House of Representatives

Tax and Superannuation Laws Amendment (2013 Measures No. 1) Bill 2013

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 5 - Introduction to loss carry-back

Outline of chapter

5.1 Schedules 5 and 6 amend the income tax law to allow corporate tax entities to carry-back losses to previous income years. This chapter provides an overview of the loss carry-back measure.

5.2 The loss carry-back measure allows corporate tax entities that have paid tax in the past, but are now in a tax loss position, to choose to obtain a refund of some of the tax they have previously paid.

5.3 The operative rules for the loss carry-back measure are primarily contained in Division 160 of the Income Tax Assessment Act 1997 (ITAA 1997).

Context of amendments

5.4 Following the Tax Forum in October 2011, the Government established the independent Business Tax Working Group (Working Group) to consider what kind of business tax system would best support Australia's future growth prospects.

5.5 In its Final Report on the Tax Treatment of Losses , the Working Group recommended that loss carry-back would be a worthwhile reform in the near term. In particular, the Working Group proposed a model that:

is limited to companies;
provides a two-year loss carry-back period on an ongoing basis; and
limits the amount of losses that can be carried back by applying a quantitative cap of at least $1 million.

5.6 On 6 May 2012, the Government announced that it would introduce loss carry-back to the income tax law for corporate tax entities.

5.7 The Government issued a consultation paper, Improving access to company losses , in July 2012.

5.8 The introduction of loss carry-back also implements Recommendation 31 of the 2010 Australia's Future Tax System Review, which says:

'...companies should be allowed to carry back a revenue loss to offset it against the prior year's taxable income, with the amount of any refund limited to the company's franking account balance.'

5.9 Loss carry-back will encourage companies to adapt to changing economic conditions and take advantage of new opportunities through investment. Firms will be able to utilise their tax losses sooner and reduce the extent to which they risk never being able to use those losses.

The case for loss carry-back

5.10 Implementing a change of business strategy may involve new investment in machinery and equipment, in the development of new goods and services and in re-skilling of people. These new investment decisions involve taking risks.

5.11 Policies that facilitate changes in business strategies and support sensible risk taking will enhance productivity growth in all sectors of the economy by increasing the quantity and quality of investment.

5.12 Under the current tax law, the Commonwealth collects, as tax, a share of any profits a company makes in an income year but does not share directly in a company's loss. Instead, future tax may be reduced because the company can deduct that loss from its future profits. This means there is an asymmetric treatment of profits and losses.

5.13 This asymmetry can mean that a company that makes a profit in one year and a loss in the next year will pay a higher effective tax rate over the two year period than another company that makes the same overall profit in a more even fashion.

Example 5.19 : Tax outcomes vary according to cash flow risk Tables 5.1 and 5.2 show the impact of the tax treatment of losses on the total tax of two companies whose net profits are identical. If a company makes the same total profit in a variable manner, by deriving a large profit followed by a loss (Table 5.1), it will pay more tax over the two year period than a company that makes the same overall profit in a more even manner, with two smaller profit years (Table 5.2).

Table 5.1 : Tax treatment for higher risk profit company
Year 1 $ Year 2 $ Total $
Profit (loss) 200 -100 100
Tax @ 30% 60 0 60
Table 5.2 : Tax treatment for lower risk profit company
Year 1 $ Year 2 $ Total $
Profit (loss) 50 50 100
Tax @ 30% 15 15 30
In this stylised example, two companies earn the same $100 total profit over two years but the company earning it in a more variable manner pays double the tax that the more conservative company pays. The risky company therefore experiences an effective tax rate of 60 per cent, compared with the statutory tax rate of 30 per cent.

5.14 The potential to incur a higher effective tax rate can lower the expected after-tax return on a potential investment. This can distort the relative attraction of competing projects from a firm's perspective, compared with their value to the economy as a whole.

Example 5.20 : Tax treatment of losses can distort investment choices Tables 5.3 and 5.4 show the impact of the tax treatment of losses for two possible investment choices that present different levels of risk. One option is a higher-risk investment, which has a 40 per cent chance of incurring a loss (20 per cent chance of incurring a loss of $60 and a 20 per cent chance of incurring a loss of $40). The other option is a lower-risk investment that has a certain profit outcome. For simplicity, the investments have one year lives.

Table 5.3 : Tax treatment for a low risk investment
Possible before-tax return on an investment ($) Probability of return (%) Before-tax expected return ($) After-tax expected return ($)
40 50 20 14
20 50 10 7
Total 100 30 21
Table 5.4 : Tax treatment for a high risk investment
Possible before-tax return on an investment ($) Probability of return (%) Before-tax expected return ($) After-tax expected return ($)
140 10 14 9.8
100 20 20 14
80 20 16 11.2
20 10 2 1.4
-40 20 -8 -8
-60 20 -12 -12
Total 100 32 16.4
In this example, the riskier investment has a higher expected before-tax return ($32) than the low-risk investment ($30). However, the expected after-tax return is greater for the low-risk investment ($21) than the high risk investment ($16.4). In practice, this outcome would generally be partially mitigated in future years by deducting the tax losses against future profits.

5.15 The asymmetric tax treatment of profits and losses can therefore give rise to a bias against riskier investments, which will tend to divert capital to investments that are of lower value for the economy as a whole.

5.16 Reducing the tax system's bias against corporate risk taking can be expected to increase the quantity and the quality of investment, improving the allocation of resources across the economy. This should have positive flow-on effects for productivity, which in turn will support growth in real wages and employment.

5.17 The introduction of loss carry-back gives profitable companies greater certainty that they will be able to utilise a loss that arises from an investment they make to adjust to changing economic circumstances. This reduces the asymmetry between the taxation treatment of profits and losses.

5.18 It also improves the cash flow of affected companies by allowing them to access their losses in a timelier manner. This promotes sensible risk taking by companies, helping them to adjust to changing economic conditions in a patchwork economy.

5.19 Restricting loss carry-back to those companies that have recently paid tax ensures that the measure is targeted to companies that have a history of conducting a profitable enterprise. The measure is not intended to provide a seed funding for starting a new enterprise.

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