Contributed by Julia Khomenko, Lawyer, Betsy-Ann Howe, Partner, National Head of Tax, K&L Gates
On 30 March 2017, the government introduced the Treasury Laws Amendment (2017 Enterprise Incentives No 1) Bill which will reform the rules regarding the use of prior year losses by companies to reduce their taxable income. The Bill forms part of a package of measures designed as part of the government’s Innovation and Science Agenda.
The new rules will apply to income years starting on or after 1 July 2015 and are intended to improve access to losses for companies and certain trusts that have had significant changes to their ownership and to allow those companies and trusts to seek out opportunities to innovate and grow without losing access to losses.
Under the current rules, companies can carry forward tax losses and utilise those losses in future income years if they pass either:
- (a) the continuity of ownership test (COT), which will broadly be met if the company has maintained the same majority ownership from the time the loss was made through until the year it wants to utilise the loss, or
- (b) the same business test (SBT), which will be satisfied if the company has carried on the same business from the time the COT is failed through until the year it wants to utilise the loss (the “same business test period”).
If the company relies on the SBT to carry forward and utilise tax losses, it cannot enter either into new types of transactions or new business activities during the same business test period.
The loss integrity rules are intended to prevent “loss trading” which occurs where a company is stripped of all its assets, except tax losses, and is sold to another company. The rules also prevent inter-entity “loss multiplication” whereby a group of companies benefit from a single economic loss more than once, by artificially duplicating the loss through a chain of interposed entities.
The SBT is also used for the purposes of certain other provisions of ITAA 1997 which apply to companies, including the rules about using prior year net capital losses and applying losses to offset capital gains where there has been a change of ownership or control, bad debt deduction provisions, and the rules concerning the transfer of losses by a joining company to the head company when joining a consolidated group. A parallel same business test also applies to widely held trusts.
Background to the reform
The SBT was raised as an area of potential reform in the government’s 2015 Tax Discussion Paper, Re:think. The Discussion Paper noted that the current integrity rules were said to lead to losses being “trapped” or never able to be used. This was said to disadvantage small businesses and businesses that undertake high-risk investments, as well as hinder the legitimate restructuring of some businesses.
One of the criticisms raised was that the current rules do not determine whether a change to a company’s ownership was motivated by tax avoidance purpose rather than commercial considerations. In addition, the same business test has been criticised on the basis that it too narrowly prescribes the range of activities that a company can engage in without risking forfeiture of its losses. The Business Tax Working Group recommended a review of the SBT to ensure the right balance between supporting the appropriate risk taking and innovation, and maintaining appropriate integrity.
How the similar business test will apply
The amendments will supplement the SBT with a more flexible “similar business test” for the purposes of determining whether a company can use its tax losses and net capital losses from prior income years. The similar business test will also apply to listed widely held trusts.
A company will satisfy the test if the business it carries on throughout the income year when it wants to use the loss (the “business continuity period”) is similar to the business it carried on at the time immediately before the change of ownership which caused it to fail the COT.
It is not clear from the Explanatory Memorandum (EM) whether any periods of dormancy between the change-over and the year of recoupment will impact the application of the similar business test, as they affect the SBT. The SBT is generally failed where the taxpayer has ceased to carry on the business it carried on immediately before the change-over, and any business it carries on thereafter will be a new business (Taxation Ruling TR 1999/9, para 47).
The focus of the similar business test will be on the identity of the business. The test requires taking into account all of the commercial operations and activities of the former business and comparing them with those of the current business.
In working out whether the current business is similar to the former business, regard must be had to the following non-exhaustive list of factors:
- (a) Same assets used to generate income: The extent to which the assets, both physical and intangible, used in the current business to generate assessable income were also used in the company’s former business to generate assessable income. Goodwill will often be important when considering this factor.
- (b) Assessable income generated from the same activities and operations: 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 EM provides an example where a company ran an Italian restaurant and then opened up a takeaway fish and chips shop. The takeaway fish and chips shop would amount to a new activity or operation that produced the company’s assessable income.
- (c) The identity of the business: A comparison between the identity of the current business and the identity of the former business. This requires a broad-ranging enquiry into the cumulative effect of all changes that are reflected in the identity of the current business compared to that of the former business, not limited to matters of mere branding and public recognition. A comparison between the core functions of the current business and those of the former business is of most significance.
- (d) Development of former business: 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. This requires consideration of whether the change is a natural organic development of the former business, having regard to the degree of connection and continuity between the former business and the current business.
According to the EM, the test requires a clear similarity in the business identity of the operations of the former business and the current business. While certain differences which result from attempts to grow or rehabilitate the business are allowed, the test will be failed if there is a change in its essential character or identity, or if there is a sudden dramatic change in the business.
The EM contains four examples of the application of the above criteria.
