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Ruling

Subject: Prior year tax losses - application of the same business test

Question 1

Will Company X, as the head company of the Company X income tax consolidated group, satisfy the same business test in section 165-210 of the Income Tax Assessment Act 1997 for the period of recoupment?

Answer

Yes

Question 2

Will the proceeds received by Company X from its Initial Public Offering represent an injection of capital for the purpose of subsection 707-325(4) of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

Income year ending 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

Company X was incorporated as a public company in Australia by Company Y with no assets or liabilities and nominal share capital.

Company Y is a wholly owned subsidiary of Company Z. Both Company Y and Company Z were incorporated in Australia.

At incorporation, Company X was a wholly owned subsidiary of Company Y and subsidiary member of the Company Z income tax consolidated group.

At a time after incorporation, Company X, Company Y and Company Z entered into an agreement under which Company X acquired certain exploration and development rights within areas owned by Company Z and licence to utilise certain infrastructure and other assets owned by Company Z (rights agreement).

A condition precedent to the rights agreement was Company X's admission to the official list of the Australian Securities Exchange (ASX) following an Initial Public Offer (IPO). The rights agreement came into effect just before the completion of the IPO.

Company X was listed on the ASX within a period of time after Company X entered into the rights agreement following its IPO (in the same income year).

At completion of the IPO, Company Y became a majority shareholder of Company X.

Prior to the IPO, Company X entered into certain activities (pre-IPO activities):

· an agreement for the future sale and purchase of resources;

· an agreement in relation to royalty obligations; and

· the rights agreement.

Company X carries on a number of projects.

Since the IPO, Company X's principal business activities are exploration and development. All activities carried out in relation to each of its projects are consistent with Company X's business of exploration and development.

The rights agreement relates to activities undertaken in relation to one of Company X's projects. That project was once the main business focus of Company X but has been placed on hold since before the beginning of the current income year. Company X's main business focus is on another project (main project).

Company X and its wholly owned Australian resident subsidiaries propose to form an income tax consolidated group with retrospective effect from the date of consolidation in the previous income year (consolidation date), with Company X as the head company.

Prior to the consolidation date, Company X has carried forward tax losses (tax loss). Company X will deduct its tax loss in the current income year (period of recoupment).

In the period of recoupment, Company X entered into a binding Heads of Agreement (Heads of Agreement) in respect of shares held by Company Y and associated arrangements (proposed transaction).

Pursuant to the Heads of Agreement, the proposed transaction will be undertaken in a particular manner, including termination of the rights agreement.

Following the proposed transaction, Company Y will retain only a small ownership interest in Company X.

Company X makes a capital gain on termination of the rights agreement.

At all times prior to the proposed transaction, Company X satisfies the continuity of ownership test (COT) in Division 165 of the Income Tax Assessment Act 1997.

Assumptions

Company X (as the head company) and its wholly owned subsidiaries form an income tax consolidated group with effect from the consolidation date in the previous income year.

Company X fails to satisfy the continuity of ownership test (COT) in Division 165 of the Income Tax Assessment Act 1997 on the date the proposed transaction is completed, which occurs before the end of the current income year.

The conditions precedent of the Heads of Agreement is satisfied before the completion of the proposed transaction.

From the completion of the proposed transaction to end of the period of recoupment (inclusive):

· Company X continues to conduct activities focussed on its main project.

· Company X undertakes limited oversight / assistance / maintenance activities in relation to its other projects.

· Company X does not derive any income from a business, undertaking or enterprise of a kind that it did not carry on before the completion of the proposed transaction.

· Company X does not derive any income from transactions of a kind that it had not entered into in the course of its business operations before the completion of the proposed transaction.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 36-25

Income Tax Assessment Act 1997 subdivision 165-A

Income Tax Assessment Act 1997 section 165-10

Income Tax Assessment Act 1997 paragraph 165-10(b)

Income Tax Assessment Act 1997 section 165-12

Income Tax Assessment Act 1997 section 165-13

Income Tax Assessment Act 1997 section 165-210

Income Tax Assessment Act 1997 subsection 165-210(1)

Income Tax Assessment Act 1997 subsection 165-210(2)

Income Tax Assessment Act 1997 paragraph 165-210(2)(a)

Income Tax Assessment Act 1997 paragraph 165-210(2)(b)

Income Tax Assessment Act 1997 subsection 165-210(3)

Income Tax Assessment Act 1997 paragraph 165-210(3)(a)

Income Tax Assessment Act 1997 paragraph 165-210(3)(b)

Income Tax Assessment Act 1997 Subdivision 707-A

Income Tax Assessment Act 1997 Subdivision 707-C

Income Tax Assessment Act 1997 section 707-325

Income Tax Assessment Act 1997 subsection 707-325(1)

Income Tax Assessment Act 1997 subsection 707-325(2)

Income Tax Assessment Act 1997 subsection 707-325(3)

Income Tax Assessment Act 1997 subsection 707-325(4)

Income Tax Assessment Act 1997 paragraph 707-325(4)(a)

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Question 1

Section 36-25 lists special rules that apply to the deduction of tax losses by companies. The special rules listed in section 36-25 include the provisions in Subdivision 165-A (Item 2). Subdivision 165-A contains the general rules governing the deduction of tax losses of earlier income years.

