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 3 - Loss recoupment rules for companies: other amendments

Outline of chapter

3.1 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.

3.2 This chapter explains amendments to the company loss recoupment rules that remove certain anomalies and clarify aspects of the existing rules.

Summary of new law

3.3 Amendments to the company loss recoupment rules:

·
provide that the COT is not failed merely because an external administrator or provisional liquidator is appointed to the tested company or to a corporate shareholder;
·
amend the application of the income injection rules to an insolvent company;
·
provide that the consolidation entry history rule is disregarded for the purposes of the SBT;
·
provide that a medical defence organisation does not fail the SBT merely because of a restructure to satisfy the requirements of the Medical Indemnity (Prudential Supervision and Product Standards) Act 2003 ;
·
treat shares held by a trustee of a family trust as if they were owned by a notional entity to ensure that a change in the trustee or the appointment of more than one trustee does not affect the COT being satisfied;
·
provide that non-profit companies, mutual affiliate companies and mutual insurance companies only need to establish continuity of voting power to satisfy the COT;
·
treat certain government bodies, statutory bodies, non-profit companies and charitable bodies as if they were persons (and not companies) for the purposes of the COT;
·
allow companies without shares to apply the COT as if their membership interests were shares;
·
provide that the alternative test applies when one or more companies become shareholders of the tested company after the start of the loss year;
·
clarify that the COT can be satisfied when the tested company is in existence for only part of the loss year or part of the income year;
·
repeal a provision that prevents companies taking into account redeemable shares when applying the COT;
·
disregard special voting shares issued by dual listed companies for the purposes of the voting power condition of the COT; and
·
correct some incorrect references to the COT ownership test period and the calculation of net capital losses.

Comparison of key features of new law and current law
New law Current law
The COT is not failed merely because the tested company or a shareholder is, or becomes, externally administered (eg, goes into liquidation) or a provisional liquidator is appointed. The COT may be failed if the tested company and a majority shareholder become externally administered.
The consolidation entry history rule is disregarded for the purposes of the SBT. The interaction between the consolidation entry history rule and the SBT is uncertain.
A company that is in existence for only part of the loss year or part of the income year can satisfy the COT. It is uncertain whether a company can satisfy the COT if it is in existence for only part of the loss year or part of the income year.
The alternative test applies if a company has shares or interests in shares in the tested company at any time in the test period. The alternative test only applies if a company has shares or interests in shares in the tested company at the start of the test period.
Shares owned by the trustee of a family trust are taken to be beneficially owned by a single notional entity. Relevant rights held by the trustee are also attributed to the single notional entity. A change in trustee is not regarded as a change in ownership. Shares owned by the trustee of a family trust are taken to be owned beneficially. Relevant rights held by the trustee are taken to be held for the trustee's own benefit.
Non-profit companies only need to satisfy the voting power condition to satisfy the COT. Non-profit companies need to satisfy the voting power and dividend and capital rights conditions to satisfy the COT.
Certain government bodies, statutory bodies, non-profit companies and charitable bodies are treated as persons and not companies for the purposes of the COT. No equivalent.
Companies without shares apply the COT as if their membership interests were shares. The application of the COT to companies without shares is uncertain.
Dual listed companies ignore special voting shares for the purposes of the voting power test. No equivalent.

Detailed explanation of new law

Externally administered companies

3.4 This Bill contains amendments to expressly provide that the appointment of a liquidator, other external administrator or a provisional liquidator to a company has no impact on:

·
whether the company satisfies the COT; or
·
whether shares or interests in shares that it holds can be taken into account in determining whether another company satisfies the COT.

3.5 Broadly, the amendments provide that:

·
the fact that a company becomes an externally administered body or a provisional liquidator is appointed does not prevent a shareholder from beneficially owning shares in the company or having control of voting power, or rights to dividends or capital in the company [Schedule 1, items 1 and 2, subsections 80B(8A) and 160ZNRA(1) of the Income Tax Assessment Act 1936 (ITAA 1936); item 73, subsection 165-208(1) of the ITAA 1997] ; and
·
the fact that a shareholder company becomes an externally administered body or a provisional liquidator is appointed does not prevent it beneficially owning shares, controlling voting power or having rights to dividends and capital distributions attaching to those shares [Schedule 1, items 1 and 2, subsections 80B(8B) and 160ZNRA(2) of the ITAA 1936; item 73, subsection 165-208(2) of the ITAA 1997] .

3.6 Accordingly, satisfaction of the COT is unaffected if the tested company, or a company interposed between the tested company and an ultimate owner, goes into external administration or a provisional liquidator is appointed to the company or interposed company.

