Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 1 - Amendments related to net capital losses
Overview
1.1 Part 1 of Schedule 1 of the Bill will amend Part IIIA of the Income Tax Assessment Act 1936 ('the Act') to rectify defects in the capital gains tax ('CGT') provisions dealing with the carry forward and transfer of net capital losses.
1.2 The amendments will ensure that:
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- net capital losses attach to the year of income in which they are incurred and are recouped or transferred in the order in which they are incurred; and
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- where a net capital loss is transferred within a company group, the transferee company is required to satisfy the same recoupment tests (for example, the continuity of ownership test or the same business test) that apply to the transferor company.
Summary of the amendments
1.3 The purpose of the amendments is to prevent capital losses incurred by a corporate taxpayer from being recouped (or transferred) where there has been a substantial change in the beneficial ownership of the company (or the transferee company where the loss is transferred) since the losses were incurred and the same business test is not satisfied.
1.4 The amendments relating to the transfer of net capital losses will affect transfer agreements resulting in net capital losses being recouped by transferee companies in the 1996-97 year of income or a subsequent year [item 22 - new subsection (3)] . The other amendments will apply in respect of the 1996-97 year of income and subsequent years [item 22 - new subsections (1) and (2)] [see paragraphs 43 and 44 below for further discussion].
Background to the legislation
1.5 Under the existing CGT provisions, a net capital loss arises in respect of a year of income where the sum of the capital losses incurred during the year of income and any net capital loss in respect of the immediately preceding year of income exceeds the capital gains accrued in the year of income.
1.6 The mechanism of calculating a net capital loss, specified in the existing subsection 160ZC(3), results in any unrecouped amount of a net capital loss being reincurred in each subsequent year. That is, prior year losses lose their identity and are absorbed into a taxpayer's current year net capital loss, which is then carried forward for recoupment or transfer in future years.
1.7 The mechanism has unintended consequences for corporate taxpayers. By subsection 160ZC(5), the carry forward of capital losses for corporate taxpayers is subject to a number of recoupment tests. Broadly, by section 80A, the majority of beneficial owners in the company must be the same throughout the year the loss was incurred and the year the loss is sought to be recouped. This test is subject to a same business test in section 80E. In addition, the conditions in section 80DA must also be satisfied.
1.8 However, these tests do not achieve their intended purpose where the year the loss was incurred and the year of recoupment are not consecutive years. Where there is a break between the two years, the effect of the above anomaly is that the company only has to satisfy the recoupment tests by comparing the year of recoupment and the immediately preceding year. This is because until recouped or transferred, net capital losses are reincurred in each subsequent year, provided the recoupment tests are met in each of those years.
1.9 In addressing the anomaly it has also been necessary to amend the provisions permitting the transfer of net capital losses between resident companies within the same 100% owned group ('group companies'). Broadly, the transfer of net capital losses is subject to a condition that the transferee and transferor companies be group companies in relation to:
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- the year the loss was incurred;
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- the year ('gain year') in which the transferee company would have derived a net capital gain but for the loss transfer; and
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- any intervening year.
1.10 However, the anomaly (resulting in net capital losses being reincurred in each subsequent year) has meant that the provisions governing the transfer of net capital losses operate defectively. More specifically, the transferee and transferor companies only have to be group companies for the whole of the gain year even where the loss was initially incurred in a year of income before the gain year.
1.11 A further defect in the net capital loss transfer provisions is that in certain circumstances, the recoupment tests applying to the transferee company are less stringent than those applying to the transferor company. This contrasts with the revenue loss transfer provisions which require both companies to satisfy the same recoupment tests.
1.12 To illustrate, where a capital loss is transferred in a year of income after the loss was incurred, the amount of a transferred net capital loss is deemed to be a capital loss incurred by the transferee company in the gain year. This means that the transferee company does not have to satisfy the recoupment tests in a year other than the gain year. In contrast, the transferor company does have to satisfy the recoupment tests and in the gain year is required to do so by comparing the gain year and the immediately preceding year. (The amendments in the Bill seeking to prevent the annual reincurrence of net capital losses would effectively require the recoupment tests to be satisfied by both the transferor and transferee companies by comparing the loss year and the gain year.)
1.13 The combined effect of the transferee company being deemed to incur a capital loss in the gain year and the anomaly resulting in the annual reincurrence of net capital losses is that a capital loss may be transferred to a company whose shareholders were not the beneficial owners of the transferor company when the capital loss was incurred.
1.14 The amendments will rectify these anomalies in the CGT provisions to ensure that they operate appropriately as originally intended.
