Presented by: Institute of Chartered Accountants Australia
Tax losses – carry-backs and carry-forwards, issues and challenges June 2013
Tax Losses – Carry-backs and carry-forwards, issues and challenges June 2013
Copyright © The Institute of Chartered Accountants in Australia 2013 2
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Table of Contents 1. Introduction ....................................................................................................................... 7
2. Overview ............................................................................................................................ 9
2.1 Methodology for deducting prior year tax losses .......................................................... 9
2.2 How to calculate a tax loss for an income year ............................................................ 9
2.3 How to deduct tax losses ........................................................................................... 10
2.3.1 Entities other than corporate tax entities ................................................................. 10
2.3.1.1 No net exempt income ........................................................................................ 10
2.3.1.2 Net exempt income ............................................................................................. 11
2.3.2 General rules for entities that are not corporate tax entities in deducting tax loss ... 11
2.3.3 Corporate tax entities ............................................................................................. 13
2.3.3.1 No net exempt income ........................................................................................ 13
2.3.3.2 Net exempt income ............................................................................................. 14
2.3.3.3 Limits on choosing the amount of tax losses to deduct – “excess franking offsets” 14
2.3.3.4 Converting excess franking offsets into tax losses .............................................. 19
2.3.3.5 General rules for corporate tax entities in deducting tax loss .............................. 21
2.3.3.6 Adjustments required if subsequent amendment to tax position .......................... 21
2.4 Net exempt income .................................................................................................... 22
2.4.1 Net exempt income of Australian resident .............................................................. 22
2.4.2 Net exempt income of a foreign resident ................................................................ 23
2.5 Special rules about tax losses .................................................................................... 23
3. Individuals ....................................................................................................................... 27
3.1 Losses from hobbies .................................................................................................. 27
3.2 General deductions .................................................................................................... 27
3.3 Carrying on a business .............................................................................................. 28
3.4 Non-commercial business losses ............................................................................... 33
3.5 Deferral of non-commercial business losses .............................................................. 33
3.5.1 Non-commercial business losses ........................................................................... 33
3.5.2 Exempt income ...................................................................................................... 34
3.5.3 Blackhole expenditure ............................................................................................ 35
3.5.4 Non-commercial business activities ........................................................................ 36
3.5.5 Grouped non-commercial business activities .......................................................... 36
3.5.6 Exception ............................................................................................................... 37
3.5.6.1 Profits test ........................................................................................................... 39
3.5.6.2 Real property test ............................................................................................... 40
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3.5.6.3 Other assets test ................................................................................................. 40
3.5.7 Commissioner’s discretion ...................................................................................... 41
3.5.8 Modifications for bankruptcy ................................................................................... 41
3.5.9 Application to certain partnerships .......................................................................... 42
4. Companies ....................................................................................................................... 43
4.1 Rules for Use of Prior Year Tax Losses by Companies .............................................. 43
4.2 Continuity of ownership test ....................................................................................... 44
4.2.1 General continuity of ownership test rules............................................................... 44
4.2.1.1 Proposed modifications clarifying aspects of the COT ......................................... 46
4.2.1.2 Special continuity of ownership test rules ............................................................ 47
4.2.1.3 Saving provision .................................................................................................. 49
4.3 Same business test .................................................................................................... 52
4.3.1 Same business test period ...................................................................................... 52
4.3.2 The same business test requirements .................................................................... 54
4.3.2.1 Positive requirement ........................................................................................... 54
4.3.2.2 Cases where positive requirement satisfied ........................................................ 56
4.3.2.3 Cases where positive requirement failed ............................................................. 57
4.3.2.4 Negative requirements ........................................................................................ 59
4.3.2.5 Anti-avoidance test .............................................................................................. 60
4.4 Applying net capital losses of earlier income year ...................................................... 61
4.5 Division 166 concessional tracing rules ...................................................................... 62
4.5.1 Which entities are able to rely on Division 166? ...................................................... 63
4.5.2 Point-in-time testing ................................................................................................ 64
4.5.3 Concessionary tracing rules .................................................................................... 65
4.5.4 Other special rules in Division 166 .......................................................................... 66
4.5.5 Final points on Division 166 .................................................................................... 69
4.5.5.1 Change in control of voting power ....................................................................... 69
4.5.5.2 Application is optional.......................................................................................... 69
4.6 Loss carry-back regime .............................................................................................. 70
4.6.1 Overview of the loss carry back regime .................................................................. 71
4.6.2 Entities eligible for loss carry-back .......................................................................... 72
4.6.3 Choice to apply the loss carry-back regime............................................................. 72
4.6.4 Relationship between loss carry-back and loss carry-forward ................................. 73
4.6.5 Losses which are subject to the loss carry-back regime.......................................... 73
4.6.6 Franking credit cap ................................................................................................. 74
4.6.7 Calculation of the loss carry-back tax offset ............................................................ 75
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4.6.8 Examples ............................................................................................................... 76
4.6.9 Overview of the loss carry-back integrity measure.................................................. 79
4.6.10 Key elements of the loss carry-back integrity measure ........................................... 80
4.6.11 Relevant Circumstances......................................................................................... 81
4.6.12 Examples ............................................................................................................... 82
4.7 Proposed improvements to the company loss recoupment rules ............................... 85
4.7.1 Modifications to the continuity of ownership test ..................................................... 85
4.7.2 Extension of the concessional tracing rules under the modified continuity of ownership test ...................................................................................................................... 85
4.7.3 Holding company interposed between a direct stakeholder and the tested company 86
4.7.4 Demerger by a top interposed entity ....................................................................... 86
4.7.5 Entity interposed between a superannuation fund and the tested company ........... 87
4.7.6 Bearer depository receipts ...................................................................................... 88
4.7.7 Applying the modified COT following an issue of new shares ................................. 89
4.7.8 Loss integrity rules – low value asset exclusion ...................................................... 89
4.8 Proposed tax loss incentive for designated infrastructure projects ............................. 90
4.9 Common errors when utilising tax losses ................................................................... 90
4.9.1 Common errors ...................................................................................................... 90
4.9.2 ATO target areas .................................................................................................... 91
4.10 Record keeping .......................................................................................................... 91
5. Modifications ................................................................................................................... 93
5.1 Tax losses and consolidated groups .......................................................................... 93
5.1.1 Overview ................................................................................................................ 93
5.1.2 Transfer of carried forward tax losses..................................................................... 93
5.1.3 Utilisation of tax losses by head company of consolidated group ........................... 94
6. Foreign Losses ............................................................................................................... 97
7. Trusts ............................................................................................................................... 99
7.1 A summary of the trust loss rules ............................................................................... 99
7.2 Important definitions .................................................................................................101
7.3 Fixed trust .................................................................................................................101
7.4 Non-fixed trust ..........................................................................................................102
7.5 Closely held trust ......................................................................................................102
7.6 Widely held trust .......................................................................................................103
7.6.1 Unlisted and listed widely held trusts .....................................................................103
7.6.2 Unlisted very widely held trust ...............................................................................103
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7.6.3 Wholesale widely held trust .................................................................................. 104
7.6.4 Family trust ........................................................................................................... 104
7.6.5 Excepted trust ....................................................................................................... 105
7.7 Fixed trusts, not widely held unit trusts or excepted trusts ........................................ 105
7.7.1 50% stake test ...................................................................................................... 106
7.7.2 Non-fixed trust stake test ...................................................................................... 106
7.8 Non-fixed trusts ........................................................................................................ 107
7.8.1 50% stake test ...................................................................................................... 107
7.8.2 Pattern of distributions test ................................................................................... 107
7.8.3 Control .................................................................................................................. 109
7.8.4 Income injection test ............................................................................................. 110
7.8.4.1 Introduction ....................................................................................................... 110
7.8.4.2 Elements of the test .......................................................................................... 110
7.8.4.3 The trust must have an allowable deduction ...................................................... 111
7.8.4.4 There must be a scheme ................................................................................... 111
7.8.4.5 There must be a connection between the deduction and one or more of the things that happen under the scheme ........................................................................................... 112
7.8.4.6 Examples .......................................................................................................... 112
8. Restricting tax deductions for related party debt ....................................................... 115
8.1 Current Law ............................................................................................................. 115
8.1.1 Debts which are outside of the TOFA regime ........................................................ 116
8.1.2 Debts which fall within the TOFA regime .............................................................. 117
8.2 Impact of the proposed amendments ....................................................................... 118
8.2.1 What is a related party? ........................................................................................ 119
8.2.2 Application date .................................................................................................... 120
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1. Introduction
This paper, aimed at an intermediate to advanced audience, discusses the recoupment of tax
losses by individuals, trusts and companies pursuant to the Income Tax Assessment Act 1997
(ITAA 1997) and Income Tax Assessment Act 1936 (ITAA 1936). It also discusses the
proposed loss carry-back rules for companies which are expected to apply from 1 July 2013.
This paper is presented as part of The Institute of Chartered Accountants in Australia (Institute)
special topics program.
References to sections in this paper are references to the ITAA 1997, unless otherwise
indicated.
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2. Overview
2.1 Methodology for deducting prior year tax losses
Subdivision 36-A contains the key provisions dealing with deductions for tax losses of earlier
years. It contains the rules for calculating the amount of the tax losses1 and the method for
deducting them2. It also provides signposts to the special rules which apply to particular types of
loss or taxpayer3
2.2 How to calculate a tax loss for an income year
.
If a taxpayer’s assessable income4 for a particular income year exceeds the allowable
deductions5, the taxpayer will be taken to have taxable income equal to the excess.6
Conversely, where the allowable deductions exceed the assessable income, the taxpayer will,
in general terms, incur a “tax loss” for that year.
7
• Adding the allowable deductions for the income year (excluding tax losses of earlier
income years);
Specifically, section 36-10 provides that a tax
loss for a particular income year is calculated by:
• Subtracting the total assessable income; and
• Subtracting any amount of “net exempt income”8 2.3.1.2 (refer to Section below),
any amount remaining is the tax loss for the income year (the loss year).
1 Section 36-10 2 Sections 36-15 and 36-17 3 Section 36-25 4 See Division 6 5 See Division 8 6 Section 4-15 7 Subsection 36-10(4) 8 Section 36-20
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A tax loss does not entitle a taxpayer to any kind of tax “refund” for that year; instead, the loss
remains available (subject to the satisfaction of any relevant general recoupment tests or until
cancellation) to be deducted from taxable income derived in subsequent income years. This
process is called “carrying forward” the loss.
Note that the meaning of tax loss and loss year is modified by section 36-55 which applies to
corporate tax entities which have an amount of excess franking offsets.
In addition, section 26-55 specifies that certain allowable deductions cannot create or add to a
tax loss. These allowable deductions include gifts, certain superannuation contributions and
gratuities.
