Edited version of private advice

Authorisation Number: 1051947048881

Date of advice: 8 February 2022

Ruling

Subject: Business continuity test - deductibility of tax losses

Question 1

If no other income earning activity has, or will, commence after the test time, can the taxpayer offset its prior year tax losses against the licence fee income received under the current licence agreement on the basis that the business continuity test has been satisfied?

Answer

Yes. Having regard to the facts and circumstances described, the Commissioner considers that the taxpayer can offset its prior year tax losses against licence fee income received under the current licence agreement on the basis that the business continuity test has been satisfied.

Question 2

If no other income earning activity has, or will, commence after the test time, if another three-year licence agreement is entered into between the taxpayer and Owner Co at the expiry of the current licence agreement in 20XX, can the taxpayer offset its prior year tax losses against the licence fee income from the new licence agreement on the basis that the business continuity test has been satisfied?

Answer

Yes. The taxpayer can offset its prior year tax losses against the licence fee income from the new licence agreement on the basis that the business continuity test has been satisfied.

Question 3

If the taxpayer were to derive licence fee income from new licence agreements under the same terms with new parties wishing to use the controlling mind's brand and name in other Australian states and territories after the test time referred to in section 165-13 of the Income Tax Assessment Act 1997 (ITAA 1997), does the taxpayer satisfy the business continuity test?

Answer

Yes. Having regard to the facts and circumstances described, the taxpayer would satisfy the business continuity test.

Question 4

If the taxpayer were to commence deriving related business activity income after the test time referred to in section 165-13 of the ITAA 1997, can the taxpayer offset its prior year tax losses against its current activity income and related activity income on the basis that the business continuity test has been met?

Answer

Yes. Having regard to the facts and circumstances described, the taxpayer can offset its prior year tax losses against its current activity income and related activity income on the basis that the business continuity test has been satisfied.

This ruling applies for the following periods:

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company Pty Ltd (the taxpayer) conducts business that includes several related activities. This overall business is conducted in conjunction with a related company, Related Co Pty Ltd (Related Co). Related Co conducts the northern operations, and the taxpayer conducts the southern operations. This business was established by the late controlling mind who resided in the southern area. The controlling mind personally held all shares in the taxpayer at all times until their passing in 20XX.

Related Co was acquired by a third party company (Owner Co) in 20XX. Owner Co conducted the northern operations through continued use of the controlling mind's brand, and it paid a licence fee to do so. The controlling mind conducted the southern operations via the taxpayer. Owner Co entered into a licencing agreement with the taxpayer, allowing Owner Co to operate using the controlling mind's business name. This business name is owned by the taxpayer and is registered with ASIC. The licence fee payable was $X per year for a term of X years.

In 20XX, Owner Co and the taxpayer entered into another X-year licence agreement effective from 20XX. That licence fee is $X for the first year, and CPI is applied to each subsequent year. The fee was paid in four equal quarterly instalments; the first instalment of the new contract totalling $X was paid to the taxpayer in 20XX covering the period 20XX to 20XX.

Owner Co was approached by the estate of the controlling mind to acquire the shares in the taxpayer. Owner Co acquired the shares in the taxpayer from the estate of the controlling mind in 20XX for $X. The licencing fee in the 20XX, 20XX, 20XX and 20XX financial years were paid quarterly to the taxpayer by Owner Co. The last instalment paid to the taxpayer after the passing of the controlling mind was in 20XX and covered the period 20XX to 20XX.

Since the agreement was renewed in 20XX, the amounts owing under it were $X, representing instalments two, three and four of year X; and $X, representing instalment one of year X. This would take the licence up to 20XX. Owner Co paid a lump sum of $X to the taxpayer in 20XX. The only change in method of payment in 20XX compared to earlier financial years was the fee being paid in a lump sum instead of quarterly.

The taxpayer's 20XX tax return has X tax losses incurred in 20XX and earlier; the balance of the tax losses, being Y were incurred after 20XX. In other words, the same business test will be applicable to X of the tax losses and the similar business test will be applicable to the remaining Y of the tax losses.

