House of Representatives

Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Bill 2005

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 2 - Loss recoupment rules for companies: same business test income ceiling

Outline of chapter

2.1 Schedule 1 to this Bill reforms the loss recoupment rules for companies by:

·
introducing a new modified continuity of ownership test (COT) to replace the existing modified COT in Division 166 of the Income Tax Assessment Act 1997 (ITAA 1997);
·
removing the same business test (SBT) for companies whose total income is more than $100 million in the year of recoupment; and
·
removing certain anomalies and clarifying some aspects of the existing law.

2.2 This chapter explains amendments that remove the SBT for companies whose total income is more than $100 million in relation to losses incurred in income years commencing on or after 1 July 2005.

Context of amendments

2.3 A company that fails the COT can nevertheless deduct a tax loss if it satisfies the SBT.

2.4 A company satisfies the SBT if it carries on the same business in the year it wishes to deduct the loss as it did immediately before it failed the COT and it does not derive income from a business or transaction of a new kind. Because of the practical difficulties in applying the COT, some companies have placed considerable reliance on the SBT to recoup prior year losses.

2.5 The introduction of tax consolidation has highlighted shortcomings with the SBT. It is difficult to compare the nature of a large and diverse business across two points in time, which may be several years apart.

2.6 This Bill introduces a ceiling for the SBT that prevents large companies (including consolidated groups) from satisfying the SBT if the total income is more than $100 million. The SBT ceiling is introduced in conjunction with measures to make the COT easier to apply. As a result, for large companies the focus of the loss recoupment rules will shift toward testing for continuity of ownership.

Summary of new law

2.7 An income ceiling of $100 million is introduced for the SBT. A company or consolidated group cannot satisfy the SBT in an income year in which its total income (including exempt income and non-assessable non-exempt income) is more than $100 million.

2.8 The ceiling only applies in relation to losses incurred in income years commencing on or after 1 July 2005.

Comparison of key features of new law and current law
New law Current law
The SBT is satisfied for a period if the company carried on the same business, engaged in no new kinds of transactions or businesses and (in relation to losses incurred in years starting on or after 1 July 2005) did not have total income of more than $100 million in the income year. The SBT is satisfied for a period if the company carried on the same business and engaged in no new kinds of transactions or businesses during that period.

Detailed explanation of new law

2.9 A total income ceiling applies to large companies (including consolidated groups) for the purposes of the SBT.

2.10 A company is not able to satisfy the SBT for the whole or a part of an income year if its total income for the income year is more than $100 million. The ceiling applies to losses incurred in income years commencing on or after 1 July 2005. [Schedule 1, items 76 and 172, section 165-212A]

2.11 Total income is tested for the income year in which the SBT period occurs.

2.12 The SBT period for tax losses and net capital losses is the income year in which the losses are recouped. Accordingly, a company cannot satisfy the SBT if its total income is more than $100 million in that year.

2.13 For example, a company incurs a tax loss in the income year ending 30 June 2006 and the company wishes to deduct the loss in the income year ended 30 June 2008. In determining whether it satisfies the SBT, the company needs to calculate its total income for the period 1 July 2007 to 30 June 2008. The total income of the company for the income years ending 30 June 2006 and 30 June 2007 will not be taken into account.

2.14 The SBT period for the application of the current year loss rules (Subdivisions 165-B and 165-CB) is that part of the year after the company fails the COT. Total income is calculated for the whole income year, even though the SBT period may only be part of the year.

2.15 The SBT period for bad debts is the second continuity period. The second continuity period is either the current income year or part of the current income year. As with the current year loss rules, the total income is calculated for the whole of the current income year, even if the second continuity period is only a part of the current income year.

2.16 If a company is a subsidiary member of a consolidated group for part of an income year, it determines its taxable income for each non-membership period as if that period were an income year (section 701-30 of the ITAA 1997)). Accordingly, in determining whether the SBT is satisfied in a non-membership period, total income is calculated for the non-membership period. However, total income is adjusted to a 12-month equivalent. [Schedule 1, item 76, section 165-212C]

2.17 The failure of the SBT because the total income ceiling is exceeded does not necessarily preclude a future deduction of a tax loss or the future application of a net capital loss. The failure of the SBT in a given income year does not extinguish a tax loss or a net capital loss (other than in the context of a transfer to the head company of a consolidated group). Accordingly, it would be possible for the SBT to be satisfied and the loss claimed in a subsequent year if total income falls below $100 million. The same outcome does not arise in respect of a bad debt since a bad debt can only be deducted in the income year in which it is written-off.

What is total income?