3.7 In addition, the appointment of an external administrator to a company does not affect control of voting power in the company for the purposes of the test in section 165-15 (or equivalent tests in sections 165-40, 165-115D, 165-115M, and 165-129). [Schedule 1, item 78, section 165-250]

3.8 A company is an 'externally-administered body corporate' under section 9 of the Corporations Act 2001 if:

·
it is being wound up;
·
a receiver, or a receiver and manager, has been appointed and is acting in respect of its property;
·
it is under administration;
·
it has executed a deed of company arrangement that has not yet been terminated; or
·
it has entered into a compromise or arrangement with another person, the administration of which has not yet been concluded.

3.9 The same rules apply in relation to an entity which has a similar status under a foreign law or the Companies Code. [Schedule 1, items 1 and 2, sections 80B and 160ZNRA of the ITAA 1936; items 73 and 78, sections 165-208 and 165-250 of the ITAA 1997]

Income injection and insolvent companies

3.10 Loss trafficking can occur when entities inject income from other sources into a loss company. The income injection provisions of the income tax law (Division 175) disallow deductions for tax losses in specified circumstances. However, the Commissioner of Taxation (Commissioner) cannot disallow a loss if the continuing shareholders will benefit from the derivation or accrual of the injected amount to an extent that the Commissioner thinks is fair and reasonable, having regard to either their respective rights and interests or their respective shareholding interests in the company.

3.11 The intention is that if continuing shareholders do not receive benefits from the income injected the loss should be denied. However, it is arguable that where a company is insolvent and in some form of external administration, the Commissioner cannot deny the loss on the grounds that it is reasonable that the benefit of income injected into the company flows to the creditors of the company rather than to the continuing shareholders.

3.12 The amendment provides that the provisions limiting the Commissioner's power to disallow a loss or deduction do not apply during a relevant income year if the company was insolvent at the time it becomes an externally-administered body corporate under the Corporations Act 2001 or an entity with similar status under a similar foreign law. [Schedule 1, item 103, section 175-100]

3.13 The amendments apply to insolvent companies whose external administration begins on or after the day this Act receives Royal Assent. [Schedule 1, item 176]

The same business test and the entry history rule

3.14 When a consolidated group or multiple entry consolidated group (MEC group) applies the SBT, its business is that of the group as a whole and not just that of the head company. This is because the single entity rule provides that subsidiary members of the group are taken to be parts of the head company for the purpose of working out the head company's liability for income tax (section 701-1).

3.15 The entry history rule provides that for certain purposes everything that happened to a subsidiary before it became a member of a consolidated or MEC group is taken to have happened to the head company (section 701-5).

3.16 If the entry history rule applies for the purposes of the SBT, the head company may be regarded as carrying on the business that subsidiary members carried on before they joined the consolidated group. This could lead to anomalous outcomes. For example, changes in the business of a subsidiary before it became a group member could cause the head company to fail the SBT.

3.17 This Bill clarifies that the entry history rule does not operate to deem the head company of a consolidated or MEC group to carry on the activities of a subsidiary member of the group during a period before the subsidiary member joined the group. [Schedule 1, item 76, section 165-212E]

3.18 When an entity joins a consolidated or MEC group, its activities are treated as activities of the head company from its joining time for the purposes of the SBT. Activities that the entity carried on before the joining time are not attributed to the head company for the purposes of determining whether the head company has carried on the same business.

3.19 The rule has practical implications only when an entity joins an existing consolidated group. The entry history rule does not affect the application of the SBT in relation to entities that join a consolidated group on its formation, because the SBT does not compare the business of the head company before and after consolidation (see section 707-400 of the ITAA 1997).

Example 3.1: Same business test and entry history rule. Innovative Solutions Ltd is the head company of a consolidated group that carries on research and development in the biotechnology industry.Innovative Solutions Ltd has tax losses from the year ended 30 June 2004 and failed the COT on 1 March 2005. It wishes to use its tax losses in the income year ended 30 June 2007 and must demonstrate that it carries on the same business in the income year ended 30 June 2007 that it carried on immediately before 1 March 2005.Innovative Solutions Ltd acquired Tests and Things Pty Ltd on 1 October 2006.Tests and Things Pty Ltd is a small company that carries on biotechnology research. The research is similar to that conducted by Innovative Solutions Ltd and its subsidiaries. Tests and Things Pty Ltd previously manufactured test tubes, but it ceased that part of its business in April 2006.