2.3 How to deduct tax losses
2.3.1 Entities other than corporate tax entities
Section 36-15 sets out how tax losses are carried forward for deduction in later income years by
an entity other than a “corporate tax entity”. “Corporate tax entity” is defined to mean a
company, corporate limited partnership, corporate unit trust or a public trading trust.9
The application of the carried forward tax losses against income depends upon whether the
entity has net exempt income.
2.3.1.1 No net exempt income
Generally, if the total assessable income for a later income year exceeds the total deductions
for that year (ignoring the tax loss), the tax loss is deducted from that excess.10 Where the tax
loss is greater than the excess, the undeducted part of the tax loss is carried forward to the next
income year.11
9 Section 960-115
There is no limit on this carry forward period (however, a 7 year limit applied to
non-primary production losses incurred before the 1990 income year).
10 Subsection 36-15(2) 11 Subsection 36-15(7)
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If the total assessable income does not exceed the total deductions, then the tax loss cannot be
deducted in that year, and is carried forward to later years.12
2.3.1.2 Net exempt income
In circumstances where the taxpayer has net exempt income in the income year in which the
taxpayer seeks to apply the tax loss, the tax loss is deducted first from the net exempt income,
and secondly from the part of the total assessable income that exceeds the total deductions.13
However, if the deductions exceed the total assessable income, then that excess is subtracted
from the net exempt income, and the tax loss is deducted from any net exempt income which
remains.
14
Accordingly, the effect under either subsection is that any prior year tax losses (or current year
losses) of the taxpayer will be automatically offset against the net exempt income of the
taxpayer for the income year.
2.3.2 General rules for entities that are not corporate tax entities in deducting tax loss
The tax losses that are deducted in accordance with section 36-15 will also be subject to the
following general rules:
• Tax losses are deducted in the order in which they are incurred;15
• Tax losses are deductible only to the extent that they have not already been deducted;
16
• The undeducted amount of a tax loss can be carried forward for deduction in later income
years.
and
17
12 Subsection 36-15(7)
13 Subsection 36-15(3) 14 Subsection 36-15(4) 15 Subsection 36-15(5) 16 Subsection 36-15(6) 17 Subsection 36-15(7)
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Example 1
Xene incurs a loss of $25,000 in the 2011 income year. In the 2012 income year, Xene’s total
assessable income is $20,000 and deductions (other than for the tax loss) are $3,000, thus
resulting in an excess of $17,000. Assuming that there is no net exempt income, the $25,000 is
carried forward so as to reduce the $17,000 to nil. The balance of $8,000 is available to be
carried forward to the 2013 and later income years.
Example 2
Assume that in the 2013 income year, Xene’s total assessable income is $50,000 and
deductions (other than for the tax loss) are $10,000, resulting in an excess of $40,000. The
unrecouped tax loss of $8,000 is carried forward so as to reduce the excess to $32,000. The tax
loss is now fully recouped.
Example 3
Assume the same facts as in Example 1, except that in the 2012 income year, Xene also has a
net exempt income of $6,000. The $25,000 tax loss is deducted first against this $6,000. The
balance $19,000 is then deducted from the $17,000 excess of total assessable income over
deductions, so as to reduce the $17,000 to nil. The balance of the tax loss $2,000 is available to
be carried forward to the 2013 income year and later income years.
Example 4
Assume that in the 2013 income year, Xene’s total assessable income is $50,000, and the
deductions (ignoring the tax loss) are $10,000, resulting in an excess of $40,000. Assume also
that Xene has net exempt income of $5,000. The balance of the tax loss $2,000 is deducted first
against the $5,000, reducing it to $3,000. The tax loss is now exhausted and no part of it is
available to be deducted against the excess of $40,000.
Example 5
Assume instead that in the 2013 income year, Xene’s total assessable income is $50,000, the
deductions (ignoring the tax loss) are $65,000, and the net exempt income is $25,000. As the
deductions exceed the total assessable income, the excess $15,000 is subtracted from the net
exempt income, resulting in a balance of $10,000. The tax loss $2,000 is deducted from that
balance, reducing it to $8,000. The tax loss is now exhausted.
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2.3.3 Corporate tax entities
Section 36-17 sets out how tax losses of corporate tax entities are carried forward for deduction
in later income years. Section 36-17 applies where the relevant entity is a corporate tax entity at
any time during the later income year.
The purpose of introducing section 36-17 was to enable a corporate tax entity to choose the
amount of prior year losses it wished to deduct in a later income year. This enables a corporate
tax entity with carried forward tax losses:
• To ensure it does not “waste” the benefit of tax offsets for franking credits received in an
income year where the corporate tax entity had current year or carried forward tax losses;
and
• To pay sufficient tax to enable it to make franked distributions to its members.
As with taxpayers that are not corporate tax entities, the application of the carried forward tax
losses against income depends upon whether the corporate tax entity has net exempt income.
2.3.3.1 No net exempt income
Subject to the limits prescribed in subsection 36-17(5) (see below), if the total assessable
income for the later income year exceeds the total deductions for that year (ignoring the tax
loss), the corporate tax entity may choose the amount of the tax loss that is deducted from the
excess.18
The corporate tax entity is able to effectively choose not to deduct any part of the tax losses by
choosing to deduct a nil amount. The balance of any tax losses remaining after the chosen
losses are deducted is carried forward to a later income year.
This is in contrast to section 36-15, which does not allow the taxpayer a choice in
deducting tax losses.
19
18 Subsection 36-17(2)
There is no limit on this carry
forward period but the utilisation of tax losses in later income years is subject to the satisfaction
of the general recoupment tests or cancellation.
19 Subsection 36-17(9)
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If the total assessable income does not exceed the total deductions, then the tax loss cannot be
deducted in that year and is carried forward into the next year.20
2.3.3.2 Net exempt income
Where, in a later income year, the corporate tax entity has net exempt income and the entity’s
total assessable income for the later income year exceeds the total deductions for that year
(ignoring the tax loss), the calculation involves two separate steps.
The first step requires that the tax loss be deducted from the net exempt income.21
The second step requires the entity to deduct such amount of the tax loss as the entity chooses
from the part of the total assessable income that exceeds the total deduction.
There is no
ability for the entity to choose not to deduct the tax losses against the net exempt income, even
if the entity does not propose to deduct losses against the net assessable income.
22
If the deductions exceed the total assessable income, then that excess is subtracted from the
net exempt income and the tax loss is deducted from any net exempt income that remains.
The entity can
effectively choose not to deduct any part of its losses against the assessable income by
choosing to deduct a nil amount.
23
2.3.3.3 Limits on choosing the amount of tax losses to deduct – “excess franking offsets”
There is no ability for the corporate tax entity to choose not to deduct the excess against any
net exempt income.
In making the choice of the amount of tax loss to be deducted, the corporate tax entity cannot
choose an amount that would result in:
• The entity generating any “excess franking offsets” (see below) which would not
otherwise have arisen if the entity had not chosen to deduct the tax loss; or
20 Subsection 36-17(9) 21 Paragraph 36-17(3)(a) 22 Paragraph 36-17(3)(b) 23 Subsection 36-17(4)
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• The entity increasing any excess franking offsets that would otherwise have arisen if the
entity had not chosen to deduct the tax loss.
The meaning of excess franking offsets is set out in section 36-55. Generally, an entity will have
excess franking offsets for an income year to the extent that:
• The total non-refundable tax offsets of the entity under Division 207 (offsets for franking
credits) and Subdivision 210-H (offsets for superannuation funds receiving distributions
franked with a venture capital credit) exceed the amount of income tax that would be
payable by the entity in respect of the income year, assuming:
- The entity did not have those tax offsets;
- The entity did not have any tax offsets that are subject to the tax offset carry forward
rules in Division 65 or the refundable tax offset rules in Division 67;
- The entity did not have any tax offsets in relation to franking deficit tax under section
205-70; and
- The entity had all its other tax offsets.
The amount of the excess will be the entity’s excess franking offsets for the income year.
Broadly, this amount reflects the franking offsets received by a corporate tax entity during the
income year that would otherwise be wasted on account of the entity’s current year losses.
Example 1
During the 2012 income year, Company A derives assessable income of $250 (consisting of a
fully franked dividend of $140, franking credit of $60 and other income of $50) and incurs
allowable income tax deductions amounting to $100. As at 1 July 2011, Company A had carried
forward revenue losses of $500.
As the tax offset of $60 attributable to Company A’s franking credit is not stated to be subject to
the refundable tax offset rules in Division 67, Company A has excess franking offsets of $15 for
the 2012 income year, calculated as follows:
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Step 1: Determine income tax payable (disregarding offsets)
Assessable income $250
Less: deductions ($100)
Taxable income $150
Tax payable $45
Step 2: Determine non-refundable tax offsets under Division 207 or Division 210
Franking credit (Division 207) $60
Step 3: Determine excess franking offsets
Franking credit (Division 207) $60
Less: Income tax payable ($45)
Excess franking offsets $15
As Company A has excess franking offsets for the 2012 income year (ignoring Company A’s tax
losses), Company A will not be able to utilise any amount of its carried forward tax losses during
the 2012 income year.24
However, Company A may be able to convert its excess franking offsets into additional tax
losses that can be carried forward by Company A, subject to satisfaction of the relevant loss
integrity rules (or cancellation).
25
Further information about the conversion of excess franking offsets is provided at Section
2.3.3.4 below.
24 Paragraph 36-17(5)(a) 25 Subsection 36-55(2)
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Example 2
During the 2012 income year, Company B derives assessable income of $200 (consisting of a
franked dividend of $70, franking credit of $30 and other income of $100) and incurs allowable
income tax deductions of $70. As at 1 July 2011, Company B had carried forward tax losses of
$200.
Company B does not have any excess franking offsets for the 2012 income year, as shown by
the following calculation:
Step 1: Determine income tax payable (disregarding offsets)
Assessable income $200
Less: deductions ($70)
Taxable income $130
Tax payable $39
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Step 2: Determine non-refundable tax offsets under Division 207 or Division 210
Franking credit (Division 207) $30
Step 3: Determine excess franking offsets
Franking credit (Division 207) $30
Less: Income tax payable ($39)
Amount remaining / excess franking offsets ($9) / Nil
As Company B does not have any excess franking offsets for the 2012 income year (ignoring
Company B’s tax losses), Company B will be able to utilise its carried forward tax losses to
reduce its taxable income during the period, subject to satisfaction of the relevant loss integrity
rules (or cancellation).
However, Company B will only be entitled to utilise an amount of tax losses that would not result
in Company B generating excess franking offsets for the 2012 income year.26
$30 = (($200 - $70 - $X)*30%)
On this basis,
Company B will only be entitled to utilise a maximum of $30 of its carried forward tax losses for
the 2012 income year, calculated using the following formula:
Where:
• $30 is the value of Company B’s non-refundable tax offsets for the 2012 income year;
• $200 is Company B’s assessable income for the 2012 income year;
• $70 is Company B’s allowable deductions for the 2012 income year;
• $X is the maximum value of carried forward losses which can be applied by Company B for
the 2012 income year; and
• 30% is the corporate income tax rate for the 2012 income year.