2.18 Total income consists of:

·
assessable income;
·
exempt income; and
·
non-assessable non-exempt income.

[Schedule 1, item 76, subsection 165-212B(1)]

2.19 Total income is a calculation of gross income and accordingly it is not reduced by current year deductions or tax losses.

2.20 The total income of a head company of a consolidated group or multiple entry consolidated group (MEC group) includes amounts derived by subsidiary members of the group. This is an outcome of the single entity rule in section 701-1 of the ITAA 1997.

2.21 Net capital gains are excluded from total income as they are not reflective of the on-going income earning potential of the company. Capital gains that are disregarded are also excluded from total income, because these amounts are neither exempt income nor non-assessable non-exempt income. [Schedule 1, item 76, subsection 165-212B(1)]

2.22 Amounts that are non-assessable non-exempt income under section 17-5 because they represent goods and services tax (GST) collected by a company are excluded from total income. [Schedule 1, item 76, paragraph 165-212B(2)(a)]

2.23 Non-assessable non-exempt income is also excluded from total income if it represents an amount that has been included in assessable income. Such amounts are excluded from total income to prevent double counting. [Schedule 1, item 76, paragraph 165-212B(2)(b)]

2.24 Examples of non-assessable non-exempt income that are excluded from total income are:

·
Amounts received on the disposal of trading stock outside the ordinary course of a business, where the market value of the trading stock is included in assessable income (section 70-90 of the ITAA 1997).
·
Attribution account payments in cases where attribution account debits arise. Broadly, attribution account payments (eg, dividends from controlled foreign companies) are exempt from tax because the profits of the foreign subsidiary have already been included in the assessable income of the Australian company under the controlled foreign companies provisions (section 23AI of the ITAA 1936).
·
Foreign investment fund attribution account payments where attribution account debits arise. Broadly, foreign investment fund attribution account payments (eg, dividends from foreign investment funds) are exempt from tax because the profits have already been included in the assessable income of the Australian company under the foreign investment fund provisions (section 23AK of the ITAA 1936).
·
Amounts distributed from a trust where the income has already been attributed to the company pursuant to Division 6AAA of Part III of the ITAA 1936 (paragraph 99B(2)(e) of the ITAA 1936).
·
Dividends that offset a shareholder loan that has been treated as a deemed dividend under Division 7A of Part III of the ITAA 1936 (subsection 109ZC(3) of the ITAA 1936).

Example 2.1: Same business test total income ceiling In the year ended 30 June 2006, Steel Limited incurs a tax loss of $50 million.On 1 August 2006, Minerals Limited acquires 60 per cent of Steel Limited pursuant to a takeover bid. As a consequence, Steel Limited fails the COT on that day.In the year ended 30 June 2007, Steel Limited has assessable income of $90 million and deductions (not including tax losses) of $60 million. $10 million of its assessable income comes from a net capital gain.In the same year, a foreign company pays Steel Limited a dividend of $25 million. The dividend is a non-portfolio dividend that is non-assessable non-exempt income under section 23AJ of the ITAA 1936.Steel Limited's taxable income is $30 million (excluding any tax loss deduction). Therefore, Steel Limited could deduct up to $30 million of its tax loss if it satisfies the relevant loss recoupment tests. Since Steel Limited has failed the COT, it must rely on the SBT.

Same business test total income ceiling

Steel Limited has been a manufacturer of steel products since 1990. It continues to conduct the same business of steel manufacturing throughout the period 1 July 2006 to 30 June 2007 (the SBT period) as it did immediately prior to 1 August 2006.Notwithstanding that it carries on the same business activities, Steel Limited cannot satisfy the SBT for the year ending 30 June 2007 because its total income for the period 1 July 2006 to 30 June 2007 is $105 million, comprising $80 million of assessable income (not including the net capital gain) and $25 million of non-assessable non-exempt income. Accordingly, Steel Limited exceeds the $100 million SBT ceiling in the income year ending 30 June 2007.Because Steel Limited does not satisfy the SBT it cannot deduct its tax loss in the income year ending 30 June 2007.

Grossing-up of total income for periods of less than 12 months

2.25 If the period in which total income is tested is not 12 months, the total income is adjusted so that it corresponds to a 12-month period. This can occur if a company:

·
comes into existence or ceases to be in existence during the relevant income year; or
·
is a subsidiary member of a consolidated group for part of the relevant income year.