Explanation of the amendments
Definition of 'net capital gain' and 'net capital loss'
1.15 New subsection 160ZC(1) describes in five steps how to work out, for the purposes of Part IIIA, if a net capital gain accrues to a taxpayer in respect of a year of income and the amount of that gain where applicable. Under step one, all of the capital gains accrued during the year of income are added together (' total capital gains '). Under step two, all of the capital losses incurred by the taxpayer during the year of income are added together (' total capital losses '). Under step three, total capital losses are subtracted from total capital gains. There will be no net capital gain where total capital losses exceed total capital gains. If there is a balance remaining after step three, it is reduced by applying net capital losses from previous years of income under step four. If this reduces the balance to nil, there is no net capital gain in respect of the year of income. If the balance is not reduced to nil, the balance is a net capital gain in respect of the year of income. [Item 1]
1.16 The provision basically reflects the existing law except that a net capital gain under the new provision takes into account not only a net capital loss of the immediately preceding year but also net capital losses of earlier years. This ties into the amended definition of a net capital loss. [Refer to transitional rules discussed in paragraphs 43 and 44 below.]
1.17 A net capital loss will be taken for the purposes of Part IIIA to have been incurred by a taxpayer in respect of a year of income where the sum of any capital losses incurred by the taxpayer during the year of income exceeds the sum of any capital gains that accrued to the taxpayer during the year of income. The net capital loss is equal to the excess [item 1 - new subsection 160ZC(2)] . Unlike under the existing law, a net capital loss of the immediately preceding year is no longer taken into account in determining the net capital loss of a current year. Under the amendment definition, a net capital loss is no longer a cumulative amount incorporating unrecouped net capital losses of earlier years.
Application of net capital loss
1.18 In a particular year of income, if there is a balance remaining after subtracting total capital losses from total capital gains for the year, a net capital loss in respect of an earlier year of income must be applied in reduction of that balance in determining the amount of a net capital gain in respect of the particular year (step 4 of new subsection 160ZC(1)). The application of the net capital loss is, however, subject to the following rules.
1.19 The first rule is that if there are two or more net capital losses, they are applied in the order in which the taxpayer incurred them [item 1 - new subsection 160ZC(3)] . Further, a net capital loss can only be applied to the extent that the loss has not already been applied in an earlier year of income [item 1 - new subsection 160ZC(3A)] . Finally, if all or part of a net capital loss cannot be applied in a year of income, the unapplied amount can be carried forward to the next year of income [item 1 - new subsection 160ZC(3B)] . The unapplied amount will attach to the year of income it was incurred.
1.20 For a corporate taxpayer, however, these rules are subject to the taxpayer not being prevented from applying a net capital loss by the recoupment tests in subsection 160ZC(5) (as amended by this Bill). Amended subsection 160ZC(5) prevents a net capital loss from being applied where, if the net capital loss were a revenue loss (within section 79E of the existing law), the loss would have been denied because of sections 80A or 80DA [item 8] . For example, a net capital loss would be prevented from being applied where a taxpayer's beneficial ownership has changed substantially and the same business test is not satisfied.
1.21 The application rules discussed above are also subject to amended subsection 160ZC(4A) . The provision applies in respect of a year of income where a taxpayer becomes bankrupt in the year of income, or has been released from any debts by the operation of an Act relating to bankruptcy. Currently in this situation, any net capital loss ('denied loss') incurred by the taxpayer in the preceding year of income cannot be taken into account in determining whether the taxpayer incurred a net capital loss or accrued a net capital gain in the year of income. The underlying policy of subsection 160ZC(4A) is to deny any capital losses incurred in respect of a year of income before bankruptcy or release from debts. To maintain this policy outcome, amended subsection 160ZC(4A) provides that any net capital loss from an earlier year of income cannot be applied in determining whether a net capital gain accrued to the taxpayer in the year of income or a later year of income. This change reflects the amended definition of a net capital loss outlined above. [Item 2]
1.22 Nevertheless, subsection 160ZC(4C) operates to restore the whole or a part of a denied loss by deeming the taxpayer to have incurred a capital loss if the taxpayer makes a payment in respect of a debt which was taken into account in determining the denied loss. Subsection 160ZC(4D), which provides for the calculation of the amount of a capital loss, ensures that the sum of capital losses deemed to have been incurred does not exceed the amount of the denied loss. Subsections 160ZC(4C) and 160ZC(4D) have been amended to ensure that they operate appropriately having regard to the amended definition of a net capital loss. [Items 3 to 7]
1.23 If a taxpayer makes a payment in respect of a debt in a year ('payment year'), only the unrecouped amount of a net capital loss can be recouped. New paragraph 160ZC(4C)(d) operates to ensure that the only amount that can be recouped post bankruptcy is that part of the net capital loss ( 'denied amount' ) that has not been recouped pre bankruptcy [item 6] . Amended subsection 160ZC(4D) ensures that the only amount that can be recouped post bankruptcy is that part of the denied amount that has not been recouped post bankruptcy, either in a year prior to the payment year or by a previous payment in that payment year [item 7] .
