Tax losses carry-backs and carry-forwards, issues and challenges June 2013

Transcription

1 Tax losses carry-backs and carry-forwards, issues and challenges June 2013 Presented by: Institute of Chartered Accountants Australia

2 Disclaimer The Institute of Chartered Accountants in Australia owns the copyright in this document. The document must not be copied or made available to third parties, in whole or in part, in any form or by any means, without the prior written consent of The Institute. The contents are for general information only. They are not intended as professional advice - for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute expressly disclaims all liability for any loss or damage arising from reliance upon any information in these papers. Copyright The Institute of Chartered Accountants in Australia

3 Table of Contents 1. Introduction Overview Methodology for deducting prior year tax losses How to calculate a tax loss for an income year How to deduct tax losses Entities other than corporate tax entities No net exempt income Net exempt income General rules for entities that are not corporate tax entities in deducting tax loss Corporate tax entities No net exempt income Net exempt income Limits on choosing the amount of tax losses to deduct excess franking offsets Converting excess franking offsets into tax losses General rules for corporate tax entities in deducting tax loss Adjustments required if subsequent amendment to tax position Net exempt income Net exempt income of Australian resident Net exempt income of a foreign resident Special rules about tax losses Individuals Losses from hobbies General deductions Carrying on a business Non-commercial business losses Deferral of non-commercial business losses Non-commercial business losses Exempt income Blackhole expenditure Non-commercial business activities Grouped non-commercial business activities Exception Profits test Real property test Copyright The Institute of Chartered Accountants in Australia

4 Other assets test Commissioner s discretion Modifications for bankruptcy Application to certain partnerships Companies Rules for Use of Prior Year Tax Losses by Companies Continuity of ownership test General continuity of ownership test rules Proposed modifications clarifying aspects of the COT Special continuity of ownership test rules Saving provision Same business test Same business test period The same business test requirements Positive requirement Cases where positive requirement satisfied Cases where positive requirement failed Negative requirements Anti-avoidance test Applying net capital losses of earlier income year Division 166 concessional tracing rules Which entities are able to rely on Division 166? Point-in-time testing Concessionary tracing rules Other special rules in Division Final points on Division Change in control of voting power Application is optional Loss carry-back regime Overview of the loss carry back regime Entities eligible for loss carry-back Choice to apply the loss carry-back regime Relationship between loss carry-back and loss carry-forward Losses which are subject to the loss carry-back regime Franking credit cap Calculation of the loss carry-back tax offset Copyright The Institute of Chartered Accountants in Australia

5 4.6.8 Examples Overview of the loss carry-back integrity measure Key elements of the loss carry-back integrity measure Relevant Circumstances Examples Proposed improvements to the company loss recoupment rules Modifications to the continuity of ownership test Extension of the concessional tracing rules under the modified continuity of ownership test Holding company interposed between a direct stakeholder and the tested company Demerger by a top interposed entity Entity interposed between a superannuation fund and the tested company Bearer depository receipts Applying the modified COT following an issue of new shares Loss integrity rules low value asset exclusion Proposed tax loss incentive for designated infrastructure projects Common errors when utilising tax losses Common errors ATO target areas Record keeping Modifications Tax losses and consolidated groups Overview Transfer of carried forward tax losses Utilisation of tax losses by head company of consolidated group Foreign Losses Trusts A summary of the trust loss rules Important definitions Fixed trust Non-fixed trust Closely held trust Widely held trust Unlisted and listed widely held trusts Unlisted very widely held trust Copyright The Institute of Chartered Accountants in Australia

6 7.6.3 Wholesale widely held trust Family trust Excepted trust Fixed trusts, not widely held unit trusts or excepted trusts % stake test Non-fixed trust stake test Non-fixed trusts % stake test Pattern of distributions test Control Income injection test Introduction Elements of the test The trust must have an allowable deduction There must be a scheme There must be a connection between the deduction and one or more of the things that happen under the scheme Examples Restricting tax deductions for related party debt Current Law Debts which are outside of the TOFA regime Debts which fall within the TOFA regime Impact of the proposed amendments What is a related party? Application date Copyright The Institute of Chartered Accountants in Australia

7 1. Introduction This paper, aimed at an intermediate to advanced audience, discusses the recoupment of tax losses by individuals, trusts and companies pursuant to the Income Tax Assessment Act 1997 (ITAA 1997) and Income Tax Assessment Act 1936 (ITAA 1936). It also discusses the proposed loss carry-back rules for companies which are expected to apply from 1 July This paper is presented as part of The Institute of Chartered Accountants in Australia (Institute) special topics program. References to sections in this paper are references to the ITAA 1997, unless otherwise indicated. Copyright The Institute of Chartered Accountants in Australia

8 Copyright The Institute of Chartered Accountants in Australia

9 2. Overview 2.1 Methodology for deducting prior year tax losses Subdivision 36-A contains the key provisions dealing with deductions for tax losses of earlier years. It contains the rules for calculating the amount of the tax losses 1 and the method for deducting them 2. It also provides signposts to the special rules which apply to particular types of loss or taxpayer How to calculate a tax loss for an income year If a taxpayer s assessable income 4 for a particular income year exceeds the allowable deductions 5, the taxpayer will be taken to have taxable income equal to the excess. 6 Conversely, where the allowable deductions exceed the assessable income, the taxpayer will, in general terms, incur a tax loss for that year. 7 Specifically, section provides that a tax loss for a particular income year is calculated by: Adding the allowable deductions for the income year (excluding tax losses of earlier income years); Subtracting the total assessable income; and Subtracting any amount of net exempt income 8 (refer to Section any amount remaining is the tax loss for the income year (the loss year). below), 1 Section Sections and Section See Division 6 5 See Division 8 6 Section Subsection 36-10(4) 8 Section Copyright The Institute of Chartered Accountants in Australia

10 A tax loss does not entitle a taxpayer to any kind of tax refund for that year; instead, the loss remains available (subject to the satisfaction of any relevant general recoupment tests or until cancellation) to be deducted from taxable income derived in subsequent income years. This process is called carrying forward the loss. Note that the meaning of tax loss and loss year is modified by section which applies to corporate tax entities which have an amount of excess franking offsets. In addition, section specifies that certain allowable deductions cannot create or add to a tax loss. These allowable deductions include gifts, certain superannuation contributions and gratuities. 2.3 How to deduct tax losses Entities other than corporate tax entities Section sets out how tax losses are carried forward for deduction in later income years by an entity other than a corporate tax entity. Corporate tax entity is defined to mean a company, corporate limited partnership, corporate unit trust or a public trading trust. 9 The application of the carried forward tax losses against income depends upon whether the entity has net exempt income No net exempt income Generally, if the total assessable income for a later income year exceeds the total deductions for that year (ignoring the tax loss), the tax loss is deducted from that excess. 10 Where the tax loss is greater than the excess, the undeducted part of the tax loss is carried forward to the next income year. 11 There is no limit on this carry forward period (however, a 7 year limit applied to non-primary production losses incurred before the 1990 income year). 9 Section Subsection 36-15(2) 11 Subsection 36-15(7) Copyright The Institute of Chartered Accountants in Australia