Pursuant to section 165-10, a company cannot deduct a tax loss unless either:

(a) it meets the conditions in section 165-12 (which is about the company maintaining the same owners); or

(b) it meets the condition in section 165-13 (which is about the company satisfying the same business test).

The conditions to be satisfied under the same business test are contained in section 165-210. Broadly, Company X satisfies the same business test if throughout the same business test period:

· it carried on the same business as it carried on immediately before the appropriate test time (subsection 165-210(1)) (same business test);

· it did not carry on any business other than a business of a kind carried on before the test time as part of the overall business (paragraph 165-210(2)(a)) (the new business test);

· it only derived assessable income from transactions of a kind that it entered into in the course of the business operations before the test time (paragraph 165-210(2)(b)) (new transactions test); and

· the provisions in subsection 165-210(3) do not apply (anti-avoidance test).

The same business test period is the income year in which the company will deduct its tax loss, i.e. the period of recoupment.

The relevant 'test time' is the time at which the company fails to meet the COT, i.e. in this case, at the completion of the proposed transaction (test time).

Same business test: subsection 165-210(1) - the primary test

The same business test is the primary, positive test: it looks to whether the business of the company in the period of recoupment is actually the same business that was carried on at the test time.

The Commissioner's view on the operation of sections 165-13 and 165-210 is set out in Taxation Ruling TR 1999/9 Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132.

Whether Company X carried on the same business is a question of fact. The issue of fact to be determined in applying the same business test is to identify the business carried on by Company X immediately before the test time, and determine whether it carried on the same business at all times during the period of recoupment.

In identifying the business of Company X, it is relevant to examine every activity carried on by Company X, although those activities must be considered as a whole.

In the period of recoupment, Company X will be the head company of the Company X income tax consolidated group. The Commissioner's views on how the same business test applies in the context of determining whether deductions are available to the head company of a consolidated group in respect of prior year tax losses are set out in Taxation Ruling TR 2007/2 Income tax: application of the same business test to consolidated and MEC groups - principally, the interaction between section 165-210 and section 707-1 of the Income Tax Assessment Act 1997.

In the context of consolidated groups, paragraph 14 of Taxation Ruling TR 2007/2 states that the principles set out in TR 1999/9 in respect of the application of the same business test to a single company apply equally to the head company of a consolidated group.

Under the single entity rule at subsection 701-1(1), subsidiary members of a consolidated group are taken for the purposes of the same business test to be parts of the head company. Therefore, when determining the one overall business carried on by Company X, as the head company of the Company X income tax consolidated group, it is necessary to have regard to the activities of the subsidiary members of the group (hereinafter 'company' also refers to 'head company').

Applying the principles in TR 1999/9 to a consolidated group, the one overall business of Company X is to be identified by examining all of the activities, enterprises or undertakings carried on:

· at the appropriate test time by all those entities that were members of the consolidated group at that time, and

· by all entities during that part of the same business test period when they were members of the consolidated group.

Determining whether Company X has carried on the same business at all times during the period of recoupment as the business carried on immediately before the test time means drawing an inference of fact having regard to all the circumstances.

Change of activities

The same business test does not mean that the business carried on by Company X during the period of recoupment must be identical in every aspect with the business that it carried on immediately before the test time. A business may be the same, even though there have been some changes in the way in which it is carried on, provided the identity of the business is not changed (emphasis added).

Mere expansion or contraction of the business may not necessarily result in a change in the identity of the business carried on by the company. However, the reduction of business activities, if carried out to a sufficient extreme, is likely to amount to more than a mere change in the scale of the business carried on by the company and so may result in a change in the identity of the business. A sudden or dramatic change that brings about a reduction, loss or permanent cessation of activities on a considerable scale could mean the same business is no longer being carried on. Similarly, the discontinuance of a significant part of business carried on by the company is also likely to result in the company not being able to satisfy the same business test. Significant expansion or contraction of the business is to be contrasted with organic growth or evolution of the business in the ordinary way. If the company expands or develops its business by a process of organic growth, it does not necessarily follow that the essential character of its business is changed.

The potential cessation of one of many projects upon termination of the rights agreement does not, on the facts and circumstances, amount to a change in the identity of the business carried on by Company X.

Accordingly, Company X carried on the same business as it carried on immediately before the test time throughout the same business test period.

The conditions in subsections 165-210(2) and 165-210(3) must also be considered.