26 Paragraph 36-17(5)(b)
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2.3.3.4 Converting excess franking offsets into tax losses
In certain circumstances, a corporate tax entity may “convert” its excess franking offsets for an
income year into additional tax losses in accordance with the method statement prescribed by
subsection 36-55(2). Broadly, that method statement is designed to prevent a corporate tax
entity’s franking offsets for an income year being wasted on account of the entity’s current year
losses. The method statement is premised on the fact that corporate tax entities (unlike
individuals) are generally not able to receive a refund in respect of franking credit offsets.27
Pursuant to the method statement in subsection 36-55(2), where a corporate tax entity has an
amount of excess franking offsets for an income year, its tax loss for the period will be
determined as follows:
Step 1: Work out the amount that would have been the entity’s tax loss for the income year
under section 36-10 (or, if applicable, sections 165-70, 175-35 or 701-30) assuming
the entity had no net exempt income;
Step 2: Divide the amount of the entity’s excess franking offsets for the income year by the
corporate tax rate;
Step 3: Add the results of Step 1 and Step 2;
Step 4: Reduce the result of Step 3 by the entity’s net exempt income for the income year.
Any positive amount remaining after Step 4 will be the entity’s tax loss for the income year.
However, if the result obtained under Step 4 is nil or negative, the entity will not have any tax
loss for the income year.
To the extent that a positive amount remains after Step 4, the income year will be taken to be a
“loss year” for the corporate tax entity.28
27 Subsections 67-25(1C), 67-25(1D) and 67-25(1E) 28 Paragraph 36-55(2)(d)
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Example
Continuing Example 1 above (see Section 2.3.3.3), Company A would be taken to have
incurred a tax loss of $50 for the 2012 income year, calculated as follows:
Step 1: Determine tax loss otherwise incurred by Company A under section 36-10
Deductions (ignoring carried forward tax losses) $100
Less: assessable income $250
Less: net exempt income Nil
Amount remaining / tax loss ($150) / Nil
Step 2: Add excess franking offsets divided by corporate tax rate
Excess franking offsets $15
Corporate income tax rate 30%
Excess franking offsets divided by tax rate $50
Step 3: Reduce the result of Step 2 by net exempt income
Net exempt income Nil
Step 4: Determine amount remaining after Step 3
Step 1 result Nil
Add: Step 2 result $50
Less: Step 3 result Nil
Amount remaining (Step 4) $50
The result remaining after applying Step 4 of the method statement in subsection 36-55(2) is
$50. As this is a positive amount, Company A will be deemed to have incurred a tax loss for the
2012 income year of $50 under paragraph 36-55(2)(c). In addition, the 2012 income year will be
treated as a “loss year” for Company A under paragraph 36-55(2)(d). This will have
ramifications for application of the continuity of ownership test (COT) and the same business
test (SBT) (see Section 4 below).
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2.3.3.5 General rules for corporate tax entities in deducting tax loss
The tax losses that a corporate tax entity chooses to deduct will be subject to the following
general rules:
• Where the entity chooses to deduct a tax loss in accordance with section 36-17, the entity
must state its choice under the relevant subsection in its income tax return.29
• Tax losses are deducted in the order in which they are incurred.
30
• Tax losses are deductible only to the extent that they have not already been deducted.
31
• The undeducted amount of a tax loss can be carried forward for deduction in subsequent
income years.
32
2.3.3.6 Adjustments required if subsequent amendment to tax position
In certain circumstances, a corporate tax entity may, after it has lodged its tax return for an
income year:
• Choose to change the amount of the tax loss that it chose to deduct in a previous income
year; or
• Choose an amount of tax loss to be deducted where a choice previously had not been
made.
This will arise where there has been a recalculation of any of the following amounts of the entity
after it has lodged its tax return for an income year:
• The tax loss the entity can deduct in that year;
• The amount of the difference between the entity’s total assessable income and total
deduction (other than tax losses) for that year; or
• The entity’s net exempt income for that year.33
29 Subsection 36-17(6)
30 Subsection 36-17(7) 31 Subsection 36-17(8) 32 Subsection 36-17(9)
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The adjustments may be made whether or not:
• The amount is recalculated in an amendment of the entity’s assessment for that year;
• The amount was a nil amount before the recalculation; or
• The amount has become a nil amount for that year.34
If the entity had chosen to deduct an amount of tax loss for the income year and, as a result of
the recalculation, the entity wishes to change that choice, the entity can change the choice by
lodging a written notice with the Commissioner.
35
For example, the entity may wish to increase the previous choice of tax loss deducted where
the entity’s assessable income was increased and tax would have been payable otherwise as a
result of the recalculation.
If, before the recalculation, the entity was not able to choose an amount of tax loss to deduct
but, as a result of a recalculation, the choice had become available, the entity may choose the
amount of tax loss to be deducted by written notice given to the Commissioner.36
2.4 Net exempt income
The net exempt income is calculated differently for residents and non-residents. The difference
in treatment reflects the fact that, in general, residents are assessable on income from all
sources, whereas non-residents are assessable only on income from sources in Australia.
2.4.1 Net exempt income of Australian resident
For Australian residents, net exempt income is calculated in accordance with subsection 36-
20(1), as follows:
• Calculate the total exempt income (as defined in section 6-20) from all sources, whether in
or out of Australia; and
33 Subsection 36-17(10) 34 Subsection 36-17(10) 35 Subsection 36-17(12) 36 Subsection 36-17(11)
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• Subtract any (non-capital) losses or outgoings incurred in deriving that exempt income,
and any taxes payable outside Australia on that exempt income.
Example
For the income year, a resident taxpayer’s only exempt income is overseas employment income
(exempt under section 23AG of the ITAA 1936) of $50,000. Non-capital expenses incurred in
deriving that income are $10,000 and the foreign tax payable on the income is $15,000. The
taxpayer’s net exempt income is $50,000 − $10,000 − $15,000 = $25,000
2.4.2 Net exempt income of a foreign resident
For foreign residents, the net exempt income is calculated in accordance with subsection 36-
20(2), as follows:
• Calculate the exempt income from sources in Australia;
• Add the amount of exempt section 26AG of the ITAA 1936 film income from all sources;
and
• Subtract any (non-capital) losses or outgoings incurred in deriving the exempt income,
and any taxes payable outside Australia on the exempt section 26AG of the ITAA 1936
film income.
The balance remaining is the foreign resident’s net exempt income.
2.5 Special rules about tax losses
Section 36-25 contains no substantive law, but guides the reader to various rules which apply in
determining the deductibility of tax losses of particular types of taxpayers.
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Amongst other things, section 36-25 alerts the reader to rules affecting tax losses in the
following situations:
• An individual goes bankrupt (Subdivision 36-B);
• A company has a change of ownership or control during an income year (Subdivision 165-
A and 165-B);
Note
Readers should be mindful of the current year loss rules contained in Subdivision 165-B which
may require a company’s tax loss (and, if applicable, taxable income) for an income year to be
determined in a special way where there is a change of ownership or control in the company
during the income year. However, a detailed exposition of these rules goes beyond the scope of
this paper.
• An arrangement is entered that is designed to exploit available losses through the
injection of income and related schemes (Division 175);
• A trust has a change of ownership or control during an income year (Division 266, 267
and 268 of Schedule 2F of the ITAA 1936); and
• A trust is involved in a scheme to take advantage of deductions (Division 270 of Schedule
2F of the ITAA 1936).
Although not mentioned in section 36-25, readers should also be mindful of Subdivisions 165-
CC and 165-CD when considering the treatment of tax losses. Broadly, these Subdivisions have
the following effect:
• Subdivision 165-CC applies where, broadly, there is a change in the ownership or control of
a company (referred to as a “changeover time”) and the company has an unrealised net loss
at that time. If the Subdivision applies, unless the company satisfies the SBT, it will not be
able to take advantage of deductions or capital losses arising from the subsequent disposal
of assets held by it at the changeover time, up to the extent of the unrealised net loss; and
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• Subdivision 165-CD applies to decrease the reduced cost base of relevant equity or debt
interests held by non-individual taxpayers in a loss company (a company with any realised
or unrealised losses) where there has been a change in majority ownership or control of the
loss company (referred to as an “alteration time”). If Subdivision 165-CD applies, the
reduced cost base of these interests is generally decreased such that any duplication of
realised or unrealised losses in the loss company is avoided on disposal of the interests.
As with the current year loss rules in Subdivision 165-B, a detailed exposition of these
Subdivisions goes beyond the scope of this paper. Readers should be aware, however, that
given the compliance burden imposed by these Subdivisions, the rules outlined above do not
apply to entities with less than $6 million net asset value (as calculated under section 152-15).
Note
Subdivisions 165-CC and 165-CD provide certain carve outs when determining losses in
respect of assets acquired for less than $10,000.
Based on a Treasury consultation paper released in July 2011, new amendments to these
Subdivisions will clarify that all membership interests (as defined under section 995-1) in an
entity which are owned by the tested company will be treated as a single asset for the purpose
of applying these carve-outs.
The consultation paper is available via the following link:
http://archive.treasury.gov.au/contentitem.asp?ContentID=2087
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3. Individuals
3.1 Losses from hobbies
Broadly, where an activity of an individual is properly characterised as a hobby or recreation,
then:
• Any money derived by the individual from the activity is generally not assessable income;
• Any losses or outgoings of the individual attributable to the activity is not deductible;
• If the activity results in a loss, the individual is not entitled to offset this loss against other
income or carry the loss forward.
Whether an activity constitutes a hobby or recreation is a question of fact.
3.2 General deductions
Broadly, a general deduction is available for a loss or outgoing under section 8-1.37
8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:
Specifically,
section 8-1 states that:
(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose of gaining or
producing your assessable income.
8-1 (2) However, you cannot deduct a loss or outgoing under this section to the extent that:
(a) it is a loss or outgoing of capital, or of a capital nature; or
(b) it is a loss or outgoing of a private or domestic nature; or
(c) it is incurred in relation to gaining or producing your exempt income or your non-
assessable non-exempt income; or
37 Subsection 8-1(3)
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(d) a provision of this Act prevents you from deducting it.
In the context of deductions for losses and outgoings relating to “hobbies”, the question often
asked is whether the hobby amounted to carrying on a business such that the loss or outgoing
had the sufficient nexus to qualify for a deduction under section 8-1. In this regard, the Court
stated in Ferguson v. FC of T (1979) 37 FLR 310 that:
“... if what he is doing is more properly described as the pursuit of a hobby or recreation or
an addiction to a sport, he will not be held to be carrying on a business, even though his
operations are fairly substantial.”