11 If the total assessable income does not exceed the total deductions, then the tax loss cannot be deducted in that year, and is carried forward to later years Net exempt income In circumstances where the taxpayer has net exempt income in the income year in which the taxpayer seeks to apply the tax loss, the tax loss is deducted first from the net exempt income, and secondly from the part of the total assessable income that exceeds the total deductions. 13 However, if the deductions exceed the total assessable income, then that excess is subtracted from the net exempt income, and the tax loss is deducted from any net exempt income which remains. 14 Accordingly, the effect under either subsection is that any prior year tax losses (or current year losses) of the taxpayer will be automatically offset against the net exempt income of the taxpayer for the income year General rules for entities that are not corporate tax entities in deducting tax loss The tax losses that are deducted in accordance with section will also be subject to the following general rules: Tax losses are deducted in the order in which they are incurred; 15 Tax losses are deductible only to the extent that they have not already been deducted; 16 and The undeducted amount of a tax loss can be carried forward for deduction in later income years Subsection 36-15(7) 13 Subsection 36-15(3) 14 Subsection 36-15(4) 15 Subsection 36-15(5) 16 Subsection 36-15(6) 17 Subsection 36-15(7) Copyright The Institute of Chartered Accountants in Australia

12 Example 1 Xene incurs a loss of $25,000 in the 2011 income year. In the 2012 income year, Xene s total assessable income is $20,000 and deductions (other than for the tax loss) are $3,000, thus resulting in an excess of $17,000. Assuming that there is no net exempt income, the $25,000 is carried forward so as to reduce the $17,000 to nil. The balance of $8,000 is available to be carried forward to the 2013 and later income years. Example 2 Assume that in the 2013 income year, Xene s total assessable income is $50,000 and deductions (other than for the tax loss) are $10,000, resulting in an excess of $40,000. The unrecouped tax loss of $8,000 is carried forward so as to reduce the excess to $32,000. The tax loss is now fully recouped. Example 3 Assume the same facts as in Example 1, except that in the 2012 income year, Xene also has a net exempt income of $6,000. The $25,000 tax loss is deducted first against this $6,000. The balance $19,000 is then deducted from the $17,000 excess of total assessable income over deductions, so as to reduce the $17,000 to nil. The balance of the tax loss $2,000 is available to be carried forward to the 2013 income year and later income years. Example 4 Assume that in the 2013 income year, Xene s total assessable income is $50,000, and the deductions (ignoring the tax loss) are $10,000, resulting in an excess of $40,000. Assume also that Xene has net exempt income of $5,000. The balance of the tax loss $2,000 is deducted first against the $5,000, reducing it to $3,000. The tax loss is now exhausted and no part of it is available to be deducted against the excess of $40,000. Example 5 Assume instead that in the 2013 income year, Xene s total assessable income is $50,000, the deductions (ignoring the tax loss) are $65,000, and the net exempt income is $25,000. As the deductions exceed the total assessable income, the excess $15,000 is subtracted from the net exempt income, resulting in a balance of $10,000. The tax loss $2,000 is deducted from that balance, reducing it to $8,000. The tax loss is now exhausted. Copyright The Institute of Chartered Accountants in Australia

13 2.3.3 Corporate tax entities Section sets out how tax losses of corporate tax entities are carried forward for deduction in later income years. Section applies where the relevant entity is a corporate tax entity at any time during the later income year. The purpose of introducing section was to enable a corporate tax entity to choose the amount of prior year losses it wished to deduct in a later income year. This enables a corporate tax entity with carried forward tax losses: To ensure it does not waste the benefit of tax offsets for franking credits received in an income year where the corporate tax entity had current year or carried forward tax losses; and To pay sufficient tax to enable it to make franked distributions to its members. As with taxpayers that are not corporate tax entities, the application of the carried forward tax losses against income depends upon whether the corporate tax entity has net exempt income No net exempt income Subject to the limits prescribed in subsection 36-17(5) (see below), if the total assessable income for the later income year exceeds the total deductions for that year (ignoring the tax loss), the corporate tax entity may choose the amount of the tax loss that is deducted from the excess. 18 This is in contrast to section 36-15, which does not allow the taxpayer a choice in deducting tax losses. The corporate tax entity is able to effectively choose not to deduct any part of the tax losses by choosing to deduct a nil amount. The balance of any tax losses remaining after the chosen losses are deducted is carried forward to a later income year. 19 There is no limit on this carry forward period but the utilisation of tax losses in later income years is subject to the satisfaction of the general recoupment tests or cancellation. 18 Subsection 36-17(2) 19 Subsection 36-17(9) Copyright The Institute of Chartered Accountants in Australia

14 If the total assessable income does not exceed the total deductions, then the tax loss cannot be deducted in that year and is carried forward into the next year Net exempt income Where, in a later income year, the corporate tax entity has net exempt income and the entity s total assessable income for the later income year exceeds the total deductions for that year (ignoring the tax loss), the calculation involves two separate steps. The first step requires that the tax loss be deducted from the net exempt income. 21 There is no ability for the entity to choose not to deduct the tax losses against the net exempt income, even if the entity does not propose to deduct losses against the net assessable income. The second step requires the entity to deduct such amount of the tax loss as the entity chooses from the part of the total assessable income that exceeds the total deduction. effectively choose not to deduct any part of its losses against the assessable income by choosing to deduct a nil amount. If the deductions exceed the total assessable income, then that excess is subtracted from the net exempt income and the tax loss is deducted from any net exempt income that remains. 22 The entity can There is no ability for the corporate tax entity to choose not to deduct the excess against any net exempt income Limits on choosing the amount of tax losses to deduct excess franking offsets In making the choice of the amount of tax loss to be deducted, the corporate tax entity cannot choose an amount that would result in: The entity generating any excess franking offsets (see below) which would not otherwise have arisen if the entity had not chosen to deduct the tax loss; or 20 Subsection 36-17(9) 21 Paragraph 36-17(3)(a) 22 Paragraph 36-17(3)(b) 23 Subsection 36-17(4) Copyright The Institute of Chartered Accountants in Australia

15 The entity increasing any excess franking offsets that would otherwise have arisen if the entity had not chosen to deduct the tax loss. The meaning of excess franking offsets is set out in section Generally, an entity will have excess franking offsets for an income year to the extent that: The total non-refundable tax offsets of the entity under Division 207 (offsets for franking credits) and Subdivision 210-H (offsets for superannuation funds receiving distributions franked with a venture capital credit) exceed the amount of income tax that would be payable by the entity in respect of the income year, assuming: - The entity did not have those tax offsets; - The entity did not have any tax offsets that are subject to the tax offset carry forward rules in Division 65 or the refundable tax offset rules in Division 67; - The entity did not have any tax offsets in relation to franking deficit tax under section ; and - The entity had all its other tax offsets. The amount of the excess will be the entity s excess franking offsets for the income year. Broadly, this amount reflects the franking offsets received by a corporate tax entity during the income year that would otherwise be wasted on account of the entity s current year losses. Example 1 During the 2012 income year, Company A derives assessable income of $250 (consisting of a fully franked dividend of $140, franking credit of $60 and other income of $50) and incurs allowable income tax deductions amounting to $100. As at 1 July 2011, Company A had carried forward revenue losses of $500. As the tax offset of $60 attributable to Company A s franking credit is not stated to be subject to the refundable tax offset rules in Division 67, Company A has excess franking offsets of $15 for the 2012 income year, calculated as follows: Copyright The Institute of Chartered Accountants in Australia

