Recent Developments in Tax Losses for Companies

Transcription

1 Recent Developments in Tax Losses for Companies 9-11 September Introduction This paper addresses the following recent developments in the tax recognition of corporate losses: the proposal to simplify the Continuity of Ownership Test (COT) for widely held companies and eligible subsidiaries refer 3. below; the proposal to remove the Same Business Test (SBT) as a basis for recouping tax losses where total income exceeds $100m in a year refer 4. below; (c) the Commissioner's view on the application of the SBT to consolidated groups refer 5. below; and (d) certain miscellaneous developments: tax losses for excess franking offsets; holding back prior year tax losses; testing times for the SBT refer 6. below. mafm M v Page 1

2 2. Context of Recent Reforms to COT and SBT The proposed changes to simplify the COT and limit access to the SBT are based on the following concerns. The first is that the concessions currently available in Division 166 of the Income Tax Assessment Act 1997 (ITAA 1997) are considered inadequate because: the concessions are only available to publicly listed companies and their 100% subsidiaries; the notional 1% shareholder concession is too low and is effectively subject to the Commissioner's discretion; and significant compliance costs are often incurred by companies in testing for a change in ownership, particularly where tracing of beneficial ownership is required through several layers of shareholders and given that testing is required each time there is an 'abnormal trading' event. The second reason is that companies have become too reliant on the SBT to access deductions for losses. The Government has stated that the SBT was always intended to have a limited use. Also, with the introduction of tax consolidation, a number of practical problems have arisen in applying the SBT. In a consolidated group, it is the head company that is taken to have carried on the 'relevant business', taking into account all the activities undertaken by it and its subsidiary members. In the case of very large consolidated groups, there is the concern that the head companies of these groups would rarely fail the SBT on the basis that they undertake such a wide range of activities that changes to those activities may not constitute a change to the overall 'business'. In light of these concerns, the Government decided that reform was needed. You will see in 3. and 4. below that the broad effect of these reforms is that, while the COT will be simplified and improved, it will come at the expense of limited access to the SBT. Notwithstanding this, the reforms are, for the most part, an improvement to the current position. However, it is noted that with the announcement of the Federal Government election, the status of these proposals (and all other pending tax changes) have become uncertain. If the Government is re-elected, it is expected that these proposals will be implemented. However, if a new government is elected, the underlying policy in relation to these reforms may be revisited, in which case, modifications may be made or the reforms may be abandoned altogether. mafm M v Page 2

3 3. The Continuity of Ownership concessions (from 1 July 2002) 3.1 Proposed changes: Prior year tax losses are generally only available for recoupment where a company satisfies the COT or the SBT. On 7 April 2004, the Australian Government issued a press release and Treasury paper, Loss Recoupment Rules for Companies (Treasury Paper) outlining proposals to simplify the COT and limit access to the SBT. The simplified COT will apply to: widely held companies (listed companies and unlisted companies with more than 50 members where no 20 or fewer persons hold 75% or more of the voting, dividend or capital distribution rights); and eligible subsidiaries (companies where shares carrying more than 50% of the relevant rights are directly or indirectly held by one or more widely held companies and/or deemed beneficial owners). Companies eligible to apply the simplified COT will retain the right to choose to apply the current test without these modifications. The proposed amendments to simplify the COT will apply to: tax losses; net capital losses; income/capital losses of part years; unrealised net losses; and bad debts. The proposals to simplify the COT are as follows: (c) (d) All direct shareholdings of less than 10% in a widely held company or eligible subsidiary will be treated as if owned by a single notional entity. Tracing beneficial ownership through these companies will not be required. (Currently, a 1% single notional shareholder concession is available for listed public companies, but is effectively subject to the Commissioner's discretion. This will be removed.) All indirect shareholdings of less than 10% will be deemed to be beneficially owned by the interposed entity. The test for continuity of ownership will be at the start of the loss year, the end of the income year in which the loss is claimed and at the end of any intervening year. The current requirement to test where there is 'abnormal trading' will be removed. mafm M v Page 3