The taxpayer was carrying on the business of licencing an intangible asset in the form of the registered business name immediately before the business continuity test time and will continue to be carrying on the business of licencing the same intangible asset during the business continuity test period.

The current licence agreement does not contain a specific renewal clause. The first licence agreement was entered into between the taxpayer and Owner Co in 20XX; the current licence was entered into in 20XX. The new X-year licence is under essentially the same terms as the current agreement.

The taxpayer last derived income from one particular business activity in the 20XX financial year. The activity was in suspension due to the ill health of the controlling mind. No income from this particular activity was derived in the 20XX or 20XX financial years from the southern region serviced by the taxpayer due to the illness and passing of the controlling mind.

Relevant legislative provisions

Income Tax Assessment Act1997 Subdivision 165-A

Income Tax Assessment Act1997 Subdivision 165-D

Income Tax Assessment Act1997 Subdivision 165-E

Income Tax Assessment Act1997 section 165-10

Income Tax Assessment Act1997 section 165-12

Income Tax Assessment Act1997 section 165-13

Income Tax Assessment Act1997 subsection 165-13(2)

Income Tax Assessment Act1997 section 165-165

Income Tax Assessment Act1997 section 165-205

Income Tax Assessment Act1997 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 section 165-211

Income Tax Assessment Act 1997 subsection 165-211(1)

Income Tax Assessment Act 1997 subsection 165-211(2)

Reasons for decision

Question 1

Subdivision 165-A of the Income Tax Assessment Act 1997 (ITAA 1997) provides the rules around deductibility of tax losses of earlier income years.

Section 165-10 of the ITAA 1997 provides that 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 business continuity test).

Subdivision 165-D of the ITAA 1997 provide the tests for finding out whether a company has maintained the same owners; section 165-205 explains what happens in the event of the death of a share owner. In your circumstances, by virtue of section 165-205 of the ITAA 1997, the continuity of ownership test failed when the shares in the taxpayer were transferred from the estate of the controlling mind to Owner Co in the 20XX financial year.

Section 165-13 of the ITAA 1997 sets out the conditions that a company must meet to be able to deduct a tax loss if it fails to meet the continuity of ownership conditions in section 165-12 of the ITAA 1997. Per subsection 165-13(2) of the ITAA 1997, the company must satisfy the business continuity test for the income year (the business continuity test period), and the test is applied to the business the company carried on immediately before the test time, per the table in subsection 165-13(2).

In your circumstances, item 1 of the table in subsection 165-13(2) of the ITAA 1997 applies to you, as it was practicable for you to show when you failed the continuity of ownership test, being the time when the shares in the company were transferred from the estate of the controlling mind to Owner Co.

The provisions for the business continuity test are contained within Subdivision 165-E of the ITAA 1997. The 'same business test' and the 'similar business test' are collectively referred to as the 'business continuity test'. The requirements for satisfying the same and similar business tests are contained with sections 165-210 and 165-211 of the ITAA 1997 respectively. Per subsection 165-211(1) of the ITAA 1997, the similar business test applies to tax losses for income years starting on or after 1 July 2015; the same business test applies to tax losses for income years starting before 1 July 2015.

In respect of passing the same business test, there is one positive limb that must be satisfied, and two negative limbs that must not be satisfied.

Positive limb

Subsection 165-210(1) of the ITAA 1997 provides that a company will satisfy the business continuity test if throughout the business continuity test period it carries on the same business as it carried on immediately before the test time.

Negative limbs

In order to deduct its tax losses, a company must not satisfy either paragraph 165-210(2)(a) or 165-210(2)(b) of the ITAA 1997.

Subsection 165-210(2) of the ITAA 1997 provides that a company will fail the business continuity test if, at any time during the business continuity test period, it derives assessable income from:

(a)  a business of a kind that it did not carry on before the test time; or

(b)  a transaction of a kind that it had not entered into in the course of its business operations before the test time.