16 Step 1: Determine income tax payable (disregarding offsets) Assessable income $250 Less: deductions ($100) Taxable income $150 Tax payable $45 Step 2: Determine non-refundable tax offsets under Division 207 or Division 210 Franking credit (Division 207) $60 Step 3: Determine excess franking offsets Franking credit (Division 207) $60 Less: Income tax payable ($45) Excess franking offsets $15 As Company A has excess franking offsets for the 2012 income year (ignoring Company A s tax losses), Company A will not be able to utilise any amount of its carried forward tax losses during the 2012 income year. 24 However, Company A may be able to convert its excess franking offsets into additional tax losses that can be carried forward by Company A, subject to satisfaction of the relevant loss integrity rules (or cancellation). 25 Further information about the conversion of excess franking offsets is provided at Section below. 24 Paragraph 36-17(5)(a) 25 Subsection 36-55(2) Copyright The Institute of Chartered Accountants in Australia

17 Example 2 During the 2012 income year, Company B derives assessable income of $200 (consisting of a franked dividend of $70, franking credit of $30 and other income of $100) and incurs allowable income tax deductions of $70. As at 1 July 2011, Company B had carried forward tax losses of $200. Company B does not have any excess franking offsets for the 2012 income year, as shown by the following calculation: Step 1: Determine income tax payable (disregarding offsets) Assessable income $200 Less: deductions ($70) Taxable income $130 Tax payable $39 Copyright The Institute of Chartered Accountants in Australia

18 Step 2: Determine non-refundable tax offsets under Division 207 or Division 210 Franking credit (Division 207) $30 Step 3: Determine excess franking offsets Franking credit (Division 207) $30 Less: Income tax payable ($39) Amount remaining / excess franking offsets ($9) / Nil As Company B does not have any excess franking offsets for the 2012 income year (ignoring Company B s tax losses), Company B will be able to utilise its carried forward tax losses to reduce its taxable income during the period, subject to satisfaction of the relevant loss integrity rules (or cancellation). However, Company B will only be entitled to utilise an amount of tax losses that would not result in Company B generating excess franking offsets for the 2012 income year. 26 On this basis, Company B will only be entitled to utilise a maximum of $30 of its carried forward tax losses for the 2012 income year, calculated using the following formula: $30 = (($200 - $70 - $X)*30%) Where: $30 is the value of Company B s non-refundable tax offsets for the 2012 income year; $200 is Company B s assessable income for the 2012 income year; $70 is Company B s allowable deductions for the 2012 income year; $X is the maximum value of carried forward losses which can be applied by Company B for the 2012 income year; and 30% is the corporate income tax rate for the 2012 income year. 26 Paragraph 36-17(5)(b) Copyright The Institute of Chartered Accountants in Australia

19 Converting excess franking offsets into tax losses In certain circumstances, a corporate tax entity may convert its excess franking offsets for an income year into additional tax losses in accordance with the method statement prescribed by subsection 36-55(2). Broadly, that method statement is designed to prevent a corporate tax entity s franking offsets for an income year being wasted on account of the entity s current year losses. The method statement is premised on the fact that corporate tax entities (unlike individuals) are generally not able to receive a refund in respect of franking credit offsets. 27 Pursuant to the method statement in subsection 36-55(2), where a corporate tax entity has an amount of excess franking offsets for an income year, its tax loss for the period will be determined as follows: Step 1: Step 2: Work out the amount that would have been the entity s tax loss for the income year under section (or, if applicable, sections , or ) assuming the entity had no net exempt income; Divide the amount of the entity s excess franking offsets for the income year by the corporate tax rate; Step 3: Add the results of Step 1 and Step 2; Step 4: Reduce the result of Step 3 by the entity s net exempt income for the income year. Any positive amount remaining after Step 4 will be the entity s tax loss for the income year. However, if the result obtained under Step 4 is nil or negative, the entity will not have any tax loss for the income year. To the extent that a positive amount remains after Step 4, the income year will be taken to be a loss year for the corporate tax entity Subsections 67-25(1C), 67-25(1D) and 67-25(1E) 28 Paragraph 36-55(2)(d) Copyright The Institute of Chartered Accountants in Australia

20 Example Continuing Example 1 above (see Section ), Company A would be taken to have incurred a tax loss of $50 for the 2012 income year, calculated as follows: Step 1: Determine tax loss otherwise incurred by Company A under section Deductions (ignoring carried forward tax losses) $100 Less: assessable income $250 Less: net exempt income Amount remaining / tax loss Nil ($150) / Nil Step 2: Add excess franking offsets divided by corporate tax rate Excess franking offsets $15 Corporate income tax rate 30% Excess franking offsets divided by tax rate $50 Step 3: Reduce the result of Step 2 by net exempt income Net exempt income Nil Step 4: Determine amount remaining after Step 3 Step 1 result Nil Add: Step 2 result $50 Less: Step 3 result Nil Amount remaining (Step 4) $50 The result remaining after applying Step 4 of the method statement in subsection 36-55(2) is $50. As this is a positive amount, Company A will be deemed to have incurred a tax loss for the 2012 income year of $50 under paragraph 36-55(2)(c). In addition, the 2012 income year will be treated as a loss year for Company A under paragraph 36-55(2)(d). This will have ramifications for application of the continuity of ownership test (COT) and the same business test (SBT) (see Section 4 below). Copyright The Institute of Chartered Accountants in Australia

21 General rules for corporate tax entities in deducting tax loss The tax losses that a corporate tax entity chooses to deduct will be subject to the following general rules: Where the entity chooses to deduct a tax loss in accordance with section 36-17, the entity must state its choice under the relevant subsection in its income tax return. 29 Tax losses are deducted in the order in which they are incurred. 30 Tax losses are deductible only to the extent that they have not already been deducted. 31 The undeducted amount of a tax loss can be carried forward for deduction in subsequent income years Adjustments required if subsequent amendment to tax position In certain circumstances, a corporate tax entity may, after it has lodged its tax return for an income year: Choose to change the amount of the tax loss that it chose to deduct in a previous income year; or Choose an amount of tax loss to be deducted where a choice previously had not been made. This will arise where there has been a recalculation of any of the following amounts of the entity after it has lodged its tax return for an income year: The tax loss the entity can deduct in that year; The amount of the difference between the entity s total assessable income and total deduction (other than tax losses) for that year; or The entity s net exempt income for that year Subsection 36-17(6) 30 Subsection 36-17(7) 31 Subsection 36-17(8) 32 Subsection 36-17(9) Copyright The Institute of Chartered Accountants in Australia