4 (e) (f) (g) (h) There will be no tracing through widely held companies unless they hold (directly or indirectly) more than 50% of the relevant rights. There will be no tracing through deemed beneficial owners (such as complying superannuation funds, complying approved deposit funds, special companies, managed investment funds with more than 20 members and non-profit organisations) interposed between the company and persons controlling them. The COT will not be failed merely because a company enters liquidation. The following special rules for non-residents are proposed: (i) (ii) where a loss company seeks to trace beneficial ownership through a listed non-resident shareholder company and 50% or more of the relevant rights in that shareholder company are held through depository entities who are prevented by law from disclosing information about beneficial ownership, then those depository entities will be treated as deemed beneficial owners - except to the extent that the true beneficial owners have been disclosed to the non-resident shareholder company; where a loss company seeks to trace beneficial ownership through a listed non-resident shareholder company and 50% or more of the relevant rights in that shareholder company are held through bearer shares, then those shares will be deemed to be held by a single notional shareholder - except to the extent that the true beneficial owners have been disclosed to the non-resident shareholder company. (i) Two integrity rules are proposed: (A) Concessionary tracing rules will not apply in circumstances where: there would be a breach of the COT if the tracing concessions were not applied; the breach did not occur by reason only of the sale of shares in the ordinary course of trading; and the company knew or could reasonably be expected to have known at that time that without the concessionary tracing rules there would be a breach of the COT. In establishing whether the company has sold shares outside the ordinary course of trading, it may be relevant to consider factors such as: whether the shares are being acquired pursuant to a takeover bid; the number and timing of shares traded; and any connection between the sale of shares and any tax loss in the company. In establishing whether a company could reasonably have been expected to know of a breach in the COT, it may be relevant to consider factors such as: mafm M v Page 4

5 any notices of substantial shareholdings provided to the loss company or its corporate shareholders as required under corporations law, or any changes to the share capital of the loss company. (B) Tracing of beneficial ownership will be required in circumstances where an entity, or group of entities, acting together control the loss company, until the loss company seeks to trace through the controlling entity(ies). mafm M v Page 5

6 3.2 Example: other shareholders John (all less than 15.38%) Coy F Coy G 40% 60% 50% 50% Coy A Coy B Listed Coy C Complying Super Fund Coy E 2% 3% 65% 18% 12% Loss Company (c) (d) (e) (f) (g) As Coy A and Coy B have a less than 10% shareholding each in Loss Company, they are treated as one shareholder. Tracing of beneficial ownership through these companies is not required. Complying Super Fund is a 'deemed beneficial owner'. Therefore tracing of beneficial ownership is not required. Coy E is not a widely held company and has greater than 10% shareholding in Loss Company. Therefore tracing of beneficial ownership through Coy E is required. Coy F and Coy G each have a 6.0% indirect interest in Loss Company (50% x 12%). Since each of the 6.0% indirect interests in Loss Company is less than 10% of relevant rights, each of the indirect interests are attributed to Coy E. Tracing is required through Listed Coy C because although Listed Coy C is a widely held company, it owns more than 50% of the interest in Loss Company. John's indirect interest in Loss company is 26% (40% x 65%) and is attributed to John. Each of the other shareholders have less than 15.38% interest in the interposed entity Listed Coy C. As all other indirect interests held through Listed Coy C are less than 10% of the relevant rights (15.38% x 65%), the remaining 39% indirect interest (60% x 65%) is attributed to Listed Coy C. mafm M v Page 6

7 3.3 Unintended Change in Majority Ownership An issue to be aware of is where there is an unintended change in continuity of ownership because of the concessional tracing rules. Consider the following example: Year One B C 6% indirect 6% indirect A Listed Co 12% 40% Complying Super Fund 48% Loss Co In Year 1: Tracing of beneficial ownership is not required beyond Listed Co and the Complying Super Fund as Listed Co holds less than a 50% interest and the Complying Super Fund is a deemed beneficial owner. Tracing is required beyond A Company as it holds more than a 10% interest. However, because both B and C each hold less than 10% (ie 50% x 12%), A is treated as the holder. mafm M v Page 7

