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Section 4: Quarantining of losses

Last updated 17 May 2020

Quarantining

If a CFC's notional allowable deductions relating to a particular class are more than the notional assessable income of that class for an accounting period, the excess cannot be claimed against notional assessable income of another class or used to reduce a net capital gain under the capital gains tax provisions.

The excess loss of a class of income is carried forward and can be claimed as a notional allowable deduction against income of the same class.

Note: The government announced in the May 2005 Budget that the foreign loss quarantining restrictions are to be removed, with effect for losses incurred in income years first commencing on or after the relevant legislation receives Royal Assent. This will mean that foreign losses may be offset against domestic income. However, foreign losses that arise before then continue to be treated under the current rules.

What are the classes of income?

Notional assessable income is divided into four classes:

  • interest
  • offshore banking
  • modified passive
  • other income.

The classes may include both income and gains of a capital nature. However, capital gains under the capital gains tax provisions are not included in any of the classes. In effect, these capital gains are treated as a separate class of income.

Interest

Most interest income, including payments in the nature of interest, falls into the interest class.

Excluded are:

  • interest that falls into the offshore banking income class
  • interest that is received in the active conduct of a trade or business - for example, interest on receivables
  • interest derived from money lending - for example, a banking business.

Offshore banking income

Offshore banking income is income derived through an offshore banking unit. It is unlikely that a CFC will have this type of income.

Modified passive income

Modified passive income is passive income other than amounts that fall within the interest class or the offshore banking income class. As mentioned previously, capital gains under the capital gains tax provisions are not included. Passive income includes rent, royalties, dividends, annuities, capital gains and amounts derived from the assignment of copyrights, for example.

Other income

The 'other income' class comprises amounts that do not fall within the other three classes.

Deductions for sometimes exempt income loss

You may claim a notional allowable deduction for a 'sometimes exempt income loss'. A sometimes exempt income loss can arise for a CFC in an accounting period if:

  • the CFC passed the active income test for the period, or
  • the CFC gained the benefit of the de minimis exemption for the period
  • and the CFC has any expenses that are not notional allowable deductions but would have been if the CFC had not passed the active income test or gained the benefit of the de minimis exemption.

How is the sometimes exempt income loss worked out?

The sometimes exempt income loss is worked out by:

  • assuming that the CFC had passed the active income test and did not have the benefit of the de minimis exemption
  • working out the amounts that would be included in the notional assessable income - called the sometimes exempt income
  • working out notional allowable deductions that would be available if the sometimes exempt income were assessable - called sometimes exempt deductions.

If sometimes exempt deductions of a class of income are more than the sometimes exempt income of that class, the difference is a sometimes exempt income loss.

Deductions for previous year losses

You may claim a notional allowable deduction for a CFC's previous years' losses. Do this separately for each class of income. In determining the loss for a particular class of notional assessable income, only the notional allowable deductions that relate to that particular class and were derived in that period are taken into account. If the notional allowable deductions are more than the notional assessable income, the difference is set off against the sometimes exempt income gain of that class for the period. The amount that remains is the CFC's loss for that class for the period.

How is a sometimes exempt income gain worked out?

The sometimes exempt income gain for each class of income is the amount of sometimes exempt income that is more than the sometimes exempt deductions. The sometimes exempt income gain reduces a CFC's loss in a class of income. Losses in the current period are reduced before losses carried forward from a previous period.

Conditions before a loss is allowed

You are allowed a notional deduction for a previous year's loss only if the CFC was a CFC when the loss was incurred and at the end of each period until the loss is claimed.

In working out the CFC's previous years' losses you must assume that you were always an attributable taxpayer who was required to work out attributable income. Therefore, it is possible to carry forward a loss from a period when you were not an attributable taxpayer.

You cannot take into account any loss incurred in a statutory accounting period that commenced before 1 July 1983.

Residency requirement for losses

A loss that was incurred in a previous statutory accounting period is only allowable if the CFC was a CFC at the end of that statutory accounting period in which the loss arose and at the end of each of the following statutory accounting periods before the eligible period.

In addition, certain residency requirements must be met before the loss may be applied against the notional assessable income of that class in the eligible period. If these are not satisfied the loss will not be taken into account.

Modifications to the general rule deal with cases where a company:

  • remains a resident of the same country, but
  • is treated as changing residence from a listed country to an unlisted country or vice versa as a result of changes to the list(s) of countries or political developments - for example, as a result of the dissolution of a country.

In these cases, the losses incurred by a CFC in an earlier period are not denied solely because the listing status of a CFC's country of residence changes.

The following table summarises the availability of losses incurred in previous statutory accounting periods.

CFC's country of residence at end of eligible period

CFC's country of residence at end of the substituted accounting period in which loss arose

Consequence

Listed

Listed

Allowable

Listed

Unlisted

Generally not allowable unless the unlisted country arose from the dissolution of the listed country or unless the unlisted country is the same country as the listed country.

Unlisted

Unlisted

Allowable

Unlisted

Listed

Generally not allowable unless the listed country is the same as the unlisted country.

Note: Losses are not allowable if they were denied in an earlier statutory accounting period

Losses confined to the CFC

Where a CFC has incurred a loss of a class of income, you cannot transfer the loss to reduce the notional assessable income of another CFC or your own assessable income. The loss is locked into the CFC.

Ordering

If there is more than one previous year's loss, you must claim the losses in the order in which they were incurred.

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