22 The adjustments may be made whether or not: The amount is recalculated in an amendment of the entity s assessment for that year; The amount was a nil amount before the recalculation; or The amount has become a nil amount for that year. 34 If the entity had chosen to deduct an amount of tax loss for the income year and, as a result of the recalculation, the entity wishes to change that choice, the entity can change the choice by lodging a written notice with the Commissioner. 35 For example, the entity may wish to increase the previous choice of tax loss deducted where the entity s assessable income was increased and tax would have been payable otherwise as a result of the recalculation. If, before the recalculation, the entity was not able to choose an amount of tax loss to deduct but, as a result of a recalculation, the choice had become available, the entity may choose the amount of tax loss to be deducted by written notice given to the Commissioner Net exempt income The net exempt income is calculated differently for residents and non-residents. The difference in treatment reflects the fact that, in general, residents are assessable on income from all sources, whereas non-residents are assessable only on income from sources in Australia Net exempt income of Australian resident For Australian residents, net exempt income is calculated in accordance with subsection 36-20(1), as follows: Calculate the total exempt income (as defined in section 6-20) from all sources, whether in or out of Australia; and 33 Subsection 36-17(10) 34 Subsection 36-17(10) 35 Subsection 36-17(12) 36 Subsection 36-17(11) Copyright The Institute of Chartered Accountants in Australia

23 Subtract any (non-capital) losses or outgoings incurred in deriving that exempt income, Example and any taxes payable outside Australia on that exempt income. For the income year, a resident taxpayer s only exempt income is overseas employment income (exempt under section 23AG of the ITAA 1936) of $50,000. Non-capital expenses incurred in deriving that income are $10,000 and the foreign tax payable on the income is $15,000. The taxpayer s net exempt income is $50,000 $10,000 $15,000 = $25, Net exempt income of a foreign resident For foreign residents, the net exempt income is calculated in accordance with subsection 36-20(2), as follows: Calculate the exempt income from sources in Australia; Add the amount of exempt section 26AG of the ITAA 1936 film income from all sources; and Subtract any (non-capital) losses or outgoings incurred in deriving the exempt income, and any taxes payable outside Australia on the exempt section 26AG of the ITAA 1936 film income. The balance remaining is the foreign resident s net exempt income. 2.5 Special rules about tax losses Section contains no substantive law, but guides the reader to various rules which apply in determining the deductibility of tax losses of particular types of taxpayers. Copyright The Institute of Chartered Accountants in Australia

24 Amongst other things, section alerts the reader to rules affecting tax losses in the following situations: An individual goes bankrupt (Subdivision 36-B); A company has a change of ownership or control during an income year (Subdivision 165- A and 165-B); Note Readers should be mindful of the current year loss rules contained in Subdivision 165-B which may require a company s tax loss (and, if applicable, taxable income) for an income year to be determined in a special way where there is a change of ownership or control in the company during the income year. However, a detailed exposition of these rules goes beyond the scope of this paper. An arrangement is entered that is designed to exploit available losses through the injection of income and related schemes (Division 175); A trust has a change of ownership or control during an income year (Division 266, 267 and 268 of Schedule 2F of the ITAA 1936); and A trust is involved in a scheme to take advantage of deductions (Division 270 of Schedule 2F of the ITAA 1936). Although not mentioned in section 36-25, readers should also be mindful of Subdivisions 165- CC and 165-CD when considering the treatment of tax losses. Broadly, these Subdivisions have the following effect: Subdivision 165-CC applies where, broadly, there is a change in the ownership or control of a company (referred to as a changeover time ) and the company has an unrealised net loss at that time. If the Subdivision applies, unless the company satisfies the SBT, it will not be able to take advantage of deductions or capital losses arising from the subsequent disposal of assets held by it at the changeover time, up to the extent of the unrealised net loss; and Copyright The Institute of Chartered Accountants in Australia

25 Subdivision 165-CD applies to decrease the reduced cost base of relevant equity or debt interests held by non-individual taxpayers in a loss company (a company with any realised or unrealised losses) where there has been a change in majority ownership or control of the loss company (referred to as an alteration time ). If Subdivision 165-CD applies, the reduced cost base of these interests is generally decreased such that any duplication of realised or unrealised losses in the loss company is avoided on disposal of the interests. As with the current year loss rules in Subdivision 165-B, a detailed exposition of these Subdivisions goes beyond the scope of this paper. Readers should be aware, however, that given the compliance burden imposed by these Subdivisions, the rules outlined above do not apply to entities with less than $6 million net asset value (as calculated under section ). Note Subdivisions 165-CC and 165-CD provide certain carve outs when determining losses in respect of assets acquired for less than $10,000. Based on a Treasury consultation paper released in July 2011, new amendments to these Subdivisions will clarify that all membership interests (as defined under section 995-1) in an entity which are owned by the tested company will be treated as a single asset for the purpose of applying these carve-outs. The consultation paper is available via the following link: Copyright The Institute of Chartered Accountants in Australia

26 Copyright The Institute of Chartered Accountants in Australia

27 3. Individuals 3.1 Losses from hobbies Broadly, where an activity of an individual is properly characterised as a hobby or recreation, then: Any money derived by the individual from the activity is generally not assessable income; Any losses or outgoings of the individual attributable to the activity is not deductible; If the activity results in a loss, the individual is not entitled to offset this loss against other income or carry the loss forward. Whether an activity constitutes a hobby or recreation is a question of fact. 3.2 General deductions Broadly, a general deduction is available for a loss or outgoing under section section 8-1 states that: Specifically, 8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) (b) it is incurred in gaining or producing your assessable income; or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. 8-1 (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) (b) (c) it is a loss or outgoing of capital, or of a capital nature; or it is a loss or outgoing of a private or domestic nature; or it is incurred in relation to gaining or producing your exempt income or your nonassessable non-exempt income; or 37 Subsection 8-1(3) Copyright The Institute of Chartered Accountants in Australia

28 (d) a provision of this Act prevents you from deducting it. In the context of deductions for losses and outgoings relating to hobbies, the question often asked is whether the hobby amounted to carrying on a business such that the loss or outgoing had the sufficient nexus to qualify for a deduction under section 8-1. In this regard, the Court stated in Ferguson v. FC of T (1979) 37 FLR 310 that:... if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business, even though his operations are fairly substantial. 3.3 Carrying on a business The question of whether an individual is carrying on a business (as opposed to a hobby or recreation) can only be determined by considering all the relevant facts and circumstances. A business is defined as including any profession, trade, employment, vocation or calling, but does not include occupation as an employee. 38 This definition is further interpreted as limiting the term business to a commercial enterprise as a going concern. 39 In most cases it is obvious whether a business is being carried on. Where it is not obvious, in particular, is where the relevant activity is subsidiary to a person s main income-producing activity, for example, where the person vigorously pursues a hobby. The main indicators of carrying on a business are as follows: Section Hope v Bathurst City Council (1980) 144 CLR 1 40 Paragraph 18 of Taxation Ruling TR 97/11 Copyright The Institute of Chartered Accountants in Australia

29 Positive More likely to be a business if factors Negative Less likely to be a business if factors Large scale operations Involves employees Frequent acts/transactions Small scale operations One person operation Infrequent acts/transactions Conducted with a view to profit Conducted as mere hobby Profitable Non-profitable Conducted over long period Short-term Conducted continuously and systematically Spasmodic In commercial premises At home Involves items typically dealt with commercially Involves exercise of specialised knowledge Involves items not ordinarily dealt with commercially Involves little knowledge or skills Significant capital investment Little or no capital investment Business records kept Records not kept, or inadequate Full-time Part-time Market research done No market research Associated with other commercial activities of taxpayer Existence of business organisation, business name No other commercial activities Conducted personally/privately Copyright The Institute of Chartered Accountants in Australia

