Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello MP)
Chapter 4 - Loss recoupment rules for companies: regulation impact statement
4.1 Under Australia's income tax regime, if a company's deductions exceed its assessable income and net exempt income in an income year, the company has a tax loss. This tax loss can be carried forward and may be deducted against assessable income for a later income year provided that the company satisfies either the continuity of ownership test (COT) or the same business test (SBT).
4.2 Currently, the COT is satisfied if the same people hold more than 50 per cent of voting power and rights to dividends and capital at all times during the test period. To apply the COT, a company must trace its ownership through companies, trusts and other entities to identify the people who ultimately hold (directly or indirectly) voting power and rights to dividends and capital distributions.
4.3 A company that fails the COT can still deduct tax losses if it satisfies the SBT. A company will satisfy the SBT if, broadly, it carries on the same business in the year it wishes to deduct the loss as it did immediately before it failed the COT.
4.4 During 2002 Treasury undertook consultation with representatives of the Australian Taxation Office (ATO) and a selected group of industry representatives and tax practitioners with a view to identifying options to improve the company loss recoupment rules. The focus was on ensuring those rules would apply appropriately when losses are transferred to a head company of a consolidated group from a subsidiary member that joins the group.
4.5 The consultation process identified that companies were placing considerable reliance on the SBT to deduct tax losses because of the uncertainty and high compliance costs associated with tracing ownership to satisfy the COT. It also identified that the SBT was a difficult and uncertain test for large and diverse businesses to apply. Tax consolidation would exacerbate these problems with the SBT because it would require the test to be applied on a group-wide basis.
4.6 A conclusion reached from the consultation process was that the tax loss recoupment rules could be improved by remedying the difficulties identified with tracing ownership to satisfy the COT. A consequence of such an approach would be decreased reliance on the SBT.
4.7 The objective is to:
- reduce the uncertainty and compliance costs associated with applying the company loss recoupment rules to widely held companies and companies owned by widely held companies; and
- broadly maintain the current rate of loss recoupment.
4.8 It is appropriate to modify the COT to make it easier for widely held companies and companies owned by widely held companies to apply. Two key implementation issues arose:
- the time that the COT test must be applied; and
- the approach for relaxing the COT tracing rules.
4.9 In addition, a range of technical modifications would clarify the operation of the COT and to make it easier to apply.
4.10 The existing law allows listed public companies and their 100 per cent subsidiaries to test for substantial continuity of ownership at the time of 'abnormal trading' and at the end of each income year if they apply the modified COT. Companies were uncertain as to the circumstances that would be regarded as being a time of 'abnormal trading' and, in some cases, this deterred them from using the modified COT.
4.11 Under this option companies would have to test for continuity of ownership when they had a known change of ownership. A company would have a known change of ownership if:
- it was reasonable for the company to conclude that it would have failed the ordinary COT rules at a particular time; and
- this failure would not have occurred by reason only of the sale of shares in a company in the ordinary course of trading for that company, or the sale of interests in an interposed entity in the ordinary course of trading for that entity.
4.12 Under this option companies would have to apply the tracing rules to test for continuity of ownership at the end of each income year and when an event that is likely to cause a change in majority ownership of a company occurs. Events that are likely to cause a change in majority ownership of a company are a takeover bid (or similar arrangement), a scheme of arrangement or a significant capital raising (more than 20 per cent of shares or capital) in either the tested company or another company that controls the tested company.
4.13 The existing tracing rules allow direct interests of less than one per cent in the tested company to be attributed to a notional entity. The only option considered was to reduce the circumstances in which the tracing rules must be applied by increasing the proportion of ownership that must be held in the tested company before a requirement to trace ownership is triggered.
4.14 Under this option this threshold would be increased. After some consideration, a 10 per cent threshold was chosen as this would align ownership tracing with other provisions in the tax law that distinguish between portfolio and non-portfolio shareholdings.
4.15 In determining an appropriate threshold of ownership for the notional entity, analysis was undertaken of the likely effect on companies listed on the Australian Stock Exchange. Analysis showed that a 10 per cent threshold would reduce the requirement to trace to 2 or fewer owners for about 90 per cent of the sample examined. On the other hand, a 5 per cent threshold, for example, would often require more significant ownership tracing.
4.16 Consultation revealed that the application of the SBT was highly uncertain for large and diverse businesses. However, the test was generally capable of reasonable application for companies that operated on a small scale and engaged in a very limited field of business.
4.17 The only practical means identified for excluding the SBT in cases where its application would be difficult and uncertain was on the basis of the size of the company or group.
4.18 Under this option companies whose total income was more than $100 million in the income year it was seeking to deduct the loss would be denied access to the SBT.
4.19 Under this option widely held companies and companies owned by widely held companies that would benefit from relaxation of the COT would be denied access to the SBT.