Same business test and entry history rule

If the entry history rule applied in relation to the SBT, Innovative Solutions Ltd would be deemed to carry on the test tube manufacturing business up until April 2006. Accordingly, it would not carry on the same business immediately before 1 March 2005 as it carries on in the income year ended 30 June 2007 and would therefore fail the SBT.The amendment confirms that, for the purposes of the SBT, Innovative Solutions Ltd is not taken to have conducted the activities of Tests and Things Pty Ltd prior to 1 October 2006. Accordingly, Innovative Solutions Ltd is not to be regarded as carrying on the test tube manufacturing business at the SBT test time and will therefore satisfy the SBT.

Medical defence organisations

3.20 The Medical Indemnity (Prudential Supervision and Product Standards) Act 2003 required medical indemnity providers to make changes to the way in which they provided medical indemnity services. In particular, it required that a medical indemnity provider be a general insurer and that medical indemnity be provided by means of a contract of insurance.

3.21 The amendments confirm that changes made by a medical defence organisation in order to conform to the requirements of the Medical Indemnity (Prudential Supervision and Product Standards) Act 2003 do not cause a failure of the SBT. Similarly, changes made by a related general insurance company because of the restructure by a medical defence organisation do not prevent the general insurance company from satisfying the SBT. [Schedule 1, item 76, section 165-212D]

Family trusts

3.22 Existing section 165-207 applies if the trustee of a family trust either directly or indirectly holds an interest in shares in the tested company. The application of the existing law is uncertain when there is a change of trustee or when there is more than one trustee of the family trust.

3.23 These amendments ensure that a single notional entity that is a person but not a company or a trustee:

·
is taken to own the shares beneficially for the purposes of the primary test [Schedule 1, item 72, subsection 165-207(2)] ; and
·
is taken to control the voting power held by the family trust and have the right to receive for its own benefit the percentage of the dividends and capital to which the trust is entitled [Schedule 1, item 72, subsection 165-207(3)] .

3.24 A change in trustee does not affect the attribution of beneficial ownership, voting power or rights to dividends or capital held by the single notional entity. [Schedule 1, item 72, subsection 165-207(4)]

3.25 The single notional entity referred to in this section is a different notional entity to the ones referred to in sections 166-225 and 166-255. [Schedule 1, item 79, subsections 166-225(3) and 166-255(3)]

Non-profit companies

3.26 A company satisfies the COT if it satisfies conditions relating to voting power, rights to dividends and rights to capital distributions.

3.27 A company that is prohibited from making any distributions to its shareholders cannot test the dividend and capital conditions because it never pays a dividend or makes a distribution of capital to its shareholders. Accordingly, under the existing rules it is uncertain how a non-profit company is to apply the COT. A similar situation exists for mutual insurance companies and mutual affiliate companies.

3.28 The amendments provide that a company that is a non-profit company, a mutual affiliate company or a mutual insurance company throughout the test period is taken to satisfy the dividend and capital conditions. As a result, these companies satisfy the COT if they satisfy the voting power condition.

3.29 This amendment applies for:

·
tax losses [Schedule 1, item 17, subsection 165-12(7A)] ;
·
current year losses [Schedule 1, item 30, subsection 165-37(4A)] ;
·
changeover times [Schedule 1, item 47, subsection 165-115C(4A)] ;
·
alteration times [Schedule 1, item 50, subsection 165-115L(5)] ; and
·
bad debts [Schedule 1, item 58, subsection 165-123(7A)] .

3.30 A company is a non-profit company (as defined in the Income Tax Act 1986 ) if it is not carried on for the profit or gain of its individual members and is prohibited from making distributions to its members. A friendly society dispensary is also a non-profit company. [Schedule 1, item 156, subsection 995-1(1)]

Certain entities treated as persons other than companies

3.31 The primary tests for the COT require the identification of persons who hold voting power, rights to dividends and rights to capital.

3.32 The alternative tests for the COT apply when the tested company has a corporate shareholder. It requires the identification of persons other than companies (and, in the case of voting power, other than trustees) who hold voting power and dividend and capital rights.

3.33 Subsection 995-1(1) of the ITAA 1997 defines 'person' to include a company. However, it does not specify whether bodies politic (eg, governments) are also regarded as persons. A similar issue arises in relation to statutory corporations which are often essentially government bodies.

3.34 These amendments ensure that government bodies and statutory corporations are to be regarded as persons (and not companies) for the purposes of a loss recoupment test. It applies to shares held by:

·
the Commonwealth, a state or a territory;
·
a municipal corporation;
·
a local governing body;
·
the government of a foreign country or of part of a foreign country; and
·
a company, established under a law, in which no person has a membership interest (eg, a statutory corporation).