30 Advertising Active No advertising Inactive or preliminary There is often significant overlap between these indicators and no individual indicator should be regarded as decisive. In addition, the weighting to be given to each indicator will vary from case to case. Note A taxpayer can obtain a Private Ruling under Division 359 of Schedule 1 to the Taxation Administration Act 1953 on whether he/she is carrying on a business (see Taxation Ruling TR 2006/11). In Taxation Ruling TR 97/11, the Commissioner considers that an activity will constitute a hobby where the following indicia are present: 41 It is evident that the taxpayer does not intend to make a profit from the activity; Losses are incurred because the activity is motivated by personal pleasure and not to make a profit and there is no plan in place to show how a profit can be made; The transaction is isolated and there is no repetition or regularity of sales; Any activity is not carried on in the same manner as a normal, ordinary business activity; There is no system to allow a profit to be produced in the conduct of the activity; The activity is conducted on a small scale; 41 Paragraph 87 of TR 97/11 Copyright The Institute of Chartered Accountants in Australia

31 There is an intention by the taxpayer to carry on a hobby, a recreation or a sport rather than a business; Any produce is sold to friends and relatives and not to the public at large. Copyright The Institute of Chartered Accountants in Australia

32 Example 1 Richard was a musician and singer in a rock band. He was also interested in dressage. Richard owned a substantial land holding on which he bred horses to obtain better mounts for his dressage competitions. He trained his own horses. He belonged to the local dressage club and usually sold any unwanted and untrained offspring through his club and the local newspaper. The sale prices were well below the expenses associated with maintaining the horses. He conducted research into breeding and training techniques and tried to keep up to date with the latest information. He kept detailed records of breeding and all expenses associated with the horses. When the horses became too old to compete he put them out to pasture, as he could not bear to part with his old companions. Was Richard carrying on a business of horse breeding? In Taxation Ruling 97/11, the Commissioner answers this question in the negative. He notes that despite the keeping of records, the organisation, the repetition and regularity of activity and the research conducted, the activity was a hobby given that: The activity was primarily motivated by his desire to compete and any returns were merely incidental to this purpose; No profit was made from the activity; There was no intention to carry on a business or to make a profit; the keeping of records, the research and the sales were all associated with Richard's dressage activities; and There was no significant commercial purpose or character to the activity. Example 2 In Case 4/2005, it was held that the taxpayer s activities which included attempts to bring his work to the market, hiring of space in a gallery, holding an exhibition and use of a public relations consultant went beyond a mere hobby or recreational activity and constituted a carrying on of a business. Copyright The Institute of Chartered Accountants in Australia

33 3.4 Non-commercial business losses Division 35 prevents losses of individuals from non-commercial business activities being offset against other assessable income in the year that the loss is incurred. Losses that cannot be offset against other income in the year in which they arise (that is, deferred losses) may be carried forward to be offset in a future year when there is a profit from the non-commercial activity or, in certain circumstances, against other income. 42 Division 35 applies to individuals (either alone or as a partner in a partnership) only Deferral of non-commercial business losses Non-commercial business losses Subject to the exception below, where deductions in relation to a non-commercial business activity for that year exceed the assessable income (if any) from the business activity for that year, the excess cannot be deducted in the income year in which it is incurred. 44 Rather, the excess is treated as being deductible from the assessable income from the business activity in the next income year in which the business activity is carried on. 45 The deductions relating to that activity must be deductible under ITAA 1936 or ITAA 1997 before Division 35 applies. In most cases, the loss will be deferred and offset against the assessable income from the noncommercial business activity in the next income year. However, if the individual makes losses in the next income year, the amount of the losses from the first and second year are added together and deferred to a future income year in which the business activity makes profits. Where the business activity ceases for a year or number of years, the loss will be carried forward and become deductible in the income year when the activity is next carried on. 42 Section Sections 35-5 and Subsection 35-10(2) 45 Paragraph 35-10(2)(b) Copyright The Institute of Chartered Accountants in Australia

34 Example Michael is a student but is also carrying on a business activity of online photo sales. Under the tests, his business activity is treated as non-commercial. He starts his business on 1 July 2000 and for the 2001 income year he obtains online sales of $3,000; however, deductions incurred in operating the business total $3,500. In 2002, his business obtains sales income of $4,000 and generates deductions of $4,100. In 2003, Michael s business derives sales of $6,000 and deductions of only $2,000. The losses for 2001 ($500) and 2002 ($100) are not allowed in those years but are carried forward to the 2003 income year, where they reduce his profit in that year ($4,000) to $3, Exempt income Section modifies the general rule which defers certain losses from a non-commercial business activity. 46 The amount of the loss that is deferred to future years is reduced by net exempt income derived by the individual in the current or future years that has not already been offset against carry forward tax losses under section or section Example Bayfield incurs a loss from his non-commercial business activity in 2002 of $17,000 and derives exempt income of $3,000. Bayfield did not have any Division 36 tax losses carried forward from earlier income years. The Division 35 amount that is deductible in a later year is $14,000 after reducing the deferred loss by the amount of exempt income. However, where there is a deferred loss from a prior year and profit arising in the current income year from a non-commercial business activity, any exempt income would reduce the deferred loss before that loss can be used to reduce the current year profit from that business activity Subsection 35-10(2) 47 Subsection 35-15(1) 48 Subsection 35-15(2) Copyright The Institute of Chartered Accountants in Australia

35 3.5.3 Blackhole expenditure Subject to the exception below, the non-commercial loss rules also apply to pre-business or post-business expenditure that is deductible under section (business related costs). 49 A taxpayer cannot deduct an amount under section for pre-business expenditure in relation to a business activity that the taxpayer proposes to carry on (either alone or in partnership) in an income year before the one in which the business activity starts to be carried on. In the income year a business activity starts to be carried on, a taxpayer can only offset a loss from the business activity carried on against other income if one of the exceptions applies. If the loss cannot be offset against other income in the income year in which it arises, it is deferred and offset in a future year when there is a profit from the same activity, or a like activity, or against other income when the taxpayer satisfies one of the tests for that activity. Example Lee, a salary earner, incurs $1,000 which is otherwise deductible under section , during the 2006 income year, for the purpose of establishing a supermarket business in the 2007 income year. She intends to carry on the business activity as a sole trader. Apart from Division 35, section would provide deductions in equal proportions for the $1,000 expenditure for the 2006 to 2010 income years. An individual taxpayer is also prevented from deducting an amount that is otherwise deductible under subsection (4) for expenditure in relation to a business activity that another entity, other than an individual (either alone or in partnership), proposes to carry on until the income year in which the activity starts to be carried on. If the business activity ceases, amounts otherwise deductible after this event under section are not deductible if one of the exceptions does not apply to the business activity before the business ceased. 49 Subsection 35-10(2A) Copyright The Institute of Chartered Accountants in Australia