There are further integrity provisions contained within subsections 165-210(3) and 165-210(4) of the ITAA 1997 that do not apply in your case.

Same business test

The Commissioner's views on the same business test are discussed in Taxation Ruling TR 1999/1 Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132.

Paragraph 12 of TR 1999/9 provides that, for the purpose of the same business test, a company is treated as carrying on one overall business at the change-over and during the period of recoupment since the reference to 'business' in the same business test is a reference to all of the activities carried on by the company at the change-over and during the period of recoupment, irrespective of whether those activities constitute or are treated by the company as constituting separate or distinct activities, enterprises, divisions or undertakings carried on by the company.

Paragraph 13 of TR 1999/9 provides that, in the same business test, the meaning of the word 'same' in the phrase 'same business as' imports identity and not merely similarity; the phrase 'same business as' is to be read as referring to the same business, in the sense of the identical business. However, this does not mean identical in all respects: what is required is the continuation of the actual business carried on immediately before the change-over.

Paragraph 13 of TR 1999/9 also provides that the analysis of whether the same business continues after the change-over may give rise to questions of degree and ultimately depends on the facts of the case. In making the analysis it needs to be acknowledged that a company may expand or contract its activities without necessarily ceasing to carry on the same business. The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail the same business test provided the business retains its identity; nor would discarding, in the ordinary way, portions of its old operations. But, if through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by either the acquisition or the loss of activities on a considerable scale, a company may fail the test.

Paragraph 36 of TR 1999/9 provides that the use of the word 'immediately' in the same business test does not mean that only those things done immediately before the change-over in the course of the business are relevant to the application of the same business test. The word 'immediately' in the same business test refers to the overall business being carried on at change-over, rather than to the particular activities taking place at that time as part of it. That is to say, the word requires reference to be made to the business carried on immediately before the change-over, but it does not require everything which that business comprises to be carried on immediately before the change-over. For not every activity that is properly to be identified as part of the overall business is necessarily taking place at the change-over: some kinds of activity may be intermittent or in temporary suspension.

Paragraph 38 of TR 1999/9 provides that to satisfy the same business test, a taxpayer must be able to show that it carried on the same business, in the sense of the identical business, at all times during the period of recoupment, as the business it carried on at the change-over. However, this does not mean that the business carried on by the taxpayer during the period of recoupment must be identical in every respect with the business that was carried on immediately before the change-over. 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.

The similar business test

Section 165-211 of the ITAA 1997 provides the similar business test, with subsection 165-211(2) providing the following factors that must be taken into account in ascertaining whether the company's current business is similar to its former business:

(a)  the extent to which the assets (including goodwill) that are used in its current business to generate assessable income throughout the business continuity test period were also used in its former business to generate assessable income;

(b)  the extent to which the activities and operations from which its current business generated assessable income throughout the business continuity test period were also the activities and operations from which its former business generated assessable income;

(c)   the identity of its current business and the identity of its former business;

(d)  the extent to which any changes to its former business result from development or commercialisation of assets, products, processes, services or marketing or organisational methods of the former business.

The Commissioner's views on the similar business test are discussed in Law Companion Ruling LCR 2019/1 The business continuity test - carrying on a similar business.

Paragraph 7 of LCR 2019/1 provides that ... the overall business must satisfy the similar business test. The meaning of 'similar' depends on the context in which the term arises. In the context of the similar business test, 'similar' does not mean similar 'kind' or 'type' of business. The focus remains on the identity of a business, as well as continuity of business activities and use of assets to generate assessable income. Accordingly, it will be more difficult to satisfy the similar business test if substantial new business activities and transactions do not evolve from, and complement, the business carried on before the test time. In contrast, where a company develops a new product or function from the business activities already carried on, and this development opens up a new business opportunity or allows the company to fill an existing gap in the market, the business as a whole is likely to satisfy the similar business test.