[Schedule 1, item 71, subsection 165-202(1)]

3.35 A company may not be able to trace its ownership through a non-profit company or a charitable body. The amendment also provides that non-profit companies and charitable bodies (including charitable institutions and charitable funds) are regarded as persons other than companies. This amendment ensures that companies do not need to trace their ownership through non-profit companies and charitable bodies. [Schedule 1, item 71, subsection 165-202(2)]

3.36 These amendments apply for the purposes of both the primary and alternative tests.

Companies without shares

3.37 The primary tests for the COT focus on rights attaching to shares and the alternative tests are only applicable if another company holds shares in the tested company. Accordingly, its unclear under the existing rules how companies without shares, such as companies limited by guarantee, can apply the COT.

3.38 These amendments ensure that companies without shares can apply the COT. Membership interests in a company without shares are treated as if they were shares for the purpose of applying a test. This means that if no companies are members of the tested company, the company applies the primary tests and treats its membership interests as if they were shares for the purposes of those tests. If a company holds membership interests in the tested company, the tested company applies the alternative tests. [Schedule 1, item 71, section 165-203]

3.39 If a company without shares is a non-profit company, the amendments relating to non-profit companies mean that the company applies the voting power test.

Application of alternative ownership tests

3.40 To work out whether it satisfies the COT, a company applies either the primary test or the alternative test for each of the conditions. The primary test looks at the immediate beneficial ownership of shares carrying voting power and dividend and capital rights. The alternative test applies where a company holds shares in the tested company and traces the ownership of the voting power and dividend and capital rights to the non-corporate shareholders.

3.41 Under the existing law, the alternative test only applies if one or more companies beneficially held shares or interests in shares in the tested company at the beginning of the ownership test period. If no companies hold shares in the tested company at the start of the test period, the primary test applies.

3.42 The effect of this rule is that the interposition of a company between existing shareholders (none of which are companies) and the tested company after the start of the test period automatically causes a company to fail the COT even though ultimate ownership remains unchanged.

3.43 The COT is amended so that the alternative test applies if a company beneficially owns shares in the tested company at any time in the ownership test period. This applies for:

·
tax losses (Subdivision 165-A);
·
current year loss rules (Subdivision 165-B);
·
changeover times (Subdivision 165-CC);
·
alteration times (Subdivision 165-CD); and
·
bad debts (Subdivision 165-C).

[Schedule 1, items 16, 29, 46, 49 and 57, subsections 165-12(6), 165-37(3), 165-115C(3), 165-115L(4) and 165-123(6)]

3.44 Thus, a company does not fail the COT merely because a holding company is interposed between individual shareholders and a tested company during the ownership test period. However, the question of whether the COT is satisfied in any particular case would depend on the effect of the same share test (see section 165-165 and subsections 165-12(7), 165-37(4), 165-115C(4) and 165-123(7)).

Companies that come into existence or cease to exist during a period

3.45 The COT requires a company to establish continuity of ownership between the start of the loss year and the end of the income year. The SBT requires that a company carry on the same business during the income year as it did immediately before it failed the COT.

3.46 The application of the loss recoupment rules to companies that come into existence during the loss year is uncertain. This uncertainty is removed by an amendment to clarify the operation of the company loss recoupment rules when a company comes into existence. If a period would start before the company comes into existence, it starts on the day the company comes into existence. That is, if a company incurs a tax loss in the year it is incorporated, it applies the COT on the basis that the loss year commenced at the time it was incorporated, rather than from the start of the income year. [Schedule 1, item 78, subsection 165-255(1)]

3.47 These amendments also clarify the application of the company loss rules to a company which ceases to exist. The amendment provides that if a period would end after the company ceases to exist, it instead ends on the day the company ceases to exist. The effect is that a company can satisfy the COT in a year it is deregistered provided it satisfies the COT up until the day of deregistration. Similarly, it can satisfy the SBT provided that it carries on the same business until the day of deregistration. [Schedule 1, item 78, subsection 165-255(2)]

3.48 These amendments apply for the purposes of Divisions 165 and 166. This includes where those Divisions are applied because of the operation of a tax provision outside those Divisions. For example, it would apply for the purposes of testing whether a loss can be transferred from a joining entity to the head company of a consolidated group.