36 3.5.4 Non-commercial business activities A non-commercial business activity is any business activity. As noted above, a business is defined as including any profession, trade, employment, vocation or calling, but does not include occupation as an employee. 50 This definition is further interpreted as limiting the term business to a commercial enterprise as a going concern. 51 This definition would exclude domestic transactions involving jointly owned family homes from being a business. Further, passive investments such as the derivation of interest, dividends and royalties are not businesses. 52 This is confirmed by the guide in section Although business activities are not defined, context suggests that they are activities connected with, or necessary for, the conduct of a business Grouped non-commercial business activities Subsection 35-10(3) permits an individual to group similar business activities together for the purpose of the rules. In effect, this allows losses from a non-commercial business activity to be offset against the assessable income arising from another closely related business activity. In determining whether an activity is part of a particular business activity, or a separate business activity, the facts and circumstances surrounding each activity should be closely considered. If the activity is not a part of another business activity it should be viewed in isolation and treated as a separate business activity, and losses from one non-commercial business activity should not be offset against income from another business activity. 50 Section Hope v Bathurst City Council (1980) 144 CLR 1 52 Commissioner of Inland Revenue v Marine Turbo Co [1920] 1 KB 193 Copyright The Institute of Chartered Accountants in Australia

37 Example Ann conducts a business activity as an olive farmer producing olive oil. She has had great success manufacturing high-grade oil and selling it both locally and to exporters. Recently, Ann started producing bottled olives in an attempt to expand her business. This new activity is sustained independently from the olive oil market activity. Division 35 will treat Ann s bottling activity as a part of her primary business activity of producing olive oil. Both her olive oil activity and her bottling activity are similar, and may therefore be looked at in aggregate against the four tests to determine whether her losses, if any, from those activities can be deducted from her other income. Ann is also a keen amateur scientist. In her home laboratory, Ann has developed a new chemical insecticide for olives. She has patented its composition and is now receiving royalties from a chemical manufacturer. Ann has also written a research paper on insecticides, which is available for purchase. Ann s research activities are not of an inherently similar nature to her olive oil production and bottling activity and will be considered as a separate business activity under Division Exception Non-commercial business losses will not be subject to the non-commercial loss rules if the following conditions are satisfied for an income year in relation to each business activity: The sum of the following is less than $250,000: - The individual s taxable income for that year; - The individual s reportable fringe benefits total for that year; - The individual s reportable superannuation contributions for that year; and - The individual s total net investment losses for that year, 53 and one of the following is satisfied: Subsection 35-10(2E) Copyright The Institute of Chartered Accountants in Australia

38 - The assessable income test: the amount of assessable income from the business activity is at least $20,000; 55 - The profits test; 56 - The real property test; 57 - The other assets test; 58 or The Commissioner has exercised the discretion set out in section for the business activity for that year; 59 The business is a primary production business or a professional arts business (for example, an author or a performing artist) for that year and the individual s assessable income for that year (other than any net capital gain) from other sources is less than $40, or Non-commercial business blackhole expenditure will also not be subject to the non-commercial loss rules if the above conditions are satisfied for the income year in which the business activity ceased or in an earlier income year Subsection 35-10(1) 55 Section Section Section Section Paragraph 35-10(1)(b) 60 Paragraph 35-10(1)(c) and subsection 35-10(4) 61 Subsection 35-10(2A) Copyright The Institute of Chartered Accountants in Australia

39 Example Amanda earned a salary of $175,000 in Also in that year, her reportable superannuation contributions were $45,000, her reportable fringe benefits were $32,000 and she had net investment losses of $13,000. Amanda also operated a natural therapies business which had assessable income of $22,000 in 2011 and deductions totalling $34,000. Assuming that there were no other amounts of assessable income or allowable deductions in 2011, Amanda does not pass the income threshold test and cannot offset the net loss of $12,000 from the natural therapies business against other income. Amanda s adjusted taxable income is $252,000, calculated as her salary income ($175,000), less the net investment losses ($13,000) plus the reportable superannuation contributions ($45,000), the reportable fringe benefits ($32,000) and the net investment losses ($13,000). That amount is more than the threshold of $250,000. Unless the Commissioner exercised the discretion in section not to apply the noncommercial losses rules in respect of the business for the 2011 income year, the $12,000 loss from the natural therapies business will be quarantined, and may only be applied against assessable income from the alternative therapies business in later income years Profits test The profits test is satisfied if, for each of at least three of the past five income years (including the current year), the sum of the deductions (disregarding any deferred losses, but including any share of deductions from a partnership) is less than the assessable income (including any share of income from a partnership) from the activity Section Copyright The Institute of Chartered Accountants in Australia

40 Real property test The real property test is satisfied if the total of the greater of the market value or reduced cost bases of real property or interests in real property used on a continuing basis in carrying on the activity is at least $500, A dwelling, and any adjacent land used in association with the dwelling, that is used mainly for private purposes and any fixtures owned by a tenant are not counted for this test Other assets test The other assets test is satisfied if the total values of assets listed below that are used on a continuing basis in carrying on the activity is at least $100,000: 65 Item Value 1 An asset whose decline in value you can deduct under Division 40 The asset s written down value 2 An item of trading stock Its value under subsection 70-45(1) 3 An asset that you lease from another entity 4 Trademarks, patents, copyrights and similar rights The sum of the amounts of the future lease payments for the asset to which you are irrevocably committed, less an appropriate amount to reflect any interest component for those lease payments Their reduced cost base 63 Section Section Section Copyright The Institute of Chartered Accountants in Australia

41 Real property or interests in real property that are taken into account for the real property test and cars, motorcycles and similar vehicles are not counted for this test. 66 Apportionment of an asset may be necessary where it is used during an income year partly in carrying on the relevant non-commercial loss business activity and partly for other purposes Commissioner s discretion The Commissioner can decide that the non-commercial loss rules do not apply to noncommercial business activity for one or more income years if the Commissioner is satisfied that it would be unreasonable to apply that rule because of one or more of the reasons described in section The taxpayer must apply to the Commissioner for a determination and the application must be made in the approved form Modifications for bankruptcy A loss from a non-commercial business activity and blackhole expenditure incurred prior to bankruptcy (or being released from a debt) cannot be deducted after the date of bankruptcy. 68 Where an individual s bankruptcy is annulled due to a composition or scheme of arrangement under which the individual s debts are released, no losses from non-commercial business activities can be deducted in the year of annulment or in later income years Subsection 35-45(4) 67 Section Subsection 35-20(1) 69 Subsection 35-20(3) Copyright The Institute of Chartered Accountants in Australia

42 3.5.9 Application to certain partnerships Division 35 applies to businesses carried on by individuals, either alone or in partnership. Therefore, a partnership that carries on a business activity and consists of at least one individual as partner will fall within the non-commercial business loss rules. Readers are directed to section which contains certain modifications to the assessable income test, real property test and other assets test. Copyright The Institute of Chartered Accountants in Australia