3.3 Carrying on a business
The question of whether an individual is carrying on a business (as opposed to a hobby or
recreation) can only be determined by considering all the relevant facts and circumstances.
A business is defined as including any profession, trade, employment, vocation or calling, but
does not include occupation as an employee.38 This definition is further interpreted as limiting
the term “business” to “a commercial enterprise as a going concern.39
In most cases it is obvious whether a business is being carried on. Where it is not obvious, in
particular, is where the relevant activity is subsidiary to a person’s main income-producing
activity, for example, where the person vigorously pursues a hobby. The main indicators of
carrying on a business are as follows:
40
38 Section 995-1 39 Hope v Bathurst City Council (1980) 144 CLR 1 40 Paragraph 18 of Taxation Ruling TR 97/11
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Positive factors More likely to be a business if…
Negative factors Less likely to be a business if…
Large scale operations Small scale operations
Involves employees One person operation
Frequent acts/transactions Infrequent acts/transactions
Conducted with a view to profit Conducted as mere hobby
Profitable Non-profitable
Conducted over long period Short-term
Conducted continuously and systematically Spasmodic
In commercial premises At home
Involves items typically dealt with
commercially
Involves items not ordinarily dealt with
commercially
Involves exercise of specialised knowledge Involves little knowledge or skills
Significant capital investment Little or no capital investment
Business records kept Records not kept, or inadequate
Full-time Part-time
Market research done No market research
Associated with other commercial activities
of taxpayer
No other commercial activities
Existence of business organisation,
business name
Conducted personally/privately
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Advertising No advertising
Active Inactive or preliminary
There is often significant overlap between these indicators and no individual indicator should be
regarded as decisive. In addition, the weighting to be given to each indicator will vary from case
to case.
Note
A taxpayer can obtain a Private Ruling under Division 359 of Schedule 1 to the Taxation
Administration Act 1953 on whether he/she is carrying on a business (see Taxation Ruling TR
2006/11).
In Taxation Ruling TR 97/11, the Commissioner considers that an activity will constitute a hobby
where the following indicia are present:41
• It is evident that the taxpayer does not intend to make a profit from the activity;
• Losses are incurred because the activity is motivated by personal pleasure and not to
make a profit and there is no plan in place to show how a profit can be made;
• The transaction is isolated and there is no repetition or regularity of sales;
• Any activity is not carried on in the same manner as a normal, ordinary business activity;
• There is no system to allow a profit to be produced in the conduct of the activity;
• The activity is conducted on a small scale;
41 Paragraph 87 of TR 97/11
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• There is an intention by the taxpayer to carry on a hobby, a recreation or a sport rather
than a business;
• Any produce is sold to friends and relatives and not to the public at large.
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Example 1
Richard was a musician and singer in a rock band. He was also interested in dressage. Richard
owned a substantial land holding on which he bred horses to obtain better mounts for his
dressage competitions. He trained his own horses. He belonged to the local dressage club and
usually sold any unwanted and untrained offspring through his club and the local newspaper.
The sale prices were well below the expenses associated with maintaining the horses. He
conducted research into breeding and training techniques and tried to keep up to date with the
latest information. He kept detailed records of breeding and all expenses associated with the
horses. When the horses became too old to compete he put them out to pasture, as he could
not bear to part with his old companions. Was Richard carrying on a business of horse
breeding?
In Taxation Ruling 97/11, the Commissioner answers this question in the negative. He notes
that despite the keeping of records, the organisation, the repetition and regularity of activity and
the research conducted, the activity was a hobby given that:
• The activity was primarily motivated by his desire to compete and any returns were merely
incidental to this purpose;
• No profit was made from the activity;
• There was no intention to carry on a business or to make a profit; the keeping of records,
the research and the sales were all associated with Richard's dressage activities; and
• There was no significant commercial purpose or character to the activity.
Example 2
In Case 4/2005, it was held that the taxpayer’s activities which included attempts to bring his
work to the market, hiring of space in a gallery, holding an exhibition and use of a public
relations consultant went beyond a mere hobby or recreational activity and constituted a
carrying on of a business.
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3.4 Non-commercial business losses
Division 35 prevents losses of individuals from non-commercial business activities being offset
against other assessable income in the year that the loss is incurred.
Losses that cannot be offset against other income in the year in which they arise (that is,
deferred losses) may be carried forward to be offset in a future year when there is a profit from
the non-commercial activity or, in certain circumstances, against other income.42
Division 35 applies to individuals (either alone or as a partner in a partnership) only.
43
3.5 Deferral of non-commercial business losses
3.5.1 Non-commercial business losses
Subject to the exception below, where deductions in relation to a non-commercial business
activity for that year exceed the assessable income (if any) from the business activity for that
year, the excess cannot be deducted in the income year in which it is incurred.44
Rather, the excess is treated as being deductible from the assessable income from the
business activity in the next income year in which the business activity is carried on.
45
In most cases, the loss will be deferred and offset against the assessable income from the non-
commercial business activity in the next income year. However, if the individual makes losses in
the next income year, the amount of the losses from the first and second year are added
together and deferred to a future income year in which the business activity makes profits.
Where the business activity ceases for a year or number of years, the loss will be carried
forward and become deductible in the income year when the activity is next carried on.
The
deductions relating to that activity must be deductible under ITAA 1936 or ITAA 1997 before
Division 35 applies.
42 Section 35-1 43 Sections 35-5 and 35-10 44 Subsection 35-10(2) 45 Paragraph 35-10(2)(b)
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Example
Michael is a student but is also carrying on a business activity of online photo sales. Under the
tests, his business activity is treated as non-commercial. He starts his business on 1 July 2000
and for the 2001 income year he obtains online sales of $3,000; however, deductions incurred
in operating the business total $3,500. In 2002, his business obtains sales income of $4,000
and generates deductions of $4,100. In 2003, Michael’s business derives sales of $6,000 and
deductions of only $2,000. The losses for 2001 ($500) and 2002 ($100) are not allowed in those
years but are carried forward to the 2003 income year, where they reduce his profit in that year
($4,000) to $3,400.
3.5.2 Exempt income
Section 35-15 modifies the general rule which defers certain losses from a non-commercial
business activity.46 The amount of the loss that is deferred to future years is reduced by net
exempt income derived by the individual in the current or future years that has not already been
offset against carry forward tax losses under section 36-10 or section 36-15.47
Example
Bayfield incurs a loss from his non-commercial business activity in 2002 of $17,000 and derives
exempt income of $3,000. Bayfield did not have any Division 36 tax losses carried forward from
earlier income years. The Division 35 amount that is deductible in a later year is $14,000 after
reducing the deferred loss by the amount of exempt income.
However, where there is a deferred loss from a prior year and profit arising in the current
income year from a non-commercial business activity, any exempt income would reduce the
deferred loss before that loss can be used to reduce the current year profit from that business
activity.48
46 Subsection 35-10(2)
47 Subsection 35-15(1) 48 Subsection 35-15(2)
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3.5.3 Blackhole expenditure
Subject to the exception below, the non-commercial loss rules also apply to pre-business or
post-business expenditure that is deductible under section 40-880 (business related costs).49
A taxpayer cannot deduct an amount under section 40-880 for pre-business expenditure in
relation to a business activity that the taxpayer proposes to carry on (either alone or in
partnership) in an income year before the one in which the business activity starts to be carried
on. In the income year a business activity starts to be carried on, a taxpayer can only offset a
loss from the business activity carried on against other income if one of the exceptions applies.
If the loss cannot be offset against other income in the income year in which it arises, it is
deferred and offset in a future year when there is a profit from the same activity, or a like
activity, or against other income when the taxpayer satisfies one of the tests for that activity.
Example
Lee, a salary earner, incurs $1,000 which is otherwise deductible under section 40-880, during
the 2006 income year, for the purpose of establishing a supermarket business in the 2007
income year. She intends to carry on the business activity as a sole trader. Apart from Division
35, section 40-880 would provide deductions in equal proportions for the $1,000 expenditure for
the 2006 to 2010 income years.
An individual taxpayer is also prevented from deducting an amount that is otherwise deductible
under subsection 40-880(4) for expenditure in relation to a business activity that another entity,
other than an individual (either alone or in partnership), proposes to carry on until the income
year in which the activity starts to be carried on.
If the business activity ceases, amounts otherwise deductible after this event under section 40-
880 are not deductible if one of the exceptions does not apply to the business activity before the
business ceased.
49 Subsection 35-10(2A)
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3.5.4 Non-commercial business activities
A non-commercial business activity is any business activity. As noted above, a business is
defined as including any profession, trade, employment, vocation or calling, but does not
include occupation as an employee.50 This definition is further interpreted as limiting the term
“business” to “a commercial enterprise as a going concern.51
This definition would exclude domestic transactions involving jointly owned family homes from
being a business. Further, passive investments such as the derivation of interest, dividends
and royalties are not businesses.
52
Although business activities are not defined, context suggests that they are activities connected
with, or necessary for, the conduct of a business.
This is confirmed by the guide in section 35-5.
3.5.5 Grouped non-commercial business activities
Subsection 35-10(3) permits an individual to group similar business activities together for the
purpose of the rules.
In effect, this allows losses from a non-commercial business activity to be offset against the
assessable income arising from another closely related business activity. In determining
whether an activity is part of a particular business activity, or a separate business activity, the
facts and circumstances surrounding each activity should be closely considered.
If the activity is not a part of another business activity it should be viewed in isolation and
treated as a separate business activity, and losses from one non-commercial business activity
should not be offset against income from another business activity.
50 Section 995-1 51 Hope v Bathurst City Council (1980) 144 CLR 1 52 Commissioner of Inland Revenue v Marine Turbo Co [1920] 1 KB 193
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Example
Ann conducts a business activity as an olive farmer producing olive oil. She has had great
success manufacturing high-grade oil and selling it both locally and to exporters. Recently, Ann
started producing bottled olives in an attempt to expand her business. This new activity is
sustained independently from the olive oil market activity. Division 35 will treat Ann’s bottling
activity as a part of her primary business activity of producing olive oil. Both her olive oil activity
and her bottling activity are similar, and may therefore be looked at in aggregate against the
four tests to determine whether her losses, if any, from those activities can be deducted from
her other income.
Ann is also a keen amateur scientist. In her home laboratory, Ann has developed a new
chemical insecticide for olives. She has patented its composition and is now receiving royalties
from a chemical manufacturer. Ann has also written a research paper on insecticides, which is
available for purchase. Ann’s research activities are not of an inherently similar nature to her
olive oil production and bottling activity and will be considered as a separate business activity
under Division 35.