8 Year Two B C 5% 1% indirect 11% indirect A Listed Co 12% 40% Complying Super Fund 48% Loss Co Third Party In Year 2: What happens if B sells 5% to C, resulting in B holding a 1% interest and C holding an 11% interest? In such circumstances, A Company will be deemed to hold B's 1% interest, but tracing the beneficial ownership will be required beyond CCompany as it now holds more than 10%. Even once tracing is complete, COT will be satisfied as there is no change in majority ownership. However, what happens if the Complying Super Fund also sells its 48% interest to a third party? Strictly speaking, there is still no change in majority ownership. However, the effect of the COT tracing rules suggests that there is, as not only has a 48% interest been transferred to a third party, but C Company (or its beneficial owners, assuming further tracing is required) is now taken to own the 11%. This is clearly an unintended consequence as the tracing rules are supposed to be concessional. We understand that Treasury is aware of this issue and hopefully it will be properly addressed when legislation is released effecting the proposal. mafm M v Page 8

9 3.4 Date of effect: Although not yet legislated, it is proposed that the simplified COT will apply in relation to income years commencing on or after 1 July It is proposed that the simplified COT will apply to: losses incurred in an income year commencing on or after 1 July 2002; and losses incurred before 1 July 2002, where the company would be entitled to utilise the loss in the first income year commencing on or after 1 July 2002 (assuming that the company had sufficient income to utilise the loss) hence for pre-1 July 2002 losses it will be necessary to demonstrate that the COT is satisfied in respect of the first income year commencing on or after 1 July mafm M v Page 9

10 4. Limiting access to the Same Business Test 4.1 Proposed change: Currently, where a company fails the COT, the company is generally able to recoup prior year tax losses if it satisfies the SBT. The Treasury Paper outlines the proposal that companies and consolidated groups with total income in excess of $100m in the income year will not be entitled to rely upon the SBT as a basis for recouping losses in that income year. In these circumstances, the losses will only be able to be recouped if the COT is passed. The SBT will remain as a basis for recouping losses for companies and consolidated groups with total income equal to or less than $100m in an income year. A company will exceed the SBT ceiling if its total income in a year exceeds $100m. In this respect: it seems that 'total income' is the sum of assessable income, exempt income, nonassessable non-exempt income, and net capital gains; the SBT ceiling appears to be a year-by-year test. That is, a company that has total income of $120m in 2006 cannot rely upon the SBT in that year, but it can rely upon the test in 2007 if its total income in that year is $90m; (c) it will be necessary for the legislation to contain rules that allow the $100m threshold to be calculated by reference to income years of less than twelve months (where relevant). 4.2 Date of effect: Although not yet legislated, it is proposed that this measure will apply to income years commencing on or after 1 July 2004, for losses incurred in income years commencing on or after 1 July Accordingly, the SBT will still be available as a basis for recouping tax losses in respect of losses incurred in an income year commencing prior to 1 July This is an important point, as: Most existing corporate groups will form a consolidated group with effect from a date prior to 1 July For a number of these groups, the formation of the consolidated group has generated substantial 'formation losses', being: (i) the five year capital losses arising under CGT Event L1, which arise in lieu of being able to push down Division 149 deemed market value cost base (refer section of ITAA 1997); mafm M v Page 10