Paragraphs 9 to 14 of LCR 2019/1 discuss four factors that must be considered, and these factors require a comparison between the essential characteristics of the business before and after the relevant change in ownership or control. The weight to be given to each factor depends on the facts and circumstances of each case. The first three factors are concerned with the aspects of the business that have continued, while the fourth factor assesses the nature of any changes that have happened. Where those changes are due to an evolution or development of the business, the business is more likely to be similar to that previously carried on.

The first factor considers the extent to which the assets used to generate assessable income throughout the business continuity test period were the assets used in the business carried on at the test time. Where the same assets of the business are being used as at the test time to generate assessable income, albeit that they may be producing a different result or effect due to the development or commercialisation of some of those assets, this factor would indicate that the business remains similar to that previously carried on.

The continuing use of certain business assets to generate assessable income rather than other assets may be more relevant to the question of whether the similar business test is passed. For example, goodwill, which is the combined result of using the business' tangible, intangible and human assets in such a way that attracts custom to the business, will be more relevant than other assets, such as generic office premises, equipment and stationery, because it is closely linked to the identity of a particular business. If the goodwill that was used throughout the business continuity test period is replaced by new goodwill, it will be necessary to consider the extent to which other assets of the business have continued to be used and the amount of weight that should be given to that in comparison to other factors.

The second factor compares the extent to which the current activities and operations from which assessable income is generated were also those from which assessable income was generated previously. Where the business operator maintains the income generating activities and operations that were previously being undertaken, despite doing them in a different or more efficient way due to business improvements, this factor would indicate that the business remains similar to that previously carried on.

The third factor compares the current identity of the business with that of the business carried on before the test time. Where new activities have not resulted in the identity of the business changing, this factor would indicate that the business remains relevantly similar to that previously carried on.

The fourth factor requires an assessment of the extent to which the changes to the business resulted from the development or commercialisation of assets, products, processes, services or marketing or organisational methods of the business. As the similar business test is designed to encourage businesses to innovate, such changes will not, in themselves, cause a business to be considered dissimilar. Where changes to the business do not result from such development or commercialisation, the business is less likely to satisfy the similar business test.

Application to your circumstances

In your case, the Commissioner considers that you have satisfied the same and similar business tests based on the facts and circumstances put to us. The current licence agreement has essentially rolled over from the previous agreement; in other words, there were no material changes to that business activity carried on by the taxpayer before and after the test time. In relation to the four factors considered above, particularly the second and third factors, the current business activity referred to in Question 1 - and the assessable income generated from this activity - is the same income-generating activity that was previously being undertaken; and there has been no change to the identity of the business.

Question 2

As discussed above in the answer to Question 1, the Commissioner considers that you have satisfied the same and similar business tests based on the facts and circumstances put to us. In respect of a new agreement, the new licence agreement is on essentially the same terms as the current licence agreement; in other words, there are no material changes to that business activity carried on by the taxpayer before and after the test time. Further, a new agreement that is essentially on the same terms as existing agreements would not result in a change to the identity of the business.

Question 3

As discussed above in the answers to Question 1 and 2, the Commissioner considers that you have satisfied the same and similar business tests based on the facts and circumstances put to us.

In respect of new agreements with new parties, the granting of new licence agreements under the same terms with new parties represents organic growth of the same business; in other words, there are no material changes to that business activity carried on by the taxpayer after the test time, relative to that activity carried on before the test time. Potential new licensees will be carrying on business activity in the same field as Owner Co and do not present a new and distinct customer market. Further, a new agreement that is essentially on the same terms as existing agreements would not result in a change to the identity of the business. This is discussed further in the answer to Question 4 below.

Question 4

The Commissioner's views on the new transactions and new business tests are discussed in TR 1999/9.