[Schedule 1, item 76, subsection 165-212C(1)]

2.26 The total income of a company whose income period is not 12 months is the amount that the company reasonably estimates would be its total income for a complete 12-month period. [Schedule 1, item 76, subsection 165-212C(2)]

2.27 For example, a company is only in existence for 3 months of the year and has a total income of $30 million. Generally, the amount adjusted for 12 months would be $120 million (4 x $30 million). However, a company's calculation of total income in these circumstances may vary if seasonal factors affect the company's business, or if total income is growing or falling through the income year.

2.28 This adjustment mechanism applies instead of section 716-850, which would otherwise operate to adjust thresholds for the purpose of subsection 701-30(3) in respect of periods of less than 365 days. [Schedule 1, item 76, subsection 165-212C(3)]

Total income ceiling and consolidation

2.29 When a company joins a consolidated group, the company must satisfy the loss recoupment tests to transfer its losses of any sort (including tax losses, net capital losses and foreign losses) to the head company of the consolidated group (section 707-120 of the ITAA 1997). Losses not transferred to the head company cannot be utilised after the joining time (section 707-150).

2.30 For the purpose of the transfer of losses to the head company of a consolidated group, a company can only satisfy the SBT if total income is $100 million or less in both:

·
the income year in which the COT was failed; and
·
the income year that ends during the trial year (or, if there is no such year, the income year in which the joining time occurs).

2.31 The SBT ceiling is not applied to a trial year because the trial year generally overlaps 2 income years and is not a period for which the joining company separately calculates its income. Instead, the ceiling applies to the total income of the company for the income year that ends during the trial year. A company does not satisfy the SBT for a trial year if its total income is more than $100 million for the income year that ends during the trial year. [Schedule 1, item 133, paragraph 716-805(1)(a)]

2.32 In some cases, an income year does not end during a trial year. This may occur when the company has recently exited a consolidated group, or has recently come into existence. If an income year does not end during the trial year, then the company calculates its total income for the income year in which the joining time occurs [Schedule 1, item 133, paragraph 716-805(1)(b)] . In such a case, the company adjusts its total income if the period is less than 12 months.

2.33 A company joining a consolidated group also has to satisfy the SBT for the income year in which the SBT test time occurs, that is, the year the company fails the COT (section 707-125). Accordingly, the company's total income must also be $100 million or less in the income year that the SBT test time occurs to satisfy the SBT for the purposes of transferring a loss to the head company of a consolidated group. [Schedule 1, item 133, subsection 716-805(2)]

2.34 For losses incurred in income years commencing on or before 30 June 1999, the SBT only needs to be satisfied for the trial year (section 707-125), but such losses are not subject to the total income ceiling.

Example 2.2: Same business test total income ceiling and consolidation Continuing from Example 2.1, on 1 September 2007, Minerals Limited acquires the remaining 40 per cent of shares in Steel Limited. Minerals Limited is the head company of a consolidated group and therefore Steel Limited joins the consolidated group. Deduction of tax loss before joining time Steel Limited will treat the period 1 July 2007 to 31 August 2007 as if it were an income year (see section 701-30).

Same business test total income ceiling and consolidation

Steel Limited's assessable income for the pre-joining time period (1 July to 31 August) is $10 million and its deductions (not including tax losses) are $8 million. It has no exempt or non-assessable non-exempt income in this period.Steel Limited can only deduct $2 million of its tax loss in the non-membership period if it satisfies the SBT.Steel Limited's total income for the non-membership period is the sum of its assessable income ($10 million), its exempt income (nil) and its non-assessable non-exempt income (nil). Its total income is adjusted by the length of the period (see section 165-212C). There are no seasonal factors affecting Steel Limited's income, so Steel Limited grosses up its total income by reference to the proportion of the income year that falls in the non-membership period. In this case, the adjustment results in total income for Steel Limited of $58.9 million ($10 million x 365/62).Steel Limited continues to carry on the same business during the non-membership period as it did immediately prior to 1 August 2006 (when it failed the COT). Accordingly, Steel Limited satisfies the other conditions for the SBT and can deduct $2 million of its tax losses, to reduce its taxable income to nil. Transfer of tax loss to Minerals Limited Steel Limited will apply sections 707-120 and 707-125 to determine whether it can transfer its remaining tax losses of $48 million to Minerals Limited on joining the consolidated group.

Transfer of tax loss to Minerals Limited

Steel Limited must satisfy the SBT for the trial year, which is 1 September 2006 to 1 September 2007 and the income year in which it failed the COT, 1 July 2006 to 30 June 2007. Steel Limited will only be able to satisfy the SBT for these periods if its total income is $100 million or less for:

·
the income year in which the test time occurred (1 July 2006 to 30 June 2007); and
·
the income year which ended during the trial year (also 1 July 2006 to 30 June 2007).