- • Former business continues to generate most of the incomeThe fact that a relatively high percentage of the income continues to be generated from the same assets, activities and operations indicates that the current business is likely to be sufficiently similar to the former business.This factor is considered significant in the first and second examples, where the test is passed. In the first example, 85% of the company’s income is generated from the former business, while in the second example, the company’s former business still continues to be a “central part” of the of the business’s income-generating activities (the percentage of income generated from those activities is not specified).
- • Slight changes to the business identity are permittedIn the second example, the identity of the business changes to a certain extent as the company exploits additional commercial applications of its technology.Originally, the company used the algae treatments it has developed to make plastics. After the failure of the COT, the company starts to use the same treatments to make a teeth-whitening product. Importantly, however, the business identity remains predominantly associated with the exploitation of algae technology.It is concluded that the similar business test is met because, among other things, the unique algae treatment continues to be central to the business and that the changes in the business identity are “slight” and reflect the evolution of the business.
- • On balance, the similarities between the former and the current business must be more significant than the new assets and activitiesIn both the first and the second examples, the test is passed on the basis that the new assets and activities do not “outweigh” the similarities of the current business and the former business. The business is considered as a whole to determine whether this conclusion would be accurate.
- • There must be a significant development or commercialisation of an asset or processThis factor is one of the main factual differences between the first and second examples where the test is met, and the remaining examples where the test is failed.In the third example, a company changes its income-producing activities from manufacturing and wholesale distribution of its own iced tea to wholesale distribution of iced tea it purchases from another producer, which results in the test being failed.The constant between the former and the current business is the company’s distribution activities, but there is no evidence that the broader business changes and the company’s move towards profitability reflect the development or commercialisation of this process.
When the similar business test will apply
The similar business test will apply to:
- tax losses incurred by companies where the loss year begins on or after 1 July 2015. In this case, the company may choose to apply the same business test or the similar business test
- net capital losses made for income years beginning on or after 1 July 2015
- calculating a company’s taxable income or tax loss, and net capital gain or net capital loss, in an income year beginning on or after 1 July 2015 because a change of ownership occurred in that income year
- unrealised losses in relation to CGT assets where the income years immediately before the one in which a change of ownership or control occurred is an income year beginning on or after 1 July 2015
- debts incurred in income years beginning on or after 1 July 2015 that the company writes off as bad.
- a tax loss for a year starting on or after 1 July 2015
- the calculation of net income and tax losses for an income year starting on or after 1 July 2015 for the purposes of Div 268 in Sch 2F
- for the purposes of the bad debt provisions, debts incurred in an income year starting on or after 1 July 2015, including debts that are extinguished by a debt/equity swap.
No new income and new transactions tests
The similar business test differs from the SBT in that there are no negative limbs concerning new income and transactions. While such changes are relevant in applying the similar business test, the test is not automatically failed where new business activities or transactions are undertaken.
Application of the integrity rules in Div 175 of ITAA 1997
The integrity rules in Div 175 of ITAA 1997 prevent tax avoidance or income injection schemes that seek to use a company’s tax losses or deductions. These rules do not currently apply where the SBT is satisfied, because the negative limbs of that test would address the relevant integrity concerns.
However, since the negative limbs are not replicated in the similar business test, Div 175 will continue to apply where the company is able to utilise losses because of the application of the similar business test.
Changes made in contemplation of a change in ownership or control
An integrity provision will prevent the similar business test from being met where changes are made to the business prior and in contemplation of a change in ownership or control for the purpose of being able to satisfy the similar business test. This provision is based on the equivalent provision in the same business test which targets contrived arrangements.
Test period and test time
A company will satisfy the similar business test in an income year if the business which it carries on throughout the “business continuity test period” (the current business) is a similar business to the business it carried on immediately before the “test time” (the former business).
That is, in a basic case, the company must carry on a similar business throughout the year of recoupment to the business it carried on immediately before the time it failed the COT.
The similar business test will not apply to a tax loss (or net capital loss) that was originally incurred by the joining entity for an income year beginning before 1 July 2015 and that subsequently joined a consolidated group.
As it is illustrated in the examples, the application of the criteria to determine whether the test is met will depend on the particular facts and circumstances in each case.
When the Exposure Draft legislation was published, one of the issues raised is the submissions was that some aspects of the test lack clarity. For example, no specific “safe harbour” percentage is provided for the purposes of assessing the extent to which the sources of income generated in the current business are the same as those from which the former business generated its income. The similar business test is met in the first example provided in the EM, where 15% of the income is generated from new activities. The test is also met in the second example, where the former business continues to be a “central part” of the income-generating activities, but no percentage is specified. It is not clear whether the test would continue to be met if income generated by new activities accounted for 25%, 50% or more than 50% of the total income of the company which seeks to utilise its prior year losses.
We expect that further guidance and clarification will be provided in relation to the requirements of the similar business test in the future.
Once the legislation is passed by the Parliament, we assume that taxpayers who have already lodged their 2016 income tax returns and are eligible to apply the similar business test to utilise losses which were previously unavailable will be able to amend their returns accordingly.