3.5.6 Exception
Non-commercial business losses will not be subject to the non-commercial loss rules if the
following conditions are satisfied for an income year in relation to each business activity:
• The sum of the following is less than $250,000:
- The individual’s taxable income for that year;
- The individual’s reportable fringe benefits total for that year;
- The individual’s reportable superannuation contributions for that year; and
- The individual’s “total net investment losses” for that year,53
and one of the following is satisfied:
54
53 Subsection 35-10(2E)
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- The assessable income test: the amount of assessable income from the business
activity is at least $20,000;55
- The profits test;
56
- The real property test;
57
- The other assets test;
58
• The Commissioner has exercised the discretion set out in section 35-55 for the business
activity for that year;
or
59
• The business is a primary production business or a professional arts business (for
example, an author or a performing artist) for that year and the individual’s assessable
income for that year (other than any net capital gain) from other sources is less than
$40,000.
or
60
Non-commercial business blackhole expenditure will also not be subject to the non-commercial
loss rules if the above conditions are satisfied for the income year in which the business activity
ceased or in an earlier income year.
61
54 Subsection 35-10(1) 55 Section 35-30 56 Section 35-35 57 Section 35-40 58 Section 35-45 59 Paragraph 35-10(1)(b) 60 Paragraph 35-10(1)(c) and subsection 35-10(4) 61 Subsection 35-10(2A)
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Example
Amanda earned a salary of $175,000 in 2011. Also in that year, her reportable superannuation
contributions were $45,000, her reportable fringe benefits were $32,000 and she had net
investment losses of $13,000.
Amanda also operated a natural therapies business which had assessable income of $22,000 in
2011 and deductions totalling $34,000.
Assuming that there were no other amounts of assessable income or allowable deductions in
2011, Amanda does not pass the income threshold test and cannot offset the net loss of
$12,000 from the natural therapies business against other income.
Amanda’s adjusted taxable income is $252,000, calculated as her salary income ($175,000),
less the net investment losses ($13,000) plus the reportable superannuation contributions
($45,000), the reportable fringe benefits ($32,000) and the net investment losses ($13,000).
That amount is more than the threshold of $250,000.
Unless the Commissioner exercised the discretion in section 35-55 not to apply the non-
commercial losses rules in respect of the business for the 2011 income year, the $12,000 loss
from the natural therapies business will be quarantined, and may only be applied against
assessable income from the alternative therapies business in later income years.
3.5.6.1 Profits test
The profits test is satisfied if, for each of at least three of the past five income years (including
the current year), the sum of the deductions (disregarding any deferred losses, but including
any share of deductions from a partnership) is less than the assessable income (including any
share of income from a partnership) from the activity.62
62 Section 35-35
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3.5.6.2 Real property test
The real property test is satisfied if the total of the greater of the market value or reduced cost
bases of real property or interests in real property used on a continuing basis in carrying on the
activity is at least $500,000.63
A dwelling, and any adjacent land used in association with the dwelling, that is used mainly for
private purposes and any fixtures owned by a tenant are not counted for this test.
64
3.5.6.3 Other assets test
The other assets test is satisfied if the total values of assets listed below that are used on a
continuing basis in carrying on the activity is at least $100,000:65
Item Value
1 An asset whose decline in value you can
deduct under Division 40
The asset’s written down value
2 An item of trading stock Its value under subsection 70-45(1)
3 An asset that you lease from another
entity
The sum of the amounts of the future
lease payments for the asset to which you
are irrevocably committed, less an
appropriate amount to reflect any interest
component for those lease payments
4 Trademarks, patents, copyrights and
similar rights
Their reduced cost base
63 Section 35-40 64 Section 35-40 65 Section 35-45
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Real property or interests in real property that are taken into account for the real property test
and cars, motorcycles and similar vehicles are not counted for this test.66
Apportionment of an asset may be necessary where it is used during an income year partly in
carrying on the relevant non-commercial loss business activity and partly for other purposes.
67
3.5.7 Commissioner’s discretion
The Commissioner can decide that the non-commercial loss rules do not apply to non-
commercial business activity for one or more income years if the Commissioner is satisfied that
it would be unreasonable to apply that rule because of one or more of the reasons described in
section 35-55. The taxpayer must apply to the Commissioner for a determination and the
application must be made in the approved form.
3.5.8 Modifications for bankruptcy
A loss from a non-commercial business activity and blackhole expenditure incurred prior to
bankruptcy (or being released from a debt) cannot be deducted after the date of bankruptcy.68
Where an individual’s bankruptcy is annulled due to a composition or scheme of arrangement
under which the individual’s debts are released, no losses from non-commercial business
activities can be deducted in the year of annulment or in later income years.
69
66 Subsection 35-45(4) 67 Section 35-50 68 Subsection 35-20(1) 69 Subsection 35-20(3)
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3.5.9 Application to certain partnerships
Division 35 applies to businesses carried on by individuals, either alone or in partnership.
Therefore, a partnership that carries on a business activity and consists of at least one
individual as partner will fall within the non-commercial business loss rules.
Readers are directed to section 35-25 which contains certain modifications to the assessable
income test, real property test and other assets test.
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4. Companies
4.1 Rules for Use of Prior Year Tax Losses by Companies
As noted above, the deductibility of tax losses by certain taxpayers may be affected by various
rules in the Tax Act.
Section 165-10 sets out the basic conditions which a company must satisfy in order to deduct
losses of earlier years.
In effect, the section provides that the company cannot deduct a tax loss unless it satisfies the
COT under section 165-12, or alternatively, if the company fails to meet that test, the SBT under
section 165-13.
Section 165-15 provides that even if the company satisfies the COT or the SBT, it still will not be
able to deduct the loss if there is a specified change in the control of the voting power in the
company enabling some person to obtain a tax advantage under the Tax Act.
A further test for deductibility is provided by section 165-215 which makes available to
companies one of the concessional tracing rules available to trusts under the trust loss
measures contained in Schedule 2F of the ITAA 1936 where the company is predominantly held
by non-fixed trusts.
Division 166 modifies the COT rules that apply to “widely held companies” and “eligible Division
166 companies”.
Warning
Subdivision 175-A enables the Commissioner, in certain circumstances, to prevent the
utilisation of a tax loss by a company where an amount of income is injected into the company
for the purpose of taking advantage of the tax loss, or a person obtains a tax advantage under a
scheme which was carried out in order to access the tax loss. Subdivision 175-A can operate
even where the company otherwise satisfies the COT requirements in section 165-12 and the
control test in section 165-15. Readers are advised to refer to ATO Interpretive Decision
2002/836, ATO Interpretive Decision 2002/845 and ATO Interpretive Decision 2010/48 for
further details in respect of the application of Subdivision 175-A.
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4.2 Continuity of ownership test
4.2.1 General continuity of ownership test rules
Section 165-12 sets out the conditions which must be satisfied under the COT. If a company
fails this test, it will not be able to claim a deduction in respect of carried forward tax losses
unless it satisfies the SBT under section 165-13.
Subsection 165-12(1) defines the period during which ownership and control of a company must
remain constant (the “ownership test period”). For the purposes of Subdivision 165-A, the
ownership test period:
• Starts at the beginning of the year in which the loss is incurred (the “loss year”), and
• Finishes at the end of the year in which the loss is utilised (the “income year”).
The term “loss year” for these purposes is defined in section 36-10, being a year in which a
company has a “tax loss” under section 36-10, or if relevant, section 36-55 (see note 2 to
section 36-10).
Section 165-255 contains the rules in relation to incomplete test periods. In this regard, section
165-255 contains rules for establishing the COT of a company that comes into existence during
the loss year (for example, on incorporation) or that ceases to exist during the income year (for
example, where the company is deregistered).
Subsections 165-12(2), 165-12(3) and 165-12(4) set out the conditions that must be satisfied
during the ownership test period before the COT is passed by a company. They provide that
there must be persons who had more than 50% of the:
• Voting power;
• Rights to dividends; and
• Rights to capital distributions,
in the company at all times during the ownership test period.
The tests for determining whether persons have more than 50% of the voting power, rights to
dividends and rights to capital distributions during a particular period are set out in sections 165-
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150, 165-155 and 165-160 (as incorporated by subsections 165-12(5) and 165-12(6).
Specifically:
• The primary test applies if no other companies beneficially own shares or interests in
shares in the loss company at any time during the ownership test period. This is expressly
stated at subsection 165-12(5). This test provides that if there are persons who, at all
times during the ownership test period, beneficially own (between them) shares that carry
(between them) the right to exercise more than 50% of the voting power, the right to
receive more than 50% of the dividends or the right to receive more than 50% of the
capital distributions in the company, then those persons are treated as having more than
50% of the voting power, dividends and capital distributions in the company at all times
during the ownership test period.70 In the case of public companies, the test will be
satisfied if it is “reasonable” to assume that it is satisfied.71
• The alternative test applies where at any time during the ownership test period, any
shares or interests in shares in the loss company are beneficially held by one or more
other companies. This is expressly stated at subsection 165-12(6). This test provides that
if there are persons (none of them companies or trustees) who between them have at all
times during the ownership test period beneficial interests in shares in the company that
carry between them more than 50% of the voting power, the right to receive more than
50% of the dividends or the right to receive more than 50% of the capital distributions in
the company, those persons are treated as having more than 50% of the voting power,
dividends and capital distributions in the company at all times during the ownership test
period. This applies whether the beneficial interests are held directly or indirectly through
one or more interposed entities and also where is it “reasonable to assume” that the
provisions of the test have been met.
72
Practically, application of the alternative test
generally requires that a tracing process be undertaken in order to determine the ultimate
individual (natural person) owners of the tested company.
70 Subsections 165-150(1), 165-155(1) and 165-160(1) 71 Subsection 165-165(7) 72 Subsections 165-150(2), 165-155(2) and 165-160(2)
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If a company is a non-profit company, a mutual affiliate company or a mutual insurance
company during the entire ownership period, it is taken to have satisfied the conditions in
subsection 165-12(3) relating to rights to dividends and subsection 165-12(4) relating to rights
to capital distributions.73
4.2.1.1 Proposed modifications clarifying aspects of the COT
As a result, these companies satisfy the COT if they satisfy the voting
power condition under either the primary or alternative test (as applicable).
Under the current law, a company which has more than one class of shares with different
owners could technically fail the COT, even if majority beneficial ownership of the company’s
shares remains the same. This may occur, for example, where the various classes of shares in
the company have unequal rights to dividends and capital distributions, or unequal voting
power. In such circumstances, it may not be possible to identify which particular group of
owners is entitled to more than 50% of the relevant rights.
In recognition of this issue, the Federal Government released draft legislation (proposed
Division 167) on 4 September 2009 which is designed to ameliorate problems encountered by
companies with multiple share classes in satisfying the COT.74
Broadly, the draft legislation would allow a company which would otherwise fail the COT to
reconsider the test, disregarding the following:
• Debt interests held in the company (such as redeemable preference shares with
characteristics that cause them to be classified as debt under Division 974); and
• Secondary share classes issued by the company (for example, special shares issued to
employees under an ESAS arrangement), provided that the value of each such class does
not exceed 10% of the total value of the company’s shares, and the combined value of all
secondary share classes does not exceed 25% of the total value of the company.