43 4. Companies 4.1 Rules for Use of Prior Year Tax Losses by Companies As noted above, the deductibility of tax losses by certain taxpayers may be affected by various rules in the Tax Act. Section sets out the basic conditions which a company must satisfy in order to deduct losses of earlier years. In effect, the section provides that the company cannot deduct a tax loss unless it satisfies the COT under section , or alternatively, if the company fails to meet that test, the SBT under section Section provides that even if the company satisfies the COT or the SBT, it still will not be able to deduct the loss if there is a specified change in the control of the voting power in the company enabling some person to obtain a tax advantage under the Tax Act. A further test for deductibility is provided by section which makes available to companies one of the concessional tracing rules available to trusts under the trust loss measures contained in Schedule 2F of the ITAA 1936 where the company is predominantly held by non-fixed trusts. Division 166 modifies the COT rules that apply to widely held companies and eligible Division 166 companies. Warning Subdivision 175-A enables the Commissioner, in certain circumstances, to prevent the utilisation of a tax loss by a company where an amount of income is injected into the company for the purpose of taking advantage of the tax loss, or a person obtains a tax advantage under a scheme which was carried out in order to access the tax loss. Subdivision 175-A can operate even where the company otherwise satisfies the COT requirements in section and the control test in section Readers are advised to refer to ATO Interpretive Decision 2002/836, ATO Interpretive Decision 2002/845 and ATO Interpretive Decision 2010/48 for further details in respect of the application of Subdivision 175-A. Copyright The Institute of Chartered Accountants in Australia

44 4.2 Continuity of ownership test General continuity of ownership test rules Section sets out the conditions which must be satisfied under the COT. If a company fails this test, it will not be able to claim a deduction in respect of carried forward tax losses unless it satisfies the SBT under section Subsection (1) defines the period during which ownership and control of a company must remain constant (the ownership test period ). For the purposes of Subdivision 165-A, the ownership test period: Starts at the beginning of the year in which the loss is incurred (the loss year ), and Finishes at the end of the year in which the loss is utilised (the income year ). The term loss year for these purposes is defined in section 36-10, being a year in which a company has a tax loss under section 36-10, or if relevant, section (see note 2 to section 36-10). Section contains the rules in relation to incomplete test periods. In this regard, section contains rules for establishing the COT of a company that comes into existence during the loss year (for example, on incorporation) or that ceases to exist during the income year (for example, where the company is deregistered). Subsections (2), (3) and (4) set out the conditions that must be satisfied during the ownership test period before the COT is passed by a company. They provide that there must be persons who had more than 50% of the: Voting power; Rights to dividends; and Rights to capital distributions, in the company at all times during the ownership test period. The tests for determining whether persons have more than 50% of the voting power, rights to dividends and rights to capital distributions during a particular period are set out in sections 165- Copyright The Institute of Chartered Accountants in Australia

45 150, and (as incorporated by subsections (5) and (6). Specifically: The primary test applies if no other companies beneficially own shares or interests in shares in the loss company at any time during the ownership test period. This is expressly stated at subsection (5). This test provides that if there are persons who, at all times during the ownership test period, beneficially own (between them) shares that carry (between them) the right to exercise more than 50% of the voting power, the right to receive more than 50% of the dividends or the right to receive more than 50% of the capital distributions in the company, then those persons are treated as having more than 50% of the voting power, dividends and capital distributions in the company at all times during the ownership test period. 70 In the case of public companies, the test will be satisfied if it is reasonable to assume that it is satisfied. 71 The alternative test applies where at any time during the ownership test period, any shares or interests in shares in the loss company are beneficially held by one or more other companies. This is expressly stated at subsection (6). This test provides that if there are persons (none of them companies or trustees) who between them have at all times during the ownership test period beneficial interests in shares in the company that carry between them more than 50% of the voting power, the right to receive more than 50% of the dividends or the right to receive more than 50% of the capital distributions in the company, those persons are treated as having more than 50% of the voting power, dividends and capital distributions in the company at all times during the ownership test period. This applies whether the beneficial interests are held directly or indirectly through one or more interposed entities and also where is it reasonable to assume that the provisions of the test have been met. 72 Practically, application of the alternative test generally requires that a tracing process be undertaken in order to determine the ultimate individual (natural person) owners of the tested company. 70 Subsections (1), (1) and (1) 71 Subsection (7) 72 Subsections (2), (2) and (2) Copyright The Institute of Chartered Accountants in Australia

46 If a company is a non-profit company, a mutual affiliate company or a mutual insurance company during the entire ownership period, it is taken to have satisfied the conditions in subsection (3) relating to rights to dividends and subsection (4) relating to rights to capital distributions. 73 As a result, these companies satisfy the COT if they satisfy the voting power condition under either the primary or alternative test (as applicable) Proposed modifications clarifying aspects of the COT Under the current law, a company which has more than one class of shares with different owners could technically fail the COT, even if majority beneficial ownership of the company s shares remains the same. This may occur, for example, where the various classes of shares in the company have unequal rights to dividends and capital distributions, or unequal voting power. In such circumstances, it may not be possible to identify which particular group of owners is entitled to more than 50% of the relevant rights. In recognition of this issue, the Federal Government released draft legislation (proposed Division 167) on 4 September 2009 which is designed to ameliorate problems encountered by companies with multiple share classes in satisfying the COT. 74 Broadly, the draft legislation would allow a company which would otherwise fail the COT to reconsider the test, disregarding the following: Debt interests held in the company (such as redeemable preference shares with characteristics that cause them to be classified as debt under Division 974); and Secondary share classes issued by the company (for example, special shares issued to employees under an ESAS arrangement), provided that the value of each such class does not exceed 10% of the total value of the company s shares, and the combined value of all secondary share classes does not exceed 25% of the total value of the company. If the company continues to fail the COT after disregarding these interests, the draft legislation allows a further mechanism, whereby any remaining shares in the company may be taken to have fixed dividend and capital rights for the purpose of applying the test. 73 Subsection (7A) 74 The draft legislation and accompanying explanatory materials can be found on the Treasury website at: Copyright The Institute of Chartered Accountants in Australia

47 The draft legislation also clarifies that, if the shares of a company have distinct voting rights, the voting power of those shares is to be tested solely by reference to the maximum number of votes that could be cast on a poll for the election of the company s directors, or on the adoption / amendment of the corporate constitution. The draft legislation is generally proposed to apply from 1 July However, modifications to the test for voting power are proposed to apply only from 1 July Consequential amendments will be made to section 170 of the ITAA 1936 to ensure that taxpayers will be able to retrospectively rely on the proposed modifications. Note A revised exposure draft of the proposed legislation was released for limited consultation in July Treasury s Forward Work Program indicates that the revised exposure draft should be released for public comment in mid to late Special continuity of ownership test rules A number of special rules expand upon particular aspects of the primary and alternative tests. Some of the more significant rules are summarised below: Unbroken continuity is necessary. In respect of income years ending after 21 September 1999, the tests are required to be satisfied during the whole of the loss year, the whole of the income year and the whole of the intervening period (referred to in total as the ownership test period ); The identity of shares is essential. In this regard, for income years ending after 21 September 1999, rights attaching to shares generally cannot be taken into account under either the primary or alternative tests unless, at all times during the relevant period, they are the same shares and are beneficially held by exactly the same shareholders (this is Copyright The Institute of Chartered Accountants in Australia