The new business test and new transactions test in subsection 165-210(2) are secondary, cumulative negative tests that look to see whether the component undertakings, enterprises or transactions of the overall business are the same in kind as previously. The tests are intended to prevent the injection of income into the company while leaving appropriate scope for the development and expansion of the company's business.

New business test: paragraph 165-210(2)(a)

Section 165-210 will not be satisfied if, at any time during the same business test period, the company derives assessable income from a business of a kind that it did not carry on before the test time (new business test: paragraph 165-210(2)(a)).

The new business test puts a limit on the type of expansion that the company may undertake if it is to maintain the benefit of accumulated losses. In order for the company to benefit from accumulated losses, it must not derive assessable income from an enterprise or undertaking of a kind that it has not carried on before the test time.

In the new business test the word 'business' has a different meaning from the word 'business' in the same business test. It is a reference to each of the different kinds or types of activities (if there is more than one kind or type of activity) comprised in the one business that is referred to in the same business test and is carried on by the company at the test time.

The content of the word 'kind' in the new business test is to be derived from the course of the company's business operations before the test time.

Company X does not on the facts and circumstances derive any income from a new business, undertaking or enterprise that it did not carry on before the test time and therefore, the new business test is satisfied.

New transactions test: paragraph 165-210(2)(b)

Section 165-210 will not be satisfied if, at any time during the same business test period, the company derives assessable income from a transaction of a kind that it had not entered into in the course of its business operations before the test time (new transactions test: paragraph 165-210(2)(b)).

In the new transactions test, 'transaction' refers to any operation or dealing from which income directly or indirectly flows or arises. A company enters into a transaction for the purposes of the new transactions test if it engages or participates in it. As in the new business test, the content of the word 'kind' in the new transaction test is to be derived from the course of the company's business operations before the test time.

The termination of the rights agreement occurs after the test time. The entering and termination of agreements in the nature of the rights agreement is, given the type of the business carried on by Company X, a transaction of a kind that Company X would have entered into before the test time. Accordingly, the new transactions test is satisfied.

Anti-avoidance test: subsection 165-210(3)

Subsection 165-210(3) is an anti-avoidance test designed to prevent a company satisfying the same business test where the company commenced to carry on new business or entered into a new kind of transaction prior to the test time, in anticipation of obtaining a deduction for a prior year loss.

Section 165-210 will not be satisfied if:

· before the test time, the company commenced to carry on a business it had not previously carried on, or entered into, in the course of its business operations, a transaction of a kind it had not previously entered into; and

· the company did so for the purpose (or for purposes that included the purpose) of satisfying the same business test in relation to obtaining a deduction for a prior year tax loss.

In the context of the anti-avoidances test, the word 'business' has the same meaning as it has for the purpose of the applying the new business test; and 'transaction', 'entered into', and 'business operations' have the same meanings they have in the new transactions test.

The anti-avoidance test applies where the purpose or one of the purposes of the company in commencing to carry on the business or entering into the transaction was the purpose of enabling the company to obtain a deduction for prior year tax losses. This is so notwithstanding that where there is more than one purpose, the tax avoidance purpose was not the dominant purpose of the company in commencing to carry on the business or enter into the transaction.

It is reasonable to conclude on the facts and circumstances that Company X entered into the proposed transaction to terminate the rights agreement as a result of an ordinary commercial arrangement in the course of carrying on its business. Accordingly, the requisite purpose as required by the anti-avoidance provision is not met and the anti-avoidance test is satisfied.

Conclusion

As subsection 165-210(1) is satisfied and subsections 165-210(2) and 165-210(3) do not apply to negate the outcome reached under subsection 165-210(1), Company X satisfies the same business test in section 165-210 throughout the period of recoupment.

Question 2

Subdivision 707-C provides the legislative framework for the utilisation of losses that have been transferred to the head company of a consolidated group under Subdivision 707-A.

The rate of utilisation of losses transferred under Subdivision 707-A to the head company of a consolidated group is limited by reference to the available fraction for the relevant bundle of losses.

As the calculation of the available fraction is the integral component for the utilisation of transferred losses, special rules are necessary to maintain the integrity of the calculation.

The integrity rule in subsection 707-325(2) provides that if:

· one or more events described in subsection 707-325(4) that occurred in the 4 years before the time an entity becomes a member of a consolidated group; and

· the modified market value of the entity worked out under subsection 707-325(1) exceeds what it would have been if none of those events occurred,

· then the modified market value of the entity worked out under subsection 707-325(1) is reduced by the amount worked out under subsection 707-325(3). Such a reduction has the effect of reducing the available fraction for a bundle of losses. The available fraction is only reduced if the market value of the entity exceeds what it would have been had the event not occurred.

Paragraph 8.91 of the Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No.1) 2002 states that the integrity rules:

… prevent a loss entity from inflating its market value before it joins a consolidated group in order to obtain a higher available fraction.