11 (ii) (iii) the capital losses arising under CGT Event L4, which arise when an entity has ACA in excess of its retained cost base assets and no reset cost base assets (refer section ); the capital losses arising under CGT Event L8, which arise when an entity has ACA in excess of the market value cap on its relevant reset cost base assets (refer section ). (c) (d) The losses described in (i), (ii) and (iii) are deemed to arise at the time of the formation of the consolidated group. Where formation occurs prior to 1 July 2004, the head company has access to both the simplified COT and the SBT in recouping these losses (whereas it would only be able to rely upon the simplified COT if the consolidated group was formed on or after 1 July 2004 and the group exceeded the $100m threshold). 4.3 Impact on Acquisitions It is interesting to reflect upon the impact of the SBT ceiling in the context of corporate acquisitions. (c) The question of whether the purchaser of a company should place any value on tax losses of a target company has been somewhat vexed. The value placed on the tax losses of a target company seems to vary across different industry sectors and, of course, it varies in line with the risk profile of particular purchasers. For example, the extraordinarily dynamic nature of the internet service provider sector has made it extremely difficult for purchasers in that sector to satisfy the SBT. On the other hand, the SBT will be more readily satisfied where the relevant business is relatively passive, such as that of a holding company. Nevertheless, the purchaser of a target company has always at least turned its mind to the question of whether the target has available tax losses. Of course the tax consolidation rules have significantly altered the landscape in this respect. Three of the key factors arising from the tax consolidation rules are: (i) (ii) (iii) the purchaser will not acquire any tax losses if the target company is a member of the vendor consolidated group the purchaser's ability to acquire the tax losses of a target is limited to circumstances in which the target is the head company of a consolidated group or a non-consolidated entity; the rate at which the purchaser is able to utilise any acquired tax losses is limited by the available fraction rules (Subdivision 707-C, ITAA 1997); and the acquisition of tax losses from the target can dilute the quantum of ACA that can be 'pushed down' on to the underlying assets of the target (section Steps 5 and 6, sections and , ITAA 1997). (d) However, as a consequence of the SBT ceiling proposal, the purchaser will be faced with a number of new considerations. mafm M v Page 11

12 (e) (f) First, as the SBT ceiling only applies to losses incurred on or after 1 July 2004, the purchaser will need to identify the extent to which the target's losses arose prior to 1 July To the extent that the target has pre-1 July 2004 losses, the purchaser will value the acquisition of such losses by reference to the factors discussed above, ie the likelihood of satisfying the SBT, risk profile, dilution of ACA, etc. Second, the purchaser will need to identify whether the target has total income in excess of the $100m threshold in the year of acquisition (presumably, the rules will be adjusted for part years). If the threshold is exceeded, then the purchaser cannot acquire the target's losses. In this respect the purchaser would need access to reasonably detailed data of the target and, at the very least, it will need co-operation and dialogue with relevant personnel of the target. This may create issues of its own, as the dynamics of 'price negotiation' between purchasers and targets have tended to involve the purchaser denying any interest in the target's losses (and thus being unwilling to pay extra for such losses). 4.4 Impact on Disposals Once a company or consolidated group has failed the COT, it will need to monitor its total income by reference to the $100m threshold. In this respect, note: in many cases, a company will want to utilise prior year tax losses to shelter the gain that arises from the disposal of a business, asset or subsidiary. However, as the $100m threshold is calculated on total income, the gain arising from the sale of the business, asset or subsidiary will be taken into account as part of the total income for the year in which the sale occurs. Hence the loss denial effect of the SBT ceiling is somewhat 'self executing'; however, note that the definition of 'total income' for these purposes is expected to include net capital gains. This means that, to the extent possible, companies will aim to execute loss-making sale transactions on capital account in the same income year in which gain-making sale transactions on capital account occur. 4.5 Impact of Division 165-CC The SBT ceiling proposal will have a significant impact on transactions involving 'Division 165-CC tagged assets'. Consider the following example. (c) HC is the head company of a consolidated group with a 30 June year end. In September 2005, 60% of the shares in HC are acquired by a new shareholder such that HC suffers a 'changeover time' for the purposes of Subdivision 165-CC of the ITAA At the changeover time, HC owned a building with a tax cost of $80m and a market value of $50m. Having regard to HC's other assets, assume that HC had a net unrealised loss at the changeover time of $25m. In August 2006, HC sells the building to a third party purchaser for $60m. As a consequence of the September 2005 changeover time, the building sold to the mafm M v Page 12