48 known as the same share rule ). 75 However, this requirement is relaxed in the case of share / unit splits 76 and share / unit consolidations; 77 Warning The same share rule may be problematic where new shares are issued by a company, or existing shares are subject to a rollover (for example, under Subdivision 124-G, which deals with the interposition of holding companies). There are no statutory carve outs applying in these circumstances and accordingly it may be necessary to rely on the saving provision to ensure COT is satisfied (refer to Section below). 78 Tests may be satisfied by one person. Each of the tests refer to persons (in the plural). However, to avoid doubt, section specifically provides that any of the tests may be satisfied by one person; A public company is taken to have satisfied any of the primary tests if it is reasonable to assume that the tests are satisfied. 79 The reason for such a provision is that the numerous sales of shares in large companies could make it impracticable to accurately determine details of beneficial ownership. Note, however, that the effect of this provision is limited, as widely held companies and eligible Division 166 companies would normally be tested under the modified rules in Division 166; Shares held by certain concessionally taxed entities (for example, a government or a charitable institution) are deemed to be held by a notional shareholder when applying the tests; 80 Shares held by the trustee or beneficiary of a deceased person s estate will be deemed to continue to be held by the deceased person when applying the tests; Section Subsections (2) and (3) 77 Subsections (4) and (5) 78 Subsection (7) 79 Subsection (7) 80 Section Section Copyright The Institute of Chartered Accountants in Australia

49 Shares held by a discretionary trust that has made a family trust election will be deemed to be held by a separate notional shareholder when applying the tests. 82 This overcomes issues which may otherwise be encountered in tracing beneficial ownership through nonfixed trusts (without reliance on Subdivision 165-F); A company will not be prevented from satisfying the tests merely because a liquidator or administrator has been appointed in respect of the company, or an interposed holding company. 83 This overcomes the decision in FC of T v Linter Textiles Ltd (in liq), 84 which confirmed that upon appointment of a liquidator to a company, the incumbent shareholders in that company cede control of their voting power to the liquidator; and The tests are subject to anti-avoidance rules contained in section and which broadly empower the Commissioner to treat shares as not being beneficially owned by certain shareholders (or as not carrying certain rights) where the Commissioner is satisfied that arrangements have been entered into to exploit the COT. These rules may be enlivened where, for example, an arrangement is entered between existing shareholders and prospective shareholders, under which the existing shareholders agree to retain their shares in a company until such time as any carried forward tax losses have been absorbed, and thereafter formally dispose of the shares to the prospective shareholders Saving provision If the continuity of majority ownership test in section is not satisfied, subsection (7) may deem the test to be satisfied where: The test is only failed because the group of persons who have maintained majority ownership of the company have not retained exactly the same shares during the relevant period (that is, the same share rule in section has been breached); and Based on the information available to the company, it is reasonable for the company to conclude that less than 50% of its tax loss has been reflected in deductions, capital losses 82 Section Section [2005] HCA K Porter & Co Pty Ltd v FCT 77 ATC 4472 Copyright The Institute of Chartered Accountants in Australia

50 or reduced gains that arose (or could arise in the future) because of the happening of a CGT event (for example, disposals) in relation to any direct or indirect equity interests in the company during the ownership test period. A company will, therefore, not be treated as having failed the COT where the company can demonstrate, for example, that the only equity interests in the company that were sold during the relevant test period have been subject to the anti-loss duplication measures in Subdivision 165-CD. 86 This is because no deduction associated with the tax loss is reflected in a loss or reduced gain on the disposal of an ownership interest that is subject to Subdivision 165-CD (as a result of the adjustments made under those provisions). Note In ATO Interpretive Decision 2012/64, the Commissioner considered the application of the saving provision contained under the modified COT in Division 166, which employs substantially the same wording as subsection (7). In that ATO ID, the Commissioner stated that the application of the saving provision cannot be anticipated before the end of the relevant test period, as it is only at this point that a company may ascertain if the requirements of the provision have been met. The Commissioner also stated that references to losses which could occur in the future, generally meant those losses which had been subject to the stop-loss rule in Subdivision 170-D. Subsection (8) specifically provides that the disposal of a direct or indirect interest in a company that triggers the application of Subdivision 165-A is taken, for the purposes of the saving provision to have occurred during the relevant ownership test period. 86 Paragraph (7)(b) Copyright The Institute of Chartered Accountants in Australia

51 Example At the start of an ownership test period, Alex holds 90% of shares in a loss company. Brian owns the remaining 10%. At this time, the company has issued 100 ordinary shares (that is, Alex owns 90 shares and Brian owns 10 shares). A hundred more new shares are then issued at some time during the test period. Of these, Alex owns 90 and Brian owns 10. The total shares on issue are now 200. The original shares held by Alex now only carry 45% of the power and rights in the company (90/200 = 45%). The original shares held by Brian now carry 5% of the power and rights in the company (10/200 = 5%). Due to the operation of the same share rule in section , only the original shares may be counted for the purposes of determining whether there has been continuity of ownership throughout the period. In the absence of a saving provision, the company would fail the COT because only 50% of the power and rights in the company have been maintained throughout the test period. To satisfy the test, more than 50% continuity must be maintained. Under the saving provision, the company will be treated as though it satisfies the COT if it is able to prove that: But for the same share rule the company would satisfy the COT (that is, there has been no substantial change in proportionate shareholding between Alex and Brian) throughout the period Alex has maintained a 90% interest and Brian has maintained a 10% interest; and Less than 50% of the loss has been duplicated during the period neither Alex nor Brian have sold any of their original shares during the ownership test period, and accordingly, neither have crystallised deductions, capital losses or reduced gains. Copyright The Institute of Chartered Accountants in Australia

52 4.3 Same business test Same business test period Section contains the SBT. A company must satisfy the SBT to deduct a tax loss if the company either: Fails, or is treated as failing, to meet any of the conditions of the COT; or It is not practicable to show that it meets all of the conditions of the COT. The SBT requires a comparison between the activities of the company during the income year (SBT period) with its activities immediately before the test time. The test time is determined in accordance with subsection (2) as follows: Situation 1 Where it is practicable to show that there is a period commencing at the start of the ownership test period (or if the company came into being during the loss year, at the time the company came into being) during which the company would satisfy 2 Where Item 1 does not apply and the company was in being throughout the loss year 3 Where Item 1 does not apply and the company came into being during the loss year Test Time The last time in the period that the COT was satisfied by the company. The start of the loss year The end of the loss year Copyright The Institute of Chartered Accountants in Australia

53 Example 1: Test time Closer Pty Ltd (Closer) is an Australian company that was incorporated on 19 December Closer is owned as to 65% by Law Limited, which was incorporated in a foreign country. The shareholders of Law Limited are not known by Closer and cannot be obtained under the law of that foreign country. Closer made a tax loss in the 2000 income year (that is, the year of incorporation). As it is not practicable to show that Closer has satisfied the COT in section since incorporation, Closer will only be able to claim the losses where it satisfies the SBT since the test time. As Closer was incorporated during the 2000 income year, the test time will be 30 June 2000, being the end of the loss year. Example 2: Test time and SBT period A company incurs a tax loss in the income year ended 30 June 2006 and wishes to deduct the tax loss in the income year ended 30 June The company fails the COT during the income year ended 30 June Based on these facts, the test time for the company will be just before the COT is failed (that is, some point during the income year ended 30 June 2007) and the SBT period will be 1 July 2007 to 30 June Copyright The Institute of Chartered Accountants in Australia