This article discusses when and how to carry forward a tax loss for companies in Australia, including the same business and similar tests.
Company losses cannot be distributed to shareholders. They must be carried forward in the company and offset against assessable income in subsequent years. Two major tests determine whether such losses can be carried forward. They are the continuity of ownership test (COT) and the same business test (SBT) which are discussed below. A company must satisfy one of these tests to carry forward its revenue tax losses – s 165-10 Income Tax Assessment Act 1997 (ITAA 97) and 165-93 ITAA 97.
The same rules apply to carry forward capital losses. Subdivision 165-CA ITAA 97 makes the ability of a company to set off a net capital loss of an earlier income year against capital gains in a later year subject to the same conditions that it must satisfy to deduct a tax loss of an earlier income year (i.e. a company cannot apply a net capital loss of an earlier year unless):
- it has the same majority ownership and control throughout the loss year and the income year (continuity of ownership test); or
- it carried on the same business and did not enter into new kinds of business or transactions (same business test).
Foreign deductions and losses are treated in the same way as other deductions and losses.
Generally, losses can be carried forward indefinitely. However, they must be utilised on a first in first out basis (i.e. earlier-year losses must be utilised before later-year losses).
Companies can choose the number of losses they wish to deduct in a later year of income. This means they need not have those losses wasted by being offset against tax-free income (e.g. against franked dividend income). It also means a company can choose not to utilise prior-year losses in a particular year to pay sufficient tax to enable it to distribute franked dividends.
IN THIS ARTICLE
The continuity of ownership test
Same share, same interest rule
Losses in companies that are majority-owned by discretionary trusts
Control test where there is a change in control of voting power
Same business test
Similar business test
Current year losses
THE CONTINUITY OF OWNERSHIP TEST
This test (contained in section 165-12 ITAA 97) requires that shares carrying more than 50% of all voting, dividend and capital rights be beneficially owned at all times during the ownership test period by the same people and in the same proportions.
The ownership test period is the period commencing from the beginning of the year in which the loss was incurred until the end of the year in which the loss is recouped.
A company incurs a tax loss in the 2014-15 income year. In the 2017-18 income year the company generated assessable income against which it wishes to claim a tax deduction for the 2014-15 tax loss.
The ownership test period commences on 1 July 2014 (the start of the loss year) and ends on 30 June 2018 (the end of the income year).
The COT must be satisfied throughout the ownership test period.
The shares can be held either directly or indirectly by an individual. The company is required to trace back to the individuals who have indirect interests in the company. This can create problems where the shares are held by a discretionary trust and this is discussed later below.
The ownership of companies does not have to be traced through a complying superannuation fund, a superannuation fund that is established in a foreign country and is regulated under foreign law, a complying approved deposit fund, a special company, or a managed investment scheme.
SAME SHARE, SAME INTEREST RULE
Section 165-165 ITAA 97 provides for determining whether the COT test is passed, the only shares in the company that can be considered are the same shares that are held by the same persons throughout the relevant period.
ABC Pty Ltd incurred a tax loss in the 2016 income year. Annie, Mary and Barry owned shares in ABC Pty Ltd as shown in the table below.
|SHAREHOLDER||SHAREHOLDING FROM 1 JULY 2015 TO 17 AUGUST 2016||SHAREHOLDING FROM 18 AUGUST 2016 TO 30 JUNE 2018||PERCENTAGE COUNTED TOWARDS COT|
On 18 August 2016, both Annie and Mary sold 75% of their shareholding in ABC Pty Ltd to Barry.
ABC Pty Ltd is seeking to deduct a tax loss in the 2018 income year. Will ABC Pty Ltd satisfy the continuity of ownership test?
No, ABC Pty Ltd will not satisfy the continuity of ownership test as only 40% of the shares have been held by the shareholders in the same way during the ownership test period.
LOSSES IN COMPANIES THAT ARE MAJORITY OWNED BY DISCRETIONARY TRUSTS
Where companies in losses are 50% or more owned by discretionary trusts, it is very difficult for them to utilise the losses unless the discretionary trusts have made family trust elections.
This is because the continuity of ownership test (COT) provides that a company needs to show that the same persons have the right to exercise >50% of the voting power, the right to receive >50% of any dividend and >50% of any distribution of capital at all times, from the start of the loss year to the end of the income year.
However, if one or more non-fixed trusts own a company, it is not possible to show which persons have the voting power or the right to receive dividends and distributions of capital.