If the company continues to fail the COT after disregarding these interests, the draft legislation
allows a further mechanism, whereby any remaining shares in the company may be taken to
have fixed dividend and capital rights for the purpose of applying the test.
73 Subsection 165-12(7A) 74 The draft legislation and accompanying explanatory materials can be found on the Treasury website at: http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1601
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The draft legislation also clarifies that, if the shares of a company have distinct voting rights, the
voting power of those shares is to be tested solely by reference to the maximum number of
votes that could be cast on a poll for the election of the company’s directors, or on the adoption
/ amendment of the corporate constitution.
The draft legislation is generally proposed to apply from 1 July 2002. However, modifications to
the test for voting power are proposed to apply only from 1 July 2007. Consequential
amendments will be made to section 170 of the ITAA 1936 to ensure that taxpayers will be able
to retrospectively rely on the proposed modifications.
Note
A revised exposure draft of the proposed legislation was released for limited consultation in July
2011. Treasury’s Forward Work Program indicates that the revised exposure draft should be
released for public comment in mid to late 2012.
4.2.1.2 Special continuity of ownership test rules
A number of special rules expand upon particular aspects of the primary and alternative tests.
Some of the more significant rules are summarised below:
• Unbroken continuity is necessary. In respect of income years ending after 21 September
1999, the tests are required to be satisfied during the whole of the loss year, the whole of
the income year and the whole of the intervening period (referred to in total as the
“ownership test period”);
• The identity of shares is essential. In this regard, for income years ending after 21
September 1999, rights attaching to shares generally cannot be taken into account under
either the primary or alternative tests unless, at all times during the relevant period, they
are the same shares and are beneficially held by exactly the same shareholders (this is
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known as the “same share rule”).75 However, this requirement is relaxed in the case of
share / unit splits76 and share / unit consolidations;77
Warning
The same share rule may be problematic where new shares are issued by a company, or
existing shares are subject to a rollover (for example, under Subdivision 124-G, which deals
with the interposition of holding companies). There are no statutory carve outs applying in these
circumstances and accordingly it may be necessary to rely on the saving provision to ensure
COT is satisfied (refer to Section 4.2.1.3 below).78
• Tests may be satisfied by one person. Each of the tests refer to persons (in the plural).
However, to avoid doubt, section 165-175 specifically provides that any of the tests may
be satisfied by one person;
• A public company is taken to have satisfied any of the primary tests if it is reasonable to
assume that the tests are satisfied.79
• Shares held by certain concessionally taxed entities (for example, a government or a
charitable institution) are deemed to be held by a notional shareholder when applying the
tests;
The reason for such a provision is that the numerous
sales of shares in large companies could make it impracticable to accurately determine
details of beneficial ownership. Note, however, that the effect of this provision is limited,
as “widely held companies” and “eligible Division 166 companies” would normally be
tested under the modified rules in Division 166;
80
• Shares held by the trustee or beneficiary of a deceased person’s estate will be deemed to
continue to be held by the deceased person when applying the tests;
81
75 Section 165-165
76 Subsections 165-165(2) and 165-165(3) 77 Subsections 165-165(4) and 165-165(5) 78 Subsection 165-12(7) 79 Subsection 165-165(7) 80 Section 165-202 81 Section 165-205
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• Shares held by a discretionary trust that has made a family trust election will be deemed
to be held by a separate notional shareholder when applying the tests.82
• A company will not be prevented from satisfying the tests merely because a liquidator or
administrator has been appointed in respect of the company, or an interposed holding
company.
This overcomes
issues which may otherwise be encountered in tracing beneficial ownership through non-
fixed trusts (without reliance on Subdivision 165-F);
83 This overcomes the decision in FC of T v Linter Textiles Ltd (in liq),84
• The tests are subject to anti-avoidance rules contained in section 165-180 and 165-185
which broadly empower the Commissioner to treat shares as not being beneficially owned
by certain shareholders (or as not carrying certain rights) where the Commissioner is
satisfied that arrangements have been entered into to exploit the COT. These rules may
be enlivened where, for example, an arrangement is entered between existing
shareholders and prospective shareholders, under which the existing shareholders agree
to retain their shares in a company until such time as any carried forward tax losses have
been absorbed, and thereafter formally dispose of the shares to the prospective
shareholders.
which
confirmed that upon appointment of a liquidator to a company, the incumbent
shareholders in that company cede control of their voting power to the liquidator; and
85
4.2.1.3 Saving provision
If the continuity of majority ownership test in section 165-12 is not satisfied, subsection 165-
12(7) may deem the test to be satisfied where:
• The test is only failed because the group of persons who have maintained majority
ownership of the company have not retained exactly the same shares during the relevant
period (that is, the same share rule in section 165-165 has been breached); and
• Based on the information available to the company, it is reasonable for the company to
conclude that less than 50% of its tax loss has been reflected in deductions, capital losses
82 Section 165-207 83 Section 165-208 84 [2005] HCA 20 85 K Porter & Co Pty Ltd v FCT 77 ATC 4472
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or reduced gains that arose (or could arise in the future) because of the happening of a
CGT event (for example, disposals) in relation to any direct or indirect equity interests in
the company during the ownership test period.
A company will, therefore, not be treated as having failed the COT where the company can
demonstrate, for example, that the only equity interests in the company that were sold during
the relevant test period have been subject to the anti-loss duplication measures in Subdivision
165-CD.86
Note
This is because no deduction associated with the tax loss is reflected in a loss or
reduced gain on the disposal of an ownership interest that is subject to Subdivision 165-CD (as
a result of the adjustments made under those provisions).
In ATO Interpretive Decision 2012/64, the Commissioner considered the application of the
saving provision contained under the modified COT in Division 166, which employs substantially
the same wording as subsection 165-12(7). In that ATO ID, the Commissioner stated that the
application of the saving provision cannot be anticipated before the end of the relevant test
period, as it is only at this point that a company may ascertain if the requirements of the
provision have been met. The Commissioner also stated that references to losses which could
occur in the future, generally meant those losses which had been subject to the stop-loss rule in
Subdivision 170-D.
Subsection 165-12(8) specifically provides that the disposal of a direct or indirect interest in a
company that triggers the application of Subdivision 165-A is taken, for the purposes of the
saving provision to have occurred during the relevant ownership test period.
86 Paragraph 165-12(7)(b)
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Example
At the start of an ownership test period, Alex holds 90% of shares in a loss company. Brian
owns the remaining 10%. At this time, the company has issued 100 ordinary shares (that is,
Alex owns 90 shares and Brian owns 10 shares).
A hundred more new shares are then issued at some time during the test period. Of these, Alex
owns 90 and Brian owns 10. The total shares on issue are now 200. The original shares held by
Alex now only carry 45% of the power and rights in the company (90/200 = 45%). The original
shares held by Brian now carry 5% of the power and rights in the company (10/200 = 5%).
Due to the operation of the same share rule in section 165-165, only the original shares may be
counted for the purposes of determining whether there has been continuity of ownership
throughout the period. In the absence of a saving provision, the company would fail the COT
because only 50% of the power and rights in the company have been maintained throughout
the test period. To satisfy the test, more than 50% continuity must be maintained.
Under the saving provision, the company will be treated as though it satisfies the COT if it is
able to prove that:
• But for the same share rule the company would satisfy the COT (that is, there has been
no substantial change in proportionate shareholding between Alex and Brian) —
throughout the period Alex has maintained a 90% interest and Brian has maintained a
10% interest; and
• Less than 50% of the loss has been duplicated during the period — neither Alex nor Brian
have sold any of their original shares during the ownership test period, and accordingly,
neither have crystallised deductions, capital losses or reduced gains.
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4.3 Same business test
4.3.1 Same business test period
Section 165-13 contains the SBT. A company must satisfy the SBT to deduct a tax loss if the
company either:
• Fails, or is treated as failing, to meet any of the conditions of the COT; or
• It is not practicable to show that it meets all of the conditions of the COT.
The SBT requires a comparison between the activities of the company during the income year
(SBT period) with its activities immediately before the “test time”. The test time is determined in
accordance with subsection 165-13(2) as follows:
Situation Test Time
1 Where it is practicable to show that there
is a period commencing at the start of the
ownership test period (or if the company
came into being during the loss year, at
the time the company came into being)
during which the company would satisfy
The last time in the period that the COT
was satisfied by the company.
2 Where Item 1 does not apply and the
company was in being throughout the loss
year
The start of the loss year
3 Where Item 1 does not apply and the
company came into being during the loss
year
The end of the loss year
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Example 1: Test time
Closer Pty Ltd (Closer) is an Australian company that was incorporated on 19 December 1999.
Closer is owned as to 65% by Law Limited, which was incorporated in a foreign country. The
shareholders of Law Limited are not known by Closer and cannot be obtained under the law of
that foreign country.
Closer made a tax loss in the 2000 income year (that is, the year of incorporation). As it is not
practicable to show that Closer has satisfied the COT in section 165-12 since incorporation,
Closer will only be able to claim the losses where it satisfies the SBT since the test time. As
Closer was incorporated during the 2000 income year, the test time will be 30 June 2000, being
the end of the loss year.
Example 2: Test time and SBT period
A company incurs a tax loss in the income year ended 30 June 2006 and wishes to deduct the
tax loss in the income year ended 30 June 2008.
The company fails the COT during the income year ended 30 June 2007.
Based on these facts, the test time for the company will be just before the COT is failed (that is,
some point during the income year ended 30 June 2007) and the SBT period will be 1 July 2007
to 30 June 2008.
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4.3.2 The same business test requirements
To satisfy the SBT, the company must satisfy all of the following requirements:87
• A positive requirement that, throughout the SBT period, the company carries on the same
business as it did immediately before the test time;
• A negative requirement that the company must not, at any time during the SBT period,
have derived assessable income from a business of a kind which it did not carry on before
the test time;
• A further negative requirement that the company must not, at any time during the SBT
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; and
• An anti-avoidance requirement which applies where a company commences certain
business activities before the test time for the purpose of satisfying the same business
requirement.
The Commissioner sets out his views on the application of the SBT in Taxation Ruling TR
1999/9 (TR 1999/9). In that ruling, the Commissioner emphasises that whether or not a
company has complied with the requirements of the SBT is a matter of fact and degree.
4.3.2.1 Positive requirement
For the purpose of the positive requirement outlined above, a company is treated as carrying on
one overall business at the test time and during the SBT period. This is because the reference
to “business” under the positive requirement is a reference to all of the activities carried on by
the company at those times, regardless of whether the company treats the activities as
constituting separate and distinct activities or enterprises. In addition, as indicated in TR 1999/9,
it is inappropriate to consider certain business activities only, to identify the business by
reference to industry standards or to have regard to activities which the company intended or
had power to carry on if it did not in fact carry on such activities.