Redeemable shares

3.49 Section 165-195 was introduced as a specific anti-avoidance measure. However, it is no longer necessary given the Commissioner's discretion in relation to arrangements affecting the beneficial ownership of shares (section 165-180) and the same share test (section 165-165). Accordingly, this Bill repeals section 165-195 and deletes the reference to existing section 165-195 in subsection 165-200(1). [Schedule 1, items 69 and 70]

3.50 If redeemable shares are issued by a company to enable it to satisfy the COT, the Commissioner would be entitled (under section 165-180) to treat the holders of the redeemable shares as if they did not beneficially own those shares. A note is added to section 165-180 to alert readers to that section's potential operation in these circumstances. [Schedule 1, item 68]

Dual listed companies

3.51 A dual listed voting share is disregarded in applying the voting power test. Accordingly, dual listed companies do not need to trace ownership of special voting shares to determine continuity of ownership. [Schedule 1, item 73, section 165-209]

3.52 A dual listed company voting share is a share in a company, issued as part of a dual listed company arrangement that does not have any rights to financial entitlements (except the amount paid up on the share and a dividend paid that is equivalent of a dividend paid on an ordinary share).

Applying capital losses of earlier years

3.53 Subsections 165-96(1), 175-40(1) and 175-45(1), paragraphs 165-235(2)(c), 175-50(1)(b) and 180-5(2)(c) and several notes, incorrectly imply that a company may apply a prior year net capital loss in calculating its net capital loss for the current year.

3.54 These provisions are amended to clarify that a prior year net capital loss cannot be taken into account in calculating the net capital loss for the current year. [Schedule 1, items 37, 38, 77, 87, 88 and 104, subsections 165-96(1), 165-235(2), 175-40(1) and 180-5(2)]

Ownership test period

3.55 Item 2 in the table headed Tax losses of corporate tax entities in section 36-25, describes the COT as requiring a comparison of owners in the loss year and the income year. The COT also requires the same owners during any intervening period. Item 2 is therefore amended to confirm that the COT requires the same owners in the loss year, the income year and any intervening period. [Schedule 1, item 7, section 36-25]

3.56 The same description of the test periods occurs in note 2 to subsection 165-96(1) and the note to subsection 175-40(2). This Bill corrects these notes by specifying that the COT applies from the beginning of the loss year to the end of the income year. [Schedule 1, items 39 and 90, subsections 165-96(1) and 175-40(2)]

Application provisions

3.57 The amendments to the ITAA 1997 relating to companies in external administration apply from the commencement of the relevant provisions in the ITAA 1997. The comparable amendments to the ITAA 1936 apply in respect of any income year for assessments made on or after 1 July 1997. [Schedule 1, item 169]

3.58 The amendments relating to the income injection rules and insolvent companies apply from the date of Royal Assent. [Schedule 1, item 176]

3.59 The amendment to disregard the entry history rule in the consolidation regime when applying the SBT applies on and after 1 July 2002, the date the consolidation regime came into effect. [Schedule 1, item 175]

3.60 The amendments relating to the application of the SBT to a medical defence organisation or general insurance company that restructures to comply with the Medical Indemnity (Prudential Supervision and Product Standards) Act 2003 apply to:

·
all tax losses incurred by the company;
·
all net capital losses made by the company; and
·
all deductions claimed in respect of bad debts written-off by the company.

[Schedule 1, item 174]

3.61 The amendment relating to family trusts applies from the time section 165-207 was first inserted into the ITAA 1997. [Schedule 1, item 173]

3.62 The amendments relating to:

·
non-profit companies;
·
shareholders that are government bodies, statutory bodies, non-profit companies and charitable bodies;
·
companies without shares;
·
dual listed companies; and
·
repeal of the provision regarding redeemable shares,

have the same application date as the modified COT amendments. [Schedule 1, item 170]

3.63 The amendments relating to the application of the alternative ownership test apply to deductions claimed for tax loses and bad debts and net capital losses applied in income years ending after 21 September 1999. This restores the position to that time. The amendments apply in relation to changeover times and alteration times from 11 November 1999, the date those provisions commenced. [Schedule 1, item 171]

Consequential amendments

3.64 The definition of 'dual listed company voting share' in subsection 125-60(3) is modified to remove the requirement that the share is issued in the head entity of a demerger group. This allows the definition to apply appropriately in respect of the COT amendments. There is no substantive effect of this change on the demerger rules. Subsection 125-60(2) is amended so that the treatment of a dual listed company voting share as not being an ownership interest only applies if the share is in a company that is the head entity of a demerger group. [Schedule 1, items 10 and 11, subsection 125-60(2) and subparagraph 125-60(3)(a)(i)]

3.65 Notes are inserted to alert readers to the amendments concerning companies in external administration, income injection and insolvent companies, companies that come into existence or cease to exist in an income year and the entry history rule. [Schedule 1, items 23, 32, 34, 51, 64, 82 to 86, 92, 94 to 97, 99 to 101 and 105]


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