The same business test cannot be relied on in this situation to carry forward the losses.
However, there is a solution. Section 165-207 ITAA 97 provides that if a trust elects to be a family trust the trustee of the family trust is taken to be an individual shareholder for the loss recoupment tests and the COT may then be met. Alternatively, the SBT may be relied on.
Example from Interpretative Decision ID 2006/157
Company A has a tax loss available to it from an earlier income year.
The trustees of trusts B and C collectively own shares that carry more than 50% of the voting power in company A, and rights to more than 50% of the dividends and capital distributions of Company A, during the whole (or the relevant part) of the loss year and the whole of the income year.
Both trust B and C have made family trust elections (FTEs) which are in force for all relevant income years.
The ID states the company meets the conditions of the continuity of ownership test (COT) as the two trusts will be taken to be persons that meet the requirements for the COT.
There is an alternative solution, but it is not at all practical. If a family trust election is not made, subdivision 165-F ITAA 1997 contains special provisions to enable the COT to be passed.
Section 165-215 provides that a company that does not meet the conditions in the COT in respect of a loss is nevertheless taken to satisfy the COT if it meets all the relevant conditions contained in that section. They are that:
at all times during the ownership test period, the company has non-fixed trusts and other owners; and the non-fixed trusts have 50% or more of the fixed entitlements
the other owners hold their entitlements throughout the ownership test period
throughout the ownership test period, the non-fixed trusts adopt the position that they have also incurred the company loss and can carry it forward under the trust loss rules (i.e. this requires that every non-fixed trust shareholder that hasn’t made a family trust election is notionally able to satisfy the trust loss rules in respect of the loss made by the company).
CONTROL TEST WHERE THERE IS A CHANGE IN CONTROL OF VOTING POWER
Even if a company passes the continuity of ownership test, section 165-15 ITAA 97 can prevent the loss from being carried forward wherein during the ownership test period, a person became able to control the voting power in the company to get some income tax benefit or advantage.
The section applies where:
- for some (or all) of the ownership test period that started at the end of the loss year, a person controlled or was able to control the voting power in the company; and
- for some (or all) of the loss year that person did not control and was not able to control that voting power; and
- that person began to control or become able to control, that voting power to gain a tax advantage or benefit, either for that person or for someone else.
Where these conditions are present, the company must satisfy the same business test to recoup its losses.
A Pty Ltd incurred a tax loss in the income year 2016-17 and is seeking a deduction for that loss in the 2017-18 income year. The shares carry equal voting, dividend and capital distribution rights.
The register of shareholders is:
The company will be subject to the control test even though it satisfies the COT. Accordingly, it will not be able to deduct the tax loss if Bill began to control (or became able to control) the voting power in A Pty Ltd to get some taxation benefit or advantage for himself or others. However, A Pty Ltd would be able to deduct the tax loss in these circumstances if it satisfied the same business test.
SAME BUSINESS TEST
If the company cannot meet the continuity of ownership test, it must satisfy the same business test in section 165-210 ITAA 97 to carry forward its losses.
This test requires that at all times in the year in which it is desired to claim the deduction for the prior year’s loss:
the company must carry on the same business (meaning the business of the company as an entirety) as it carried on immediately before the change in ownership (same business test); and
the company must not derive income from a business (meaning a particular undertaking or enterprise) of a kind that it did not carry on before the change in ownership (new business test); and
the company must not derive income from a transaction of a kind that it had not entered into during its business operations before the change in ownership (new transactions test), and
the company must not enter into a scheme to get around the above tests (i.e. enter into a new business or new transactions before the change in ownership, so that the same business test would be satisfied after the change in ownership).
Taxation Ruling TR 1999/9 states that the Taxation Office will strictly apply these tests with potentially dire consequences for companies whose new owners have pruned the company’s businesses, introduced new profitable activities, restructured or made any other changes.
A company owns and operates a very expensive Japanese restaurant. The restaurant makes losses and changes hands. The new owners change the restaurant to an Italian restaurant that serves cheap pasta meals. In TR 1999/9, the ruling stated this would fail the new business test and the losses could not be carried forward.
SIMILAR BUSINESS TEST
To introduce flexibility to the same business test, the Government introduced a new similar business test in Treasury Laws Amendment (2017 Enterprise Incentives No 1) Act 2017 (the legislation). This Act made amendments to the ITAA 97 that supplement the existing same business test with a new and more flexible similar business test. The tests are collectively known as the “business continuity test”. The amendments are backdated to income years starting on or after 1 July 2015.