87 Section 165-210
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In determining whether the positive requirement has been satisfied, the word “same” in the
phrase “same business as” is read as referring to the same business, in the sense of an
identical business. However, this does not mean identical in all respects. It requires the
continuation of the actual business carried on immediately before the test time. In this regard,
the Commissioner acknowledges that some changes may be permissible in the way in which
the business is carried on, provided that the identity of the business carried on immediately
before the test time is unchanged – for example, a change in one of the company’s many
suppliers.
Similarly, the ruling states that a company will not always fail to satisfy the positive requirement
where its activities expand or contract. In this regard, so long as the business carried on by the
company retains its identity, the organic growth of the business through the adoption of new
compatible operations or the discarding of old operations will not in themselves result in the
company failing the SBT. However, if the business changes its essential character, or there is a
sudden and dramatic change in the business due to the acquisition or loss of activities on a
considerable scale, it may be difficult to pass the SBT.
In determining whether the positive requirement has been satisfied, the Commissioner sets out
a non-exhaustive list of indicia which may generally be considered.88
• Business or trade name;
These indicia can broadly
be summarised as follows:
• Business location;
• Directors, management and employees;
• Customers and suppliers;
• Goodwill;
• Products and stock;
• Methods of manufacturing;
88 Paragraph 61 of TR 1999/9
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• Methods of selling (for example, outright sale versus leasing);
• Capital and financing; and
• Intellectual property.
4.3.2.2 Cases where positive requirement satisfied
In DFCT v Australasian Feed Pty Ltd89
In Lilyvale Hotel Pty Ltd v FCT
(a case concerning former section 80E of the ITAA
1936), the Federal Court confirmed the AAT’s decision that the company continued to carry on
the same business following a change of ownership, despite going into receivership and
entering into an arrangement to sell its product (sheep feed) almost exclusively to an entity with
which it had previously had only one major dealing. This was because the taxpayer continued to
produce the same product from the same mill, obtained its supplies from the same sources,
continued to trade under the same name and retained most of its employees. Indeed, according
to the Court the only significant change that arose to the taxpayer’s business subsequent to the
change of ownership concerned the entry of the near-exclusive sales arrangement. However,
as was indicated in the case, the market into which the taxpayer made its sales remained
generically the same, even if the customer base had shifted.
90
The taxpayer’s owners sold the taxpayer to Reco Harbour Grand Pte Ltd (a company owned by
the Government of Singapore Investment Corporation Pte Ltd) with the sale completing on 30
August 2002. From 30 August 2002 until 30 June 2003 the hotel was operated and managed by
the taxpayer under the pre-sale name ANA Harbour Grand. The taxpayer claimed a deduction
for past losses amounting to $10,579,458 in its tax return for the period 1 January 2002 to 31
March 2003.
, the Full Federal Court found that the taxpayer was carrying on
the same business. The taxpayer owned and operated the ANA Hotel Sydney (later known as
the ANA Harbour Grand Hotel and then the Shangri-La Hotel). The hotel was operated and
managed by ANA Enterprises Australia Pty Ltd pursuant to an operating and management
agreement.
89 2000 ATC 4632 90 [2009] FCAFC 21
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The Full Federal Court found that the primary judge fell into error in concluding that in
answering the “same business test” one had to have regard to the management of the
business. In the court’s opinion, the fact that at one stage the taxpayer conducted its hotel
business without the intervention of a hotel management group and at another did so with the
assistance of such a hotel management group is a distinction without a difference.
The Court found that the taxpayer had correctly described the business which it carried on as
that of:
“owning and operating ... [a] hotel to derive revenue from its guests and profits from its
operation”. The execution of the management of the hotel at different times in different ways
had no bearing upon the identification of the business carried on by the taxpayer.”
4.3.2.3 Cases where positive requirement failed
In Avondale Motors (Parts) Pty Ltd v FCT91
In these circumstances, Gibbs J held that even if the company had not effectively discontinued
its business (thereby disqualifying it from relying on the SBT), the company would still have
failed to satisfy the SBT under former section 80E of the ITAA 1936. To this end, Gibbs J
emphasised that the SBT requires an identical (not merely similar) business to be carried on at
all relevant times. Accordingly, notwithstanding that the company carried on a similar kind of
business following the change of ownership, the differences outlined above meant that the
business could not satisfy the SBT (as it was not materially identical to that previously carried
on by the taxpayer).
, a company that originally sold spare motor parts
and accessories effectively discontinued its business prior to a change in majority ownership.
Following the change in ownership, the company’s business was resumed, but under a different
name and management, through different premises and using different plant and stock.
In TelePacific Pty Ltd v FCT92
91 71 ATC 4101
, which also considered former section 80E of the ITAA 1936, the
Federal Court held that the taxpayer did not satisfy the SBT because the company acquired the
relevant business after the date of the disqualifying change in ownership. The disqualifying
92 2005 ATC 4107
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ownership took place on the date the takeover of the company became unconditional, not the
later date of payment of the consideration for the takeover. However, the business was only
acquired on the later of the date the contract was entered into or the satisfaction of the
conditions precedent. Before this date, the company did not carry on the business because it
did not own it. Further, the acquisition of the new business could not be considered to be the
same business as was previously carried on because its customer base was different, its
product was different, it was a retailer by contrast with the previous business of a wholesaler, its
area of operations was much wider and it had many more staff.
A company that derived income from a rental property ceased to carry on business, and
therefore could not satisfy the SBT, when the mortgagee of the property entered into
possession, following a default on the mortgage.93
Similarly, in Coal Developments (German Creek) Pty Ltd v FCT
94
, the Full Federal Court held
that a taxpayer’s winding up activities in relation to a business did not constitute the carrying on
of the business and therefore the taxpayer could not satisfy the SBT. From 3 December 1990
until 25 June 2001, the taxpayer and its parent company held interests in a coal mining joint
venture. On 25 June 2001, the taxpayer and its parent sold their joint venture interests to
another company. The taxpayer claimed that, after the sale, it continued to carry out activities
arising out of its participation in the joint venture. However, the court held that there was a
disposal of the business as a whole once and for all on 25 June 2001. Consequently, after that
date, the taxpayer could no longer be said to be carrying on the same business. The activities
engaged in by the taxpayer were incidents of the management or disposal of assets following
the discontinuance of business, rather than incidents of the continued conduct of the business.
93 FCT v R & D Holdings Pty Ltd 2007 ATC 4731 94 [2007] FCA 1324
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4.3.2.4 Negative requirements
As discussed above, the SBT also comprises two negative limbs (referred to as the new
business test and the new transaction test). Both of these tests are embodied in subsection
165-210(2).
The new business test provides that the SBT will be failed where a company, during the SBT
period, derives assessable income from a business of a kind that it did not carry on before the
test time. TR 1999/9 indicates that the new business test is concerned with separate enterprises
or business lines (rather than an overall business). According to the Commissioner, the new
business test puts a limit on the type of expansion a company may undertake if it is to retain the
benefit of accumulated losses. The test is intended to prevent the injection of income into a loss
company through the addition of distinct operations, whilst permitting, within similar fields of
endeavour, the development and expansion of the overall business carried on immediately
before the test time.
The new business test will be particularly relevant in takeover or merger situations, where
additional business operations may be commenced or transferred to an existing company with
tax losses. Unless these operations are of a similar kind to those already carried on by the
company, there would generally be a failure of the SBT.
Similarly, the new transaction test provides that the SBT will be failed where a company, during
the SBT period, 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. Although the Commissioner
adopts a broad view of the meaning of “transaction” in the new transaction test (being any
operation or dealing from which income may arise), TR 1999/9 indicates that the new
transaction test will generally not be failed where a company undertakes transactions that could
have been entered into ordinarily and naturally in the course of the company’s business
operations before the test time (even if such transactions had not actually been entered by the
company).
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Tip
According to the Commissioner, the new business test and new transaction test are subject to a
de minimis requirement. In this regard, where an amount of income derived through a new
business line or transaction is so trifling as to be negligible (particularly when compared with the
value of the accumulated losses), the SBT should not be failed.95
Warning
For the purposes of the new business and new transaction tests, the Commissioner interprets
the phrase “before the test time” very broadly. According to the Commissioner, it is relevant to
examine the period from immediately before the test time to the point in the past where the
business can no longer be described as the business carried on immediately before the test
time.96
4.3.2.5 Anti-avoidance test
Even where the company otherwise satisfies the positive and negative requirements outlined
above, the company will fail the SBT to the extent that:97
• Before the test time, the company started to carry on a business it had not previously
carried on, or entered into a transaction of a kind it had not previously entered; and
• The company did so for the purpose, or for purposes including the purpose, of satisfying
the SBT.
95 Paragraphs 89 and 90 of TR 1999/9 96 Paragraph 88 of TR 1999/9 97 Subsection 165-210(3)
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These requirements together are referred to as the anti-avoidance test. TR 1999/9 indicates
that the reference to business in the anti-avoidance test is to a separate undertaking or
enterprise (rather than an overall business). The ruling also emphasises that where a company
changes its activities prior to the test time for the purpose of satisfying the SBT, the anti-
avoidance test will be enlivened, even if the relevant purpose is not the dominant purpose of the
taxpayer in bringing about the change.
4.4 Applying net capital losses of earlier income year
Subsection 165-96(1) sets out when a company cannot take a carried forward net capital loss
into account in calculating its net capital gain for an income year.
“Net capital gain” is explained in sections 102-5 and 165-111 and “net capital loss” is explained
in sections 102-10 and 165-114. Note that subsection 102-10(2) provides that a taxpayer
cannot deduct a net capital loss from its assessable income for any income year.
The company cannot take the earlier capital loss into account if, assuming the loss were a tax
loss rather than a capital loss and section 165-20 (when a company can deduct part of a loss)
were disregarded, the COT or SBT is not satisfied. The loss will also be unavailable where the
control test in section 165-15 is failed by the company.
Therefore, if a company does not satisfy either the COT or the SBT, in addition to the control
test, it cannot deduct a net capital loss from an earlier year in calculating its current year net
capital gain. However, a company may be able to apply the loss if it satisfies the alternative test
provided for in Subdivision 165-F (special provisions relating to ownership by non-fixed trusts).
If a company is prevented from applying a net capital loss under subsection 165-96(1), it can
apply part of a loss in accordance with subsection 165-96(2). A company can apply part of the
loss that it made during part of that earlier income year if, assuming that part of the year were
the whole income year, the company would have been entitled to apply the net capital loss.
Warning
A company may not be able to take advantage of prior year net capital losses where, broadly, a
capital gain is injected into the company or a scheme exists to provide the benefit of the capital
loss to another person (for more information, readers are advised to refer to Subdivisions 175-
CA and 175-CB).
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4.5 Division 166 concessional tracing rules
Division 166 provides an alternative, simpler test for establishing that the COT has been
satisfied in relation to a “widely held” or “eligible Division 166 company” by modifying the
application of Division 165.