Steel Limited's total income is $105 million for the income year 1 July 2006 to 30 June 2007 (see Example 2.1), and will not be able to satisfy the SBT. Accordingly, Steel Limited will not be able to transfer its tax losses to Minerals Limited.

Interaction with consolidation bad debt rules

2.35 Subdivision 709-D concerns the interaction between consolidation and the deduction of bad debts. Subdivision 709-D applies if a debt is written-off as bad and is held by a company that is a member of a consolidated group for some, but not all, of the time between when the debt was incurred and when it was written-off. In such a case, Subdivision 709-D divides the test period into segments (debt test periods) for the purposes of applying the COT and the SBT.

2.36 A company can only claim the bad debt deduction if each entity that was owed the debt would have been entitled to deduct it in its debt test income year. This requires each entity to satisfy the COT or the SBT for its debt test income year.

2.37 A debt test income year (and hence the SBT period) ends either at the end of the income year in which the debt is written-off or the end of the debt test period. A debt test income year that ends at the end of an income year may be a normal 12-month income year or a shorter period if the debt test period starts after the start of the income year (item 1 in the table in subsection 709-215(3)).

2.38 In a case to which item 2 in the table in subsection 709-215(3) applies, the debt test income year will only end at the end of an income year if the debt test period ends at the end of an income year. Regardless of the length of the debt test period, the debt test income year will be no more than 12 months. However, it could be shorter than 12 months or it could overlap 2 income years.

2.39 The SBT ceiling applies to the income year in which the debt is written-off (when item 1 in the table in subsection 709-215(3) applies). It also applies to an income year in which a debt test period ends (when item 2 in the table in subsection 709-215(3) applies) - broadly, this is the income year in which an entity ceased to be owed the debt. If total income of the entity is more than $100 million in such a year, the entity cannot satisfy the SBT for its debt test income year. [Schedule 1, item 133, subsection 716-805(3)]

Interaction between consolidation and loss integrity measures

2.40 Subdivisions 715-A and 715-D (in part) deal with the interaction between Subdivision 165-CC (change of ownership or control of a company that has an unrealised net loss) and Part 3-90 (consolidation).

2.41 The SBT is applied in the following contexts on formation of a consolidated group or when an entity joins the group:

·
On an entity joining a consolidated group, the step 1 amount of the allocable cost amount may be reduced in relation to a membership interest in the joining entity that is a Subdivision 165-CC tagged asset, unless the member holding the interest satisfies the SBT (section 715-50).
·
On an entity joining a consolidated group, the step 2 amount of the allocable cost amount may be reduced in relation to an accounting liability that the joining entity owes to another member of the group if the accounting liability is a Subdivision 165-CC tagged asset, unless that other member satisfies the SBT (section 715-55).
·
On formation of a consolidated group, a loss denial pool may be created if the head company owns a capital gains tax (CGT) asset that is a Subdivision 165-CC tagged asset unless the head company satisfies the SBT (section 715-60).
·
On formation of a consolidated group, a loss denial pool may be created if a chosen transitional entity holds a Subdivision 165-CC tagged asset unless the entity satisfies the SBT (section 715-70).
·
On formation of a consolidated group, a loss denial pool may be created if the head company has a Subdivision 170-D deferred loss that it made on a Subdivision 165-CC tagged asset and it does not satisfy the SBT (section 715-355).
·
On an entity joining a consolidated group, a loss denial pool may be created if the entity has a Subdivision 170-D deferred loss that it made on a Subdivision 165-CC tagged asset and it does not satisfy the SBT (section 715-360).

2.42 In all of these cases, the SBT period is the trial year of either the head company or the relevant member. The total income ceiling is tested for the income year that ends during the relevant trial year. [Schedule 1, item 133, paragraph 716-805(4)(b)]

2.43 For example, section 715-50 requires a member of a consolidated group to apply the SBT for the period consisting of the head company's trial year. For the purposes of section 715-50, the total income ceiling is applied in relation to the income year that ended during the head company's trial year.