It operates with the overall object to establish, at a particular point in time (the joining time), that fraction of the joined group's market value said to be attributable to the joining entity.

The integrity rule only considers the effect of the event on the market value of the entity and if it has increased, then a reduction will be effected. The provisions concentrate on describing which transactions are relevant and then dealing with the effect of the event so entered into.

The purpose of the transaction or act is not a factor that determines the application of the integrity rule. In particular, whether the transaction has the purpose (either objective or subjective) of increasing the market value of the entity or the available fraction is not determinative. An injection of capital can arise either before or after the entity made the relevant loss.

Subsection 707-325(4) describes the events that are referred to in subsection 707-325(2). Relevantly in this case, paragraph 707-325(4)(a) identifies one event as an injection of capital into the entity or an associate of the entity.

The expression 'injection of capital' is not defined for the purposes of paragraph 707-325(4)(a). Accordingly, it has its ordinary meaning consistent with the purposes of the provisions.

The Commissioner provides guidance on the expression 'injection of capital' in Taxation Ruling TR 2004/9 Income Tax: consolidation: what is meant by 'injection of capital' in section 707-325 of the Income Tax Assessment Act 1997?

The expression 'injection of capital' for the purposes of paragraph 707-325(4)(a) covers transactions and acts with the following inter-related characteristics (paragraph 9 of TR 2004/9):

· Wealth introduced from outside

· Enhanced net assets

· Equity interests affected

· Not related to earnings and profit

· External party required

· Of a capital nature.

Paragraph 13 of TR 2004/9 provides that the most common form of an injection of capital is by way of the issue of shares for consideration. Accordingly, on the facts and circumstances, the IPO is, prima facie, an injection of capital in Company X.

However, paragraph 17 of TR 2004/9 states:

An initial share issue is not considered to be an injection of capital for the purposes of paragraph 707-325(4)(a) of the ITAA 1997. This is because an initial share issue is not considered to be an 'injection of capital into the entity'. An initial share issue is part of the process of the formation of the entity.

The meaning of the expression 'initial share issue' is considered in paragraph 18 of TR 2004/9. An 'initial share issue' for the purposes of TR 2004/9 is an equity raising made:

· at or around the time of the formation of the company, or

· before the company commenced any operating or trading activity and its only activity to date (if any) related directly to the raising of initial finance.

TR 2004/9 provides that an equity contribution will not be treated as an initial capitalisation if the payment is not made within a reasonable period of time, is delayed without cause relating to the formation process or it forms part of a wider transaction that is not limited to the formation process, or is contrived to appear as an initial capitalisation.

Equity raising made at or around the time of the formation of a company

The time of the formation of a company refers to the time when the company comes into existence. A company comes into existence when it is incorporated. The expression 'at or around the time of the formation of the company' refers to a period of time approximately near to the time when the company was incorporated.

The date of incorporation of Company X is the time of its formation. The period between the date of incorporation and completion of the IPO is not, on the facts and circumstances, considered to be a period of time, within the context of TR 2004/9, approximately near to the time Company X was incorporated.

Furthermore on the facts and circumstances the IPO, being a condition precedent to the rights agreement, forms part of a wider transaction that is not limited to the formation process.

Equity raising before the company commenced any operating or trading activity and its only activity to date is related directly to the raising of initial finance

To be an initial share issue for the purposes of TR 2004/9, the equity raising made from Company X's IPO must have been made before Company X commenced any operating or trading activity and all of its pre-IPO activities must be related directly to the raising of initial finance.

The expressions 'operating or trading activity' and 'related directly to the raising of initial finance' are not defined in TR 2004/9 and therefore, take their ordinary meanings.

The Macquarie Dictionary defines the term 'activity' to relevantly mean: a specific deed or action. Company X's pre-IPO activities involved entering into a number of agreements. The act of entering into each of these agreements is an 'activity' within the ordinary meaning of that term. In the present context, the expression 'operating or trading activity' refers to the conduct of Company X's business operations.

The act of entering into the agreements do not on the facts and circumstances constitute operating or trading activities. However, the outcomes sought to be achieved under the agreements entered into by Company X before the IPO are on the facts and circumstances related directly to the conduct of business operations. The pre-IPO activities were not on the facts and circumstances related directly to the raising of initial finance as required by TR 2004/9. Example 2 at paragraphs 100 to 101 of TR 2004/9 provides guidance on the sort of activities which are considered to be 'related directly to the raising of initial finance'.

As the equity raising made by Company X's IPO is not an initial share issue as described in TR 2004/9 and displays all of the characteristics of an injection of capital (paragraph 9 of TR 2004/9), the capital proceeds received by Company X from its IPO is an injection of capital into Company X for the purposes of paragraph 707-325(4)(a).

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