1.24 A consequential amendment has been made to section 245-125 of the commercial debt forgiveness provisions contained in Schedule 2C of the Act. Paragraph 245-125(a) currently defines a deductible net capital loss, for the purposes of the provisions, as a net capital loss which has been incurred by the debtor in respect of the year of income immediately preceding the forgiveness year of income and which would be taken into account in determining whether a net capital gain accrued to the debtor or the debtor incurred a net capital loss in respect of the forgiveness year of income.
1.25 Amended paragraph 245-125(a) reflects the proposed changes to the calculation of a net capital loss in section 160ZC [item 21] . Specifically, amended subparagraph 245-125(a)(i) states that a 'deductible net capital loss' is a net capital loss that has been incurred in respect of a year of income earlier than the forgiveness year of income. Also, a 'deductible net capital loss' is a net capital loss that would be applied in determining whether a net capital gain accrued to the debtor in respect of the forgiveness year of income if the taxpayer derived sufficient capital gains. [Item 21 - amended subparagraph 245-125(a)(ii)]
1.26 Part 2 of Schedule 1 of the Bill will make a consequential amendment to item 4 of Schedule 5 of the Taxation Laws Amendment Act (No. 1) 1997 . Schedule 5 introduced roll-over relief provisions for disposals of small business assets. Item 4 inserted a note at the end of subsection 160ZC(4), advising that an amount of a net capital loss referred to in subsection 160ZC(4) may be reduced under subsections 160ZZPR(2) or 160ZZPS(2) of the roll-over relief provisions. Subsection 160ZC(4) currently determines the amount of a net capital loss that was incurred by a taxpayer in respect of a year of income.
1.27 New subsection 160ZC(2) will replace current subsection 160ZC(4) and consequently the note described above will appear at the end of new subsection 160ZC(2). As a result, item 4 of Schedule 5 will be omitted. [Item 23]
1.28 Part 3 of Schedule 1 of the Bill will make a consequential amendment to item 238 of Schedule 1 of the Income Tax (Consequential Amendments) Act 1997 . The amendment will align the amended wording of subsection 160ZC(5) (as discussed in paragraph 20 above) to the amendment to the subsection by the Income Tax (Consequential Amendments) Act 1997 [item 24] . The amendment will be effective immediately after the commencement of the Income Tax (Consequential Amendments) Act 1997 [subclause 2(2)] .
Transfer of net capital losses
1.29 Amended subsection 160ZP(7) provides some of the conditions to be satisfied before a net capital loss can be transferred between two companies. [Items 9 to 14]
1.30 New paragraph 160ZP(7)(a) requires the transferor company ( 'loss company' ) to be a resident and to have incurred a net capital loss in respect of a year of income ( 'loss year' ) [item 10] . Amended paragraph 160ZP(7)(b) requires a net capital gain to have accrued to a resident transferee company ( 'gain company' ) in a gain year that is either the same as the loss year or a later year of income [item 11] .
1.31 Where the gain year is a year of income after the loss year, a net capital loss can only be transferred if the loss could have been applied in working out a net capital gain if the loss company had derived sufficient capital gains during the gain year [item 12 - new paragraph 160ZP(7)(baa)] . This requirement would not be satisfied if, for example, there was a substantial change in the beneficial ownership of the loss company during the gain year and the same business test is not satisfied. In these circumstances, subsection 160ZC(5) (as amended) would prevent the net capital loss from being applied in the gain year because the recoupment tests in section 80A would not be satisfied.
1.32 Where the gain year and the loss year are the same year, no specific provision is necessary to ensure that the loss company satisfies the recoupment tests in the year of income. By virtue of paragraph 160Z(9)(b), a net capital loss could not arise in respect of the year of income unless the relevant recoupment tests were satisfied throughout the year. (Paragraph 160Z(9)(b) operates in certain circumstances to deny all capital losses incurred during a year of income.)
1.33 New paragraph 160ZP(7)(c) requires the loss company and gain company to agree to the transfer of a part or the whole of the net capital loss ( 'transferred amount' ) from the loss to the gain company. [Item 13]
1.34 As the amendments to section 160ZC mean that a net capital loss will no longer be reincurred in each subsequent year but instead will attach to the year in which it is initially incurred, paragraphs 160ZP(7)(d) and (e) will operate as intended. That is, where the gain year is a year of income after the loss year, the loss company will have to be a group company in relation to the gain company for the loss year, the gain year and any intervening years of income.