2.44 If there is no income year which ends during the trial year, then the SBT ceiling is instead applied to the income year in which the joining time occurs for the entity whose trial year is used as the SBT period. [Schedule 1, item 133, paragraph 716-805(4)(c)]

2.45 If a company leaves the consolidated group with a Subdivision 165-CC tagged asset and the head company has a final residual unrealised net loss greater than nil, then there may be certain consequences for the head company or the leaving entity unless the head company satisfies the SBT (section 715-95). The SBT period is the period starting 12 months before the leaving time (or more recently if the head company has come into existence in the last 12 months) and ending just before the leaving time. In such a case, the total income ceiling is applied to the income year of the head company that ends within the 12 months before the leaving time. [Schedule 1, item 133, paragraph 716-805(4)(a)]

2.46 However, if no income year of the head company ends in this period (eg, if the head company recently came into existence or ceased to be a member of a consolidated group), the total income ceiling is applied to the income year in which the leaving time occurs. [Schedule 1, item 133, paragraph 716-805(4)(c)]

Application and transitional provisions

2.47 The amendments relating to the SBT total income ceiling apply to:

·
tax losses incurred in income years commencing on or after 1 July 2005;
·
net capital losses made in income years commencing on or after 1 July 2005; and
·
deductions claimed in respect of bad debts incurred in income years commencing on or after 1 July 2005.

[Schedule 1, subitem 172(1)]

2.48 If a company has a substituted accounting period, the SBT ceiling will apply to its first income year commencing after 1 July 2005. For example, an early balancing company whose substituted accounting period is 1 April to 31 March will first be subject to the SBT for losses incurred in its income year commencing 1 April 2006.

Effect of deemed dates

2.49 Section 165-115B treats a tax loss or a net capital loss as having been made in the income year immediately before the changeover time. Accordingly, the SBT ceiling will not apply to a loss that is treated by section 165-115B as having been deemed to be made in an income year commencing before 1 July 2005.

2.50 Section 707-140 treats the head company of a consolidated group as having made a loss of any sort that is transferred to it in the income year in which it is transferred. However, the deemed date for the loss is disregarded in determining whether the SBT ceiling applies. If the loss was actually incurred by the joining entity in an income year commencing before 1 July 2005, the SBT ceiling will not apply. Further, if a loss has previously been transferred, the SBT ceiling will not apply if the loss was originally incurred by the entity that first made it in an income year commencing before 1 July 2005. [Schedule 1, paragraph 172(2)(a)]

2.51 Subdivision 709-D provides for the deduction of a bad debt if the debt is owed to a consolidated group for some of the period it was in existence. Section 709-215 modifies the period in which continuity of ownership is tested. However, it does not deem the debt to be incurred on a date different from that it was actually incurred. Accordingly, section 709-215 does not affect the application of the SBT ceiling to a bad debt. The SBT ceiling does not apply to debts incurred before 1 July 2005 that are later written-off as bad even though the first and second continuity periods may commence after that date.

Unrealised losses

2.52 There is an exception to the application of the SBT ceiling in respect of a tax loss or a net capital loss if the company had a unrealised net loss immediately before the commencement of its first income year starting on or after 1 July 2005. The exception operates by comparing the tax loss or net capital loss made in an income year, with the tax loss or net capital loss that would have been made in that year, if a changeover time occurred just before the start of the company's first income year commencing on or after 1 July 2005.

2.53 If there is an unrealised net loss at a changeover time, future deductions or capital losses may be recharacterised as tax losses or net capital losses (as appropriate) for the income year before the changeover time. An outcome of this recharacterisation is that a tax loss or net capital loss in the current year may be reduced. The SBT ceiling does not apply to a tax loss or net capital loss to the extent that the deduction or capital loss comprising the tax loss or net capital loss relates to an unrealised net loss immediately before 1 July 2005. [Schedule 1, paragraph 172(2)(b)]

Foreign losses

2.54 As foreign losses are subject to the SBT in the same way as tax losses (subsection 160AFD(6)), the SBT ceiling applies to a foreign loss incurred in an income year commencing on or after 1 July 2005.

Consequential amendments

2.55 The SBT ceiling is an element of whether a company satisfies the SBT. The concept of a company 'satisfying the same business test' replaces the existing concept in Divisions 165 and 166 of a company 'carrying on the same business' in the amendments to incorporate the SBT ceiling into the SBT.

2.56 This Bill amends references to a company 'carrying on the same business' (or similar) to 'satisfying the same business test' (or similar) in provisions, guides and notes to provisions as required. [Schedule 1, items 4 to 9, 13, 18, 22, 27, 31, 41, 53, 59, 63, 66, 80, 89 and 98]

2.57 Notes and changes to guide material and tables alert readers of this Bill to the SBT ceiling. [Schedule 1, items 12, 14, 19 to 21, 24 to 26, 28, 33, 35, 36, 40, 43 to 45, 52, 55, 62, 65, 67, 74, 75, 81, 90, 107, 108, 110, 113, 115, 119 to 132, 137, 138 and 140]


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