, exempt income and non-assessable non-exempt income, but then to exclude net capital gains, amounts representing GST collected on sales and other amounts.
The removal of access to the SBT applies to tax losses, net capital losses and foreign losses incurred in the 2005-06 and later years of income. The removal of access to the SBT for bad debts applies to bad debts written off in the 2005-06 and later years of income.
Other measures
The Government has also taken the opportunity in the Bill to do some housekeeping – to fix some, though by no means all, of the problems that these rules currently generate.
First, the Bill will reverse the impact of the High Court decision in the Linter Textiles case. In that case, the High Court held that tax losses did not survive the appointment of a liquidator because the existing shareholders lost control of the company to the liquidator. The Bill will reverse this result.
The Bill also attempts to make the tests which have to be applied (measuring rights to vote, receive dividends and capital) relevant for non-profit companies and mutual companies. These kinds of companies will not pay dividends or return capital and so tests based on dividends and capital could not be met. These kinds of companies will now need only to satisfy the test concerning control of voting power.
The Bill also attempts to regularise the position of shares and interests in shares in loss companies held by Commonwealth and State governments, foreign governments, some statutory corporations, non-profit organisations and charities. These entities will now be treated as owners of their shares, rather than as intermediaries for other persons.
Comments
Despite the extensive consultation, the Bill as released does not address many of the criticisms directed at the Exposure Draft during the consultation period.
Despite the existence of the debt-equity rules since 2001, the new regime is still framed around interests which are “shares.” This legacy will create interesting problems for companies with shares that are debt interests – many will no longer be able to rely on the SBT to avoid having to negotiate the implications of issuing and redeeming shares which are debt interests, and paying dividends on these shares.
Despite many submissions, the regime still divides the world into three groups – large corporates (who will usually benefit from the modified COT rules but at the cost of denial of access to the SBT); small corporates (who will rarely benefit from the modified COT rules but retain access to the SBT); and the rest (who do not benefit from the modified COT rules and may be denied access to the SBT). This third group contains the real losers from this regime. They are perhaps few in number, but are still significant companies with a turnover exceeding $100m per annum.
Unhappily, other issues with the treatment of losses remain unaffected by these rules. In so far as a company has to rely on the ownership of a parcel of shares held by a fixed trust, the company will still face the difficulty that many trusts which would seem to be “fixed” will not meet the test in the legislation.
Finally, the loss of access to the SBT will clearly have commercial impacts and international implications. In some industries, the commercial practice is to put research and development, infrastructure projects or capital-intensive operations into special purpose companies which are then sold if and when the venture moves into a more stable phase. This strategy will have to be re-thought – these companies would lose the benefit of their losses if their turnover exceeds the $100m threshold.
And the local subsidiaries of foreign multi-nationals may find themselves with very unhappy outcomes from the loss of access to the SBT. A merger occurring in Japan or the UK can easily result in the cancellation of the tax losses of the Australian subsidiary. The millions invested in development costs for a new product will disappear and the local subsidiary will suddenly find itself paying tax much sooner than it had expected, and on a figure which bears little resemblance to its true profit.
For further information, please contact,
Michael Moschner
61 2 9225 5969
michael.moschner@gf.com.au
www.gf.com.au