New transactions test

Paragraph 15 of TR 1999/9 provides that ... the new transactions test is directed to preventing the injection of income into a loss company that has satisfied the same business test and the new business test. The new transactions test includes all transactions entered into in the course of the company's business operations and not merely those that are 'isolated' or 'independent'. However, generally speaking, the new transactions test is not failed by transactions of a type that could have been entered into ordinarily and naturally in the course of the business operations carried on by the company before the change-over. Conversely, a transaction entered into during the period of recoupment and which is outside the course of the business operations before the change-over, or which is extraordinary or unnatural when judged by the course of the business operations before the change-over, is usually a transaction of a different kind from the transactions actually entered into by the company before the change-over.

Paragraph 16 of TR 1999/9 provides that a transaction from which income is derived during the period of recoupment, which could have been entered into before the change-over in the course of the company's business operations, and which is neither extraordinary nor unnatural in the context of the business carried on by the company at the change-over, is generally a transaction of the same kind as transactions actually entered into by the company before the change-over.

Paragraph 17 of TR 1999/9 provides that in the new transactions test, 'transaction' refers to any operation or dealing from which income directly or indirectly flows or arises, and a company enters into a transaction for the purposes of the new transactions test if it engages or participates in it. The new transactions test is intended to extend to every means by which a company may derive income, including transactions of a passive or investment character. The words 'business operations' refer to everything that a company undertakes or does; together, the business operations constitute the business, meaning the overall business, of the company.

Paragraph 79 of TR 1999/9 provides that in Fielder Downs, Campbell J indicated a company fails the new transactions test if the company derives income during the period of recoupment from a transaction that was of a different kind from the transactions the company had entered into in the course of the business carried on by the company at the change-over... Paragraph 80 of TR 1999/9 goes on to discuss that it would seem that [Campbell J] did not regard transactions as being caught by the test if they were transactions that could have been carried on in the course of the company's operations prior to the change-over. Paragraph 81 of TR 1999/9 provides that... transactions that could have been entered into in the course of business operations before the change-over consistently with its ordinary course, are usually transactions of the same kind as those that actually had been entered into.

'Transaction', 'entered into' and 'business operations' have a broad meaning

Paragraph 82 of TR 1999/9 explains that the new transactions test is concerned to ensure that a company deducts losses from income from transactions of the same kind as the operations by which it generated income before the change-over.

Whether a business or a transaction is 'of a kind' entered into in the course of business operations before the change-over

Paragraph 86 of TR 1999/9 provides that a transaction that is entered into during the period of recoupment, which could have been entered into in the course of business operations before the change-over, and which is neither extraordinary nor unnatural in the context of the business carried on by the company at the change-over, is generally a transaction of the same kind as transactions actually entered into by the company before the change-over.

New business test

Paragraph 14 of TR 1999/9 provides that ... in the new business test there is a reference to 'business of a kind' that the company did not carry on before the change-over. In the new business test the word 'business' has a different meaning from the word 'business' in the same business test; it refers to each kind of enterprise or undertaking comprised in the overall business carried on by the company at the change-over and during the period of recoupment. The new business test puts a limit on the type of expansion the company may undertake if it is to retain the benefit of accumulated losses; for the taxpayer may not engage in an undertaking or enterprise of a kind in which it did not engage before the change-over and still benefit from accumulated losses.

Changes of activities

Paragraph 39 of TR 1999/9 provides that a mere expansion or contraction of the taxpayer's business may not result in a change in the identity of the business carried on by the taxpayer.

Paragraph 40 of TR 1999/9 provides that ... a sudden and dramatic expansion or contraction brought about by the acquisition or loss of activities on a considerable scale could mean the same business is no longer being carried on. As Walton J observed in Rolls-Royce Motors Ltd v. Bamford:

'There is all the difference in the world between an organic growth of trade and a sudden and dramatic change brought about by either the acquisition or loss of activities on a considerable scale.'

Paragraph 43 of TR 1999/9 provides that the question of whether the discontinuation of an activity will produce a change of business is, however, ultimately one of degree. Sudden and dramatic change brought about by either the loss or acquisition of activities on a considerable scale is to be contrasted with an organic growth of a business...