1.35 Where the conditions for transfer are met, new subsection 160ZP(7AAA) specifies some of the consequences of the transfer of the whole or part of a net capital loss ('transferred amount') [item 15] . The loss company's net capital loss in respect of the loss year is reduced by the transferred amount thus preventing a loss from being recouped more than once.
1.36 If the gain year is the same year of income as the loss year, the transferred amount is taken to be a capital loss incurred by the gain company during the gain year. This provision is subject to paragraph 160Z(9)(b) so that the capital loss would be denied to the gain company if the company does not satisfy the recoupment tests throughout the gain year. [Item 15 -new subparagraph 160ZP(7AAA)(b)(i)]
1.37 If the gain year is a year of income after the loss year, the transferred amount is taken to be a net capital loss incurred by the gain company in respect of the loss year [item 15 - new subparagraph 160ZP(7AAA)(b)(ii)] . This is to ensure that, like the loss company, the gain company is required to satisfy the recoupment tests in subsection 160ZC(5)(as amended).
Maximum amount that can be transferred
1.38 Where the gain year is a year of income after the loss year, the transferred amount cannot exceed the amount referred to in new subsection 160ZC(3B) as the 'unapplied amount' [item 17 - new subsection 160ZP(8A)] . In other words, an amount of a net capital loss already recouped by the loss company cannot be transferred.
1.39 Further, the maximum amount of a net capital loss that can be transferred cannot exceed the amount of a net capital gain that would have accrued to the gain company in the gain year after taking into account losses previously transferred to the gain company in the gain year [item 17 - amended subsection 160ZP(8)] . That is, the gain company cannot incur a net capital loss by virtue of the net capital loss being transferred. If the amount specified in the agreement between the loss company and the gain company exceeds the maximum amount, only the maximum amount is deemed to have been transferred [item 17 - new subsection 160ZP(8B)] .
1.40 An amendment of the assessment of either the gain company or the loss company is one possible reason why the amount specified in an agreement might exceed the amount of a net capital loss that can be transferred [item 17 - new subsection 160ZP(8C)] . For example, where a net capital loss has been transferred in a year of income and the assessment of the gain company for the gain year is subsequently amended to reduce the capital gains accrued to the company, it is possible that the amendment may cause the net capital loss to exceed the maximum amount. If this is the case, the amount deemed to have been transferred is the amount of the net capital gain (as reduced by the amendment) that would have accrued to the gain company but for the loss transfer, net of any previous loss transfers.
1.41 Where two or more net capital losses of a loss company are able to be transferred under section 160ZP, those net capital losses must be transferred in the order in which they were incurred. [Item 17 - new subsection 160ZP(8D)]
1.42 Consequential amendments have been made to reflect the operation of new subsection 160ZP(7AAA) so that, where a loss is transferred to a gain company, the gain company will be taken to incur either a capital loss or a net capital loss depending on whether the gain year is the same year as the loss year or a later year of income. [Items 18 and 19 - amended subsections 160ZP(11) and (12); item 20 - amended subsection 160ZP(15)]
1.43 The amendments relating to the determination of net capital gains and net capital losses will apply in respect of the 1996-97 year of income and all later years of income [item 22 - new subitem (1)] . In determining a taxpayer's net capital gain for those years, the taxpayer's net capital loss for the 1995-96 year of income is to be calculated as if these amendments (excluding the amendments relating to loss transfers - see below) had not been made [item 22 - new paragraph (2)(a) of subitem (2)] . In addition, the taxpayer will be taken not to have incurred a net capital loss for any year of income prior to the 1995-96 year of income ('earlier net capital loss'), except for the purposes of calculating a 1995-96 net capital loss [item 22 - new paragraph (2)(b) of subitem (2)] . That is, all earlier net capital losses will neither be separately available for recoupment nor transfer in a 1996-97 year or a later year. This is because any unrecouped amount of an earlier net capital loss is reflected in a net capital loss in respect of the 1995-96 year of income. This prevents an earlier net capital loss from being utilised more than once.
1.44 The amendments to section 160ZP will apply to transfer agreements where the gain year is the 1996-97 year of income or a later year [item 22 - new subitem (3)] . For example, where an amount of a net capital loss in respect of the 1995-96 year of income is transferred and the gain year is the 1996-97 year of income or a later year, the loss company's net capital loss in respect of the 1995-96 year is reduced by the transferred amount and this amount is deemed to be a net capital loss of the gain company for the 1995-96 year.