As with the same business test, the business continuity test applies to the deductibility of tax losses, capital losses, and bad debts. It also is relevant to whether a company joining a consolidated group can transfer its losses to the head company of the consolidated group.
The similar business test looks at all the commercial operations and activities of the former business and compares them with all the commercial operations and activities of the current business to work out if the businesses are “similar”.
The negative limbs of the same business test (the new business test and the new transaction test) are not replicated in the similar business test, allowing companies to legitimately enter into new lines of business without losing access to tax losses.
As with the same business test, the focus of the similar business test is on the identity of the business. It is not sufficient for the current business to be of a similar ‘kind’ or ‘type’ to the former business. For example, it is not enough to say that the former business was in the hospitality industry and the current business is in the hospitality industry. Instead, the test looks at all the commercial operations and activities of the former business and compares them with all the commercial operations and activities of the current business to work out if the businesses are similar.
In working out whether the current business is similar to the former business, regard must be had to the following four factors, which are not exhaustive:
- the extent to which the assets (including goodwill) used in the current business to generate assessable income were also used in the company’s former business to generate assessable income;
- the extent to which the activities and operations from which the current business generates assessable income were also the activities and operations from which the former business generated assessable income;
- the identity of the current business and the identity of the former business; and
- the extent to which any changes to the former business resulted from the development or commercialisation of assets, products, processes, services, or marketing or organisational methods, of the former business.
Example from Explanatory Memorandum to the legislation
Furnish Art Pty Ltd is a start-up online retail company that sells various household furniture items from established brands. In its first year, Furnish Art made a tax loss.
Through conducting this business, Furnish Art discovered that there was a market for affordable, high-quality mattresses.
While it continues selling furniture from established brands, Furnish Art decided to expand the mattress component of its business. To acquire the funds necessary to make this change, Furnish Art gained a new equity investor, causing it to fail the continuity of ownership test.
Furnish Art researched and developed its mattresses (and applied them to register its patents, trademarks and designs with IP Australia) and it outsourced the manufacturing of the mattresses to a local factory.
Furnish Art commenced selling its new mattresses through its website and under its established ‘Furnish Art’ brand name, alongside the other furniture products. Approximately 15 per cent of Furnish Art’s sales are from its specialised mattresses.
Furnish Art then became profitable and sought to recoup the tax losses incurred before the ownership change.
Furnish Art would satisfy a similar business test.
About the first factor, the current business is generating income from the same assets as the former business in so far as it continues to generate income from its brand name, website and goodwill. However, it is also generating income from new assets, namely, the various intellectual property rights connected to the range of new mattresses.
About the second factor, the current business is generating income from the same activities and operations to the extent that it is generated from the online reselling of furniture items from established brands. However, income is also being generated from the sale of the specialised mattresses that Furnish Art has developed.
About the third factor, there is a change in Furnish Art’s business from reselling established products to both reselling established products and selling mattresses it has developed itself.
However, the change supplements the former business’s identity as a subsidiary or ancillary business activity, rather than replacing the former business. This indicates that the current identity of the Furnish Art business is sufficiently similar to the identity of the former business.
About the fourth factor, the change to the business reflects the ongoing development of the former business’s assets and processes. The current business makes use of many of the assets, processes and methods of the former business, including the business website, marketing strategies and organisational methods.
The above analysis of the factors leads to the conclusion that the former business and the current business are sufficiently similar to satisfy the test. The identity of the Furnish Art business has been maintained, and although the business has changed and derived income from new assets, these new assets and activities do not outweigh the similarities between the former and current business and the current business’s reliance on the development of the former business’s assets.
This conclusion would likely be different if Furnish Art ceased to sell other furniture products and instead became exclusively an online retailer of mattresses which it developed itself.
CURRENT YEAR LOSSES
The current year loss rules in Subdiv 165-B ITAA 97 require an income year to be split into two periods (pre and post-change of control) to restrict a tax loss incurred in one part of an income year from being recouped against taxable income attributable to the other part of the same income year.
The current year loss rules apply if, during an income year, a company:
- changes majority underlying ownership or control of voting power, and
- fails the SBT for the remainder of the year, and
- has incurred a ‘notional loss’ in a period of the income year, whether before or after the change in ownership.
The notional loss of one period cannot be offset against the notional taxable income of another period.
The notional loss can however be carried forward and offset against net assessable income in a future income year, provided it then satisfies the COT and control test or, failing that, the SBT.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.