Paragraph 53 of TR 1999/9 provides, in contrast with the cases listed in paragraph 52 of TR 1999/9, the case of a company whose business, while not discontinued, is undergoing a period of inactivity, e.g., the case of the taxpayers in The Merchison Steamship Co Ltd v. Turner; Kirk and Randall Ltd v. Dunn; and FC of T v. Broken Hill South Limited: although the last must be regarded as a borderline example. The circumstances accounting for the inactivity, whether the company is actively holding itself out for business though obtaining none, and whether there is the expectation of a resumption of active operations within a reasonable time, are matters to be examined in determining whether the business is still being carried on.

Paragraph 54 of TR 1999/9 provides that in determining whether a business carried on during the period of recoupment is a new business commenced after the cessation of the business carried on immediately before the change-over, or the same business (having undergone a period of reduced activity) as the business then carried on, it is also relevant to examine the circumstances in which activity resumed, changes in those activities when resumed, their location, and whether there is continuity of name, custom and goodwill.

Paragraph 55 of TR 1999/9 discusses the importance of the continuity of custom and goodwill in deciding whether the same business or a new business is being carried on after a change-over.

Paragraph 60 of TR 1999/9 provides guidelines for determining whether a taxpayer has satisfied the same business test, which relevantly include consideration of inactivity, and the circumstances accounting for the inactivity and in which activity is resumed. Subparagraph 60(d) of TR 1999/9 provides that an expansion or contraction of the taxpayer's business activities may not, in itself, result in a change in the identity of the business carried on by the taxpayer: Gibbs J in Avondale Motors... In particular, the organic growth of a business through the adoption of new compatible operations in the ordinary way... may not cause a taxpayer to fail the same business test, but a sudden and dramatic change brought about by the loss or acquisition of business operations on a considerable scale is likely to do so.

Paragraph 64 of TR 1999/9 provides that the new business test requires that the taxpayer company did not, at any time during the period of recoupment, derive income from... a business of a kind it did not carry on before the change-over.

Paragraph 66 of TR 1999/9 provides that whether the new business test or the new transactions test is satisfied by a company in a particular case is a question of fact. The legislative intention underlying these provisions is to prevent the injection of income into the loss company while permitting, within limits consistent with the prevention of tax avoidance, the development and expansion of the overall business carried on immediately before the change-over. Such an injection of income might occur by means of activities that form part of the business and would not cause the business to cease to be the same...

Paragraph 68 of TR 1999/9 provides that 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 be 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 taxpayer at the change-over. Thus, each particular undertaking or enterprise carried on or out by the taxpayer, as part of its overall business in the period of recoupment, is tested by the new business test.

Application to your circumstances

The taxpayer last derived its related activity income in the 20XX financial year. The related activity was in suspension due to the ill health of the controlling mind. No related activity income was derived in the 20XX or 20XX financial years from the southern region serviced by the taxpayer due to the illness and passing of the controlling mind.

The circumstances that resulted in the temporary suspension of the related business activity were beyond the taxpayer's control, and it is considered that had those circumstances not occurred, there would have been no suspension of that related business activity. The circumstances resulting in a resumption of this related business activity would be considered to be an organic continuation of the related activity to be carried on either by Owner Co or by a third party to be engaged by Owner Co.

Transactions resulting from this resumed related business activity could have been entered into before the test time (and indeed were) and such transactions are neither extraordinary nor unnatural in the context of the business carried on by the taxpayer before the test time. The resumption of this related business activity would be the resumption of an activity that had been temporarily suspended, but still comprised part of the taxpayer's overall business. It is the same field of endeavour that the taxpayer was engaged in before the test time.

There is continuity of name, custom, and goodwill of the business. There are no material changes to this business activity nor the business identity or goodwill; the essential identity of the business has not changed.

Throughout the business continuity test period, the taxpayer carried on the same business as it did immediately before the test time. The taxpayer will not, at any time during the business continuity test period, have derived assessable income from a business of a kind which it did not carry on before the test time. The taxpayer will not, at any time during the business continuity test period, have derived 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.