13 third party is a '165-CC tagged asset', meaning that the loss on the sale of the building is denied unless HC can satisfy the SBT (section B, ITAA 1997). (d) If HC's total income for YE 30 June 2007 exceeds $100m, the SBT ceiling proposal will preclude HC from relying upon the SBT as a basis for recouping a tax loss. As the loss arising from the sale of the 165-CC tagged asset (ie the building) can only be recouped by satisfying the SBT, then it seems that the HC will be denied the $20m loss arising from the sale of the building. Hence it seems that one key implication of the SBT ceiling proposal for companies and consolidated groups that exceed the $100m ceiling is that net unrealised losses which exist at the time of a change in majority ownership will be denied once the losses are realised. 4.6 Impact on Project Finance Project finance structures often rely upon a financial model under which the project vehicle is to be sheltered from tax by carry forward tax losses for a number of years. This type of arrangement effectively ensures that the debt providers are repaid principal and interest from pre-tax cash flows. Where the project generates total income in excess of $100m, the debt providers are clearly exposed to the risk of changes in ownership of the project vehicle over the period for which it is expected that the vehicle's income is to be sheltered by carry forward tax losses. mafm M v Page 13

14 5. Same Business Test and Consolidated Groups The application of the SBT to consolidated groups and MEC groups is a substantial topic in itself and is beyond the scope of this paper. However, it is relevant to note the following: (c) (d) (e) The ATO has acknowledged the difficulties that arise from applying the current SBT to consolidated groups and MEC groups, and in particular the ATO acknowledges the difficulties that arise from the Single Entity Rule (section 701-1, ITAA 1997). The ATO has released a non-binding discussion paper on the application of the SBT to consolidated groups. It is intended that the discussion paper be used by the ATO to draft a Taxation Ruling on this issue. The discussion paper addresses four potential interpretative approaches to this issue, one of which is the 'divisional approach'. It is stated that taxpayers will not be exposed to penalties on amended assessments if they apply the divisional approach and the ATO ultimately decides to adopt a different approach. (f) The divisional approach adopts a literal application of the Single Entity Rule under this approach the head company is taken to carry on one single business incorporating all activities conducted by all members of the group. Hence the group is treated as a single entity operating a single business along divisional lines for the purposes of the SBT. (g) Under the Divisional approach, the ATO would apply the principles set out in TR1999/9 for the purposes of applying the SBT to the single, multi-divisional business of the head company. mafm M v Page 14

15 6. Miscellaneous Developments 6.1 Avoiding wastage of current year tax losses Statement of change Provisions in the Taxation Laws Amendment Act (No. 5) 2003, which received Royal Assent on 17 December 2003, enable certain entities to convert excess franking offsets in a year into an equivalent amount of tax losses and be carried forward for deduction in later years of income. These provisions apply to corporate tax entities (including head companies of consolidated groups) which are not generally entitled to a refund of excess franking offsets, namely companies, corporate limited partnerships, corporate unit trusts and public trading trusts. The tax loss is calculated as follows: Step 1: Calculate the entity's franking offsets from receiving franked dividends. Step 2: Calculate the entity's income tax payable, ignoring the franking offsets. (c) Step 3: If Step 1 amount is greater than Step 2 amount, the difference between Step 1 and Step 2 amounts is the excess franking offset amount. (d) Step 4: Divide the excess franking offset amount by 30% tax rate to convert amount to a tax loss. (e) Step 5: Work out the entity's tax loss for the year (ignoring net exempt income) and add this amount to Step 4 amount. (f) Step 6: From Step 5 amount deduct net exempt income. This amount is the tax loss for the year. If it is a negative/nil amount, the tax loss is nil for the year. mafm M v Page 15