4.20 Under this option companies that are members of consolidated groups would be denied access to the SBT.
4.21 The changes to the COT will impact on widely held companies and companies owned by widely held companies.
4.22 The changes to the SBT will impact on large companies.
4.23 These changes will potentially affect about 1,000 to 1,400 companies and corporate groups (although the numbers vary from year to year).
4.24 The companies that are affected by the removal of the SBT are those most likely to benefit from the simplified COT. In this sense, it is not expected that loss recoupment rates will alter over the longer term.
4.25 Changes of ownership during an income year that are not due to takeovers, schemes of arrangement or substantial capital raisings would be identified. Thus companies would not be able to offset a loss incurred in one part of an income year when it was owned by one set of shareholders against income derived in another part of the year when it was owned by different shareholders. Therefore, there could be a small gain to revenue.
4.26 Companies would have to apply the ordinary COT rules if there was a known change of ownership. This would place a heavy compliance burden on companies with large share registers and would be inconsistent with the rationale for providing special rules. Compliance costs would be increased.
4.27 Widely held companies would continue to be uncertain as to when they would have to apply the tracing rules to test for continuity of ownership.
4.28 Practical problems that arise under option 1 are the level of information that would be required to decide whether a known change of ownership had occurred and whether off-market transactions, such as dividend investment schemes, had to be taken into account.
4.29 The practical problems arise from the wide range of potential sources that information would need to be drawn from to determine whether a known change of ownership had occurred. The possible sources of information that could indicate a change of majority ownership include notices of substantial shareholdings, media reporting of dealings in a company's shares and market or industry knowledge of substantial transactions.
4.30 Under option 2 the circumstances in which widely held companies and companies owned by widely held companies would have to apply the tracing rules to test for continuity of ownership would be certain.
4.31 It would clearly achieve the policy objective of making the company loss recoupment rules more certain and reducing compliance costs for widely held companies and companies owned by widely held companies. Specifying the times for testing continuity of ownership would reduce compliance costs. Estimates of compliance cost savings cannot be quantified due to the lack of data.
4.32 Under option 2 widely held companies and companies owned by widely held companies could have a change of ownership during an income year but will not have to apply the tracing rules to test for continuity of ownership until the end of the income year. In limited circumstances this could allow companies to offset a loss incurred in one part of an income year when it was owned by one set of shareholders against income derived in another part of the year when it was owned by different shareholders. These circumstances would occur if the change in majority ownership arose from transactions that are not a takeover, scheme of arrangement or significant capital raising. Therefore, there is a slight risk to revenue under option 2.
4.33 A 10 per cent threshold would align ownership tracing with other provisions in the tax law that distinguish between portfolio and non-portfolio shareholdings. A higher threshold would lower the compliance costs for companies because less tracing of ownership would be required. Compliance costs cannot be quantified due to the lack of empirical data in this area.
4.34 A 10 per cent threshold is beneficial because it would substantially reduce compliance costs for widely held companies and companies owned by widely held companies.
4.35 The higher the threshold the more significant the risk that significant ownership changes in the tested company would be effectively ignored in applying the COT. Therefore, moving to a higher threshold of 10 per cent could allow companies to access prior year losses inappropriately. This could occur if a company was wholly-owned by shareholders holding less than 10 per cent and all the shareholders sold their shares to other shareholders each of whom then held less than 10 per cent. Therefore, there is a slight risk to revenue under this approach.
4.36 Size of the company or group is the most practical means for excluding cases from the SBT where its application would be difficult and uncertain.
4.37 Particular difficulties arise for a consolidated group because determining the business of the head entity would require a detailed analysis of all the activities being undertaken by the group at the test time (ie, when it fails the COT) and through the SBT period. The uncertainty arises in determining whether the introduction of new activities or cessation of previous activities is a change in the business a company or group is conducting.
4.38 The benefit of an income ceiling is that it draws on income as already reported in company tax returns. An income ceiling of $100 million was chosen having regard to the following factors.
- The high correlation between companies with total income exceeding $100 million and companies that benefit from the proposed reforms to the COT.
- An income ceiling of $100 million does not exclude the SBT for small and medium sized companies - the SBT generally operates in a manner consistent with the policy intent for these companies.
- An income ceiling of $100 million is consistent with the ATO's definition of the large business segment. Consequently, there is detailed information and monitoring concerning this segment.
4.39 A test based on an income ceiling causes difficulty for companies whose total income fluctuates over and under the ceiling from year to year. In addition, although the level at which the ceiling is set is soundly based, it is somewhat arbitrary.
4.40 This option is consistent with the New Zealand approach (on which the COT modifications are largely based). This approach has the advantage that the two offsetting measures would affect exactly the same group.