16 Examples Company A Company B Trading income Franked dividend 70 (30 fr. cr.) 70 (30 fr. cr.) Deductions Taxable income (ignoring offsets) = = nil Note: There is a $40 excess of deductions over grossed up assessable income Tax (A) 160 x 30% = $48 Nil Tax offset (B) $30 franking credit $30 franking credit Excess franking offset (excess of B over A) Nil $30 Tax loss (excess of deductions over assessable income, plus excess franking offset divided by 30%) Nil 40+(30 0.3) = $140 Date of effect: Applies to the income year in which 1 July 2002 falls and later income years. 6.2 Electing to hold back prior year tax losses Statement of change Provisions in the Taxation Laws Amendment Act (No. 5) 2003 amend the rules relating to the utilisation of prior year tax losses by corporate tax entities. Broadly, these rules enable corporate tax entities to choose the amount of prior year losses they will deduct against excess assessable income in a later year (after offsetting the prior year tax loss against any net exempt income). The entity can choose a nil amount. The amount of the prior year loss that the entity can choose to apply against its current year excess assessable income is subject to the following: mafm M v Page 16

17 if, ignoring the tax losses, the entity would have excess franking offsets for the year, the entity must choose a nil amount; if, ignoring the tax losses, the entity would have no excess franking offset for the year, it must not choose an amount that would cause the entity to have excess franking offsets for the year. These limitations ensure that prior year losses are not able to be 'refreshed' as current year losses. The entity makes the choice as to the amount of the prior year tax loss to be deducted against excess assessable income in the entity's income tax return as lodged with the ATO. In the circumstance where an entity has more than one tax loss, it must deduct the losses in the order in which they were incurred. mafm M v Page 17

18 Example: Trading income 100 Company C Franked dividend 70 (30 fr. cr.) Deductions 100 Prior year tax loss 90 Taxable income = 100 Tax payable 100 x 30% = $30 Available tax offset $30 Comment If C were to apply its $90 prior year tax loss, this would reduce the tax payable to less than $30 and, therefore, the prior year loss would be wasted on $100 taxable income that is otherwise fully sheltered by the $30 tax offset. This would also produce an excess franking offset. The provisions state that C is not permitted to apply the prior year tax loss and, as a consequence, C does not waste the $90 prior year tax loss. Note the integrity aspect. If C were permitted to apply the prior year tax loss, it would have the effect of generating an excess franking offset and would therefore generate a tax loss. If that were allowed to occur, the prior year tax loss would be refreshed in the current year. Date of effect: Applies to deductions of tax losses in the income year in which 1 July 2002 falls and later income years. 6.3 Testing Times for Same Business Test If a company fails the COT, it may be able to rely on the SBT to recoup its losses. In order for a company to satisfy the SBT, it must be able to demonstrate that it carried on the 'same business' both immediately before the disqualifying change of ownership and during the year it claims the loss. mafm M v Page 18

19 Provisions in the Taxation Laws Amendment Act (No. 5) 2003 amended Division 165 of the ITAA 1997 to remove an anomaly that was precluding some companies from accessing the SBT on the basis that they were unable to establish the precise date on which they failed the COT. The amendments in Taxation Laws Amendment Act (No. 5) 2003 widened the circumstances in which SBT would become available by providing a default test time at which SBT could be applied if a company were unable to determine precisely when it failed the COT. The effect of these amendments is that the test time for application for SBT is now the latest time that a company can show it failed the COT. However, if this is not possible, a default test time can be used, which is the start of the loss year, or if the company came into existence during the loss year, the end of the loss year. In most cases, if the default test time is used, it will be harder to pass the SBT as the relevant test period will be longer. Accordingly, it is still in the interests of companies to be able to determine the precise date they fail the COT. Date of effect: Applies to the use of SBT starting from the 1997/98 income year. Martin Fry and Brad Schwarz 8 September mafm M v Page 19