4.41 The option would exclude a number of small to medium size companies from the SBT and leave existing issues with large closely held companies and groups unresolved. If closely held groups could continue to rely on the SBT they would not be concerned about failing the COT on technical grounds.
4.42 The option would also discourage large companies from using the modified COT if they could access the SBT by using the ordinary COT.
4.43 The problems with the SBT were exacerbated by tax consolidation. Therefore, this option would target the source of concerns that had been raised about the SBT.
4.44 This option would introduce non-neutrality in the taxation of consolidated groups and single companies. It would discriminate against consolidated groups and discourage consolidation. The consolidation regime was introduced to promote business efficiency as well as tax system integrity. Denying consolidated groups access to the SBT would continue the inconsistent treatment of wholly-owned groups with losses. As large single companies would continue to have access to the SBT, there would be no incentive to resolve technical problems with the COT.
4.45 The changes to the COT will reduce revenue, but the changes to the SBT will increase revenue. The net revenue effect of the changes is unquantifiable.
4.46 It is expected that the new COT tracing rules and the SBT total income ceiling will reduce administration costs for the ATO by reducing requests by taxpayers for rulings and by simplifying company audits.
4.47 The changes are expected to provide greater certainty in the tax treatment of company losses. This is expected to address inefficiencies arising from compliance difficulties, uncertainties and anomalies relating the current company loss recoupment rules. These inefficiencies arise from the need to divert company resources to non-productive areas. Therefore, the changes would improve resource allocation and benefit the economy.
4.48 Commencing in 2002, extensive consultation was carried out to identify means of improving the company loss recoupment rules.
4.49 Meetings were held in April, August and November 2002. Attendees included representatives of the Treasury and the ATO, partners of several accounting firms and representatives of the Law Council of Australia, the Taxation Institute of Australia, the Institute of Chartered Accountants in Australia and the Corporate Tax Association.
4.50 Participants in the consultation process were forwarded a draft discussion paper in November 2002 and a further draft reform proposal in March 2003.
4.51 Their comments were taken into account in developing a discussion paper outlining proposed reforms to the company loss recoupment rules. This paper was released publicly on 7 April 2004 at the same time the Government announced the measure.
4.52 Confidential targeted consultation with stakeholders occurred in July 2004 and meetings were held with stakeholders to discuss the issues raised in submissions.
4.53 On 11 February 2005, an exposure draft of the legislation was publicly released. Those who made submissions in response to the exposure draft were invited to further consultation meetings that were held in May and August 2005.
4.54 Participants in the consultation process strongly supported the objective of making the company loss recoupment rules more certain and reducing compliance costs for widely held companies and companies owned by widely held companies. The key change suggested by participants was to adopt specific testing times (rather than a known change of ownership approach) for determining the time when widely held companies and companies owned by widely held companies have to apply the tracing rules to test for continuity of ownership.
4.55 Other suggested changes to the legislation were relatively minor and related mainly to clarifying the application of the legislation in particular circumstances and making various technical refinements. Most of these changes have been incorporated into the current legislation.
4.56 The option to identify specific testing times (option 2) is the preferred approach. This option better achieves the policy objective of making the company loss recoupment rules more certain and reducing compliance costs for widely held companies and companies owned by widely held companies and is strongly supported by participants in the consultation process. It is not expected to alter significantly the rate at which losses are recouped.
4.57 The only option considered was to reduce the circumstances in which the tracing rules must be applied by increasing the proportion of ownership that must be held in the tested company before a requirement to trace ownership is triggered and by removing the tracing requirement in certain circumstances. A 10 per cent threshold for the notional entity rule was preferable because it better achieves the policy objective of reducing compliance costs.
4.58 The modifications to the COT apply from the income year commencing on or after 1 July 2002. These changes will benefit affected taxpayers and remove the difficulties that arise under the current law in applying the COT to widely held companies and companies owned by widely held companies.
4.59 The option to deny access to the SBT to companies with total income exceeding $100 million (option 1) is the preferred approach. This approach is the only practical option for excluding the SBT in cases where its application is difficult and uncertain. This approach also ensures that small to medium size companies retain access to the SBT.
4.60 Although companies will need to calculate their total income to determine whether they are eligible for the SBT, the total income ceiling is not expected to impose a significant compliance burden because it is based on information that companies already collect for taxation purposes.
4.61 The option to exclude all companies that benefit from the COT changes from the SBT (option 2) is not preferred because it would inappropriately increase compliance costs for small to medium size companies that would be denied access to the SBT.
4.62 The option to exclude all consolidated groups from the SBT (option 3) is not preferred because it would introduce an unjustifiable non-neutrality in the taxation of consolidated groups and single companies.
4.63 The removal of the SBT for companies whose total income exceeds $100 million applies from the income year commencing on or after 1 July 2005.
4.64 The Treasury and the ATO will monitor this taxation measure as part of the whole taxation system on an ongoing basis.