Ordinarily, determining whether a company satisfies the COT involves continuous testing of
beneficial ownership throughout the loss year, income year and any intervening period.
However, considerable issues may be encountered in continuously testing the beneficial
ownership of public companies due to the multiplicity of share transactions undertaken in
respect of these companies, and the difficulty of tracing through upstream holding structures
(often involving nominee vehicles or significant chains of interposed entities). In recognition of
this, the Commissioner has in the past exercised the discretion to disregard normal stock
exchange transactions in determining whether a public company had complied with the test.
With the introduction of Division 166 (initially in 1997 and revised in 2005), public companies
and certain other eligible entities are now able to rely on the modified COT in utilising tax
losses. Broadly, the modified COT is aimed at providing statutory (as opposed to administrative)
relief for companies with accumulated losses where the application of the usual rules in Division
165 would be inappropriate or constitute an excessive compliance burden.
Note
The modified COT (as revised) may be relied upon for losses incurred in an income year
commencing on or after 1 July 2002. Tax losses incurred before 1 July 2002 may also be
tested under the modified COT, provided that those losses could have been deducted, in
accordance with former Divisions 165 and 166, in the first income year commencing after 30
June 2002.
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4.5.1 Which entities are able to rely on Division 166?
Companies that are either “widely held companies” or “eligible Division 166 companies”
throughout an income year can apply the modified COT in Division 166. A company that is
widely held for part of the income year and is an eligible Division 166 company for the rest of
the income year can also apply the modified COT.98
“Widely held companies” are defined in section 995-1 to be companies:
• Listed on an approved stock exchange; or
• Companies with more than 50 members, unless:
– At any time in the income year, 20 or fewer people hold or have the right to acquire
or become the holder of shares representing 75% or more of the value of shares in
the company, other than shares entitled to a fixed rate of dividend only;
– At any time during the income year, 20 or fewer people are capable of exercising
75% or more of the voting power in the company;
– In that income year, 20 or fewer people receive 75% or more of any dividend paid by
the company; or
– If no dividend was paid by the Company during the income year, the Commissioner
is of the opinion that if a dividend had been paid by the company at any time during
the income year, 20 or fewer people would have received 75% or more of that
dividend.
“Eligible Division 166 companies” are defined in section 995-1 to be companies where more
than 50% of the voting power, rights to dividends or rights to capital distributions are held by
one or more widely held companies, superannuation funds, approved deposit funds, special
companies, managed investment schemes, prescribed entities, non-profit companies, charitable
institutions, charitable funds or any other kind of charitable bodies.
98 See, for example, subsection 166-5(1)
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4.5.2 Point-in-time testing
Pursuant to the modified COT requirements set out in Division 166, ownership in an eligible
company is only required to be tested at particular points in time, rather than continuously over
periods. Specifically:
• In the case of tax losses, net capital losses, foreign losses and film losses, Subdivision
166-A modifies the application of the COT. In this regard, the COT is satisfied if there is
“substantial continuity of ownership” between the beginning of the loss year and each test
time in the ownership test period.99
– A company will demonstrate substantial continuity of ownership if it satisfies the
alternative test in relation to its voting, dividend and capital rights. This test will be
satisfied where, at each relevant test time, the same persons (other than companies
and trustees) directly or indirectly hold more than 50% of the voting power, rights to
dividends and rights to any distributions of capital in respect of the company.
For these purposes:
100
– Relevant test times include the end of each income year and the end of a “corporate
change” in the company. A typical example of a corporate change is a takeover bid
for shares in the company.
A
company may rely on the concessionary tracing rules contained in Subdivision 166-
E in order to demonstrate substantial continuity of ownership (refer to Section 4.5.3
below); and
101
• In the case of current year losses, Subdivision 166-B modifies the application of the COT.
Substantial continuity of ownership is tested by comparing ownership at the beginning of
the income year with ownership at the end of each corporate change event during the
year;
102
• In the case of unrealised losses, in determining whether a “changeover time” has
occurred, Subdivision 166-CA modifies the application of Subdivision 165-CC. There is no
changeover time in a particular income year if there is substantial continuity of ownership
between the reference time, the end of that income year and any other test times in that
99 Section 166-5 100 Section 166-145 101 Subsection 166-175(1) 102 Section 166-20
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year.103
• In the case of multiplication of losses within a group of companies, in determining whether
an “alteration time” has occurred, Subdivision 166-CA modifies the application of
Subdivision 165-CD. There is no alteration time in a particular income year if there is
substantial continuity of ownership between the reference time, the end of that income
year and any other test times in that year.
The reference time is the date of the last changeover time for the company for the
purposes of Subdivision 165-CC. If no changeover time has previously occurred, the
reference time is the later of 11 November 1999 and the date the company came into
existence; and
104
4.5.3 Concessionary tracing rules
The reference time is the date of the last
alteration time for the company for the purposes of Subdivision 165-CD. If no alteration
time has previously occurred, the reference time is the later of 11 November 1999 and the
date the company came into existence.
In addition to point-in-time testing, Division 166 also contains several concessions that simplify
the tracing of beneficial owners. These concessions may be summarised as follows:
• A direct stake of less than 10% is attributed to a single notional entity.105
• An indirect stake of less than 10% is attributed to the top interposed entity as an ultimate
owner;
Note, however,
that such attribution is subject to the minimum interest rule contained in section 166-270.
Under this rule, the notional entity can never be taken, at a test time, to control more
voting power, rights to dividends or rights to capital distributions in respect of a company
than it did at the beginning of the loss year;
106
• A stake of between 10% and 50% held by a widely held company is attributed to the
widely held company as an ultimate owner;
107
103 Section 166-80
104 Section 166-80 105 Section 166-225 106 Section 166-230 107 Section 166-240
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• A stake held by an entity deemed to be a beneficial owner (certain superannuation funds,
approved deposit funds, FHSA Trusts, special companies or managed investment
schemes) is generally attributed to that entity as an ultimate owner.108 However, where the
entity has 10 or fewer members, the stake will be attributed in equal proportions to those
members.109 Note that section 166-245 cannot apply where sections 166-225, 166-230 or
166-240 have already applied.110
• An indirect stake held by way of bearer shares in a foreign listed company is attributed to
a single notional entity in certain circumstances.
111 This is subject to the minimum interest
rule explained above;112
• An indirect stake held by a depository entity through shares in a foreign listed company is
attributed to a single notional entity in certain circumstances.
and
113
Tip
If any of the tracing concessions outlined above apply, the actual beneficial owners of shares in
the tested company are effectively deemed not to be beneficial owners for the purpose of
applying the modified COT.114
4.5.4 Other special rules in Division 166
The modified COT in Division 166 is also subject to the following general rules, which readers
should be mindful of:
• Subsection 166-235(7) states that if a company holds a stake in the tested company as a
nominee for one or more other entities, that stake can be attributed to the respective
entities directly for the purposes of determining substantial continuity of ownership.
108 Section 166-245 109 Subsection 166-245(4) 110 Paragraph 166-245(1)(b) 111 Section 166-255 112 Paragraph 166-270(1)(b) 113 Section 166-270 114 Section 166-265
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Consequently, if the nominee company holds stakes of less than 10% on behalf of other
entities, then each of these different stakes may be attributed to the single notional
shareholder pursuant to section 166-225;
Example
Assume Nominee Co holds 30% of the shares in Loss Co, but holds those shares on behalf of 5
different entities, each with a respective interest of 6% in Loss Co.
Under subsection 166-235(7), the 6% interests may be attributed directly to the respective
entities. This will have the effect that each of those entities will be deemed to directly hold 6% of
the shares in Loss Co for the purposes of applying the modified COT. Since each direct interest
is less than 10%, section 166-225 will then operate to attribute all of the interests to a notional
beneficial owner.
It is acknowledged that it may not always be practical to ascertain the interests held in Nominee
companies such as Nominee Co.
• Section 166-165 incorporates the provisions in Subdivision 165-D (specifically, the
concessionary tracing rules and the various anti-avoidance tests under Division 165) for
the purposes of applying the modified COT;
• Section 166-272 contains a same share rule which is similar in effect to that prescribed
under Division 165. However, this rule only applies to stakes held directly or indirectly by
the following entities:
– A top interposed entity (for indirect stakes of less than 10%);
– A widely held company;
– An entity deemed to be a beneficial owner under section 166-245; or
– A depository entity subject to section 166-260.
The rule is subject to a saving provision in subsection 166-272(8) which substantially
mirrors that contained under subsection 165-12(7).
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Note
The same share rule in section 166-272 does not apply to stakes held by the notional entity
created under section 166-225. Accordingly, it is not necessary that the same shareholders hold
direct stakes of less than 10% in applying the modified COT. However, the minimum interest
rule may still need to be considered in these circumstances.
• The concessionary tracing rules in Subdivision 166-E are subject to the controlled test
companies rule under section 166-280. This rule effectively prevents the concessionary
tracing rules from hiding significant interests in a tested company. In this regard, a tested
company will generally not be entitled to apply a tracing rule when determining substantial
continuity of ownership if:
– The tested company is sufficiently influenced by a controlling entity which directly or
indirectly holds a stake in the company; or
– The tested company is a widely held company and its voting power is controlled by:
An individual (together with associates) directly or indirectly controlling more
than 25% of the voting power; or
A company or trustee (together with associates) directly or indirectly
controlling more than 50% of the voting power.
Example
Assume Controller Co indirectly holds more than 50% of the voting power in Loss Co but does
so through a number of stakes in entities which directly hold less than 10% of the shares in
Loss Co.
In the absence of the controlled test companies rule, the tracing rule about direct stakes of less
than 10% would attribute these interests to a single notional entity under section 166-225.
However, where the controlled test companies rule applies, the tracing concession in section
166-225 will be inapplicable and it will be necessary to trace through those less than 10% direct
stakes to the ultimate stakeholders (thereby uncovering Controller Co’s real interest in Loss
Co).
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• Division 166 is intended to be a concessional regime applying to eligible companies.
Accordingly, to the extent that application of a tracing rule in Subdivision 166-E produces
a less favourable result than would have been achieved by the tested company under the
ordinary regimes, the effect of that rule may be disregarded.115
4.5.5 Final points on Division 166
4.5.5.1 Change in control of voting power
Under Division 165, continuity of voting control is an additional precondition which a company
must satisfy in order to deduct losses.116
4.5.5.2 Application is optional
This requirement is not modified by Division 166.
Widely held companies and eligible Division 166 companies must, therefore, continue to comply
with this requirement.
The rules in Division 166 provide an alternative to the COT rules, and will apply unless the
company chooses to have the COT rules apply.117
The company may elect to have the COT rules under Division 165 apply for any income year. A
company may also make separate elections in relation to carried forward tax losses and
current-year tax losses.
115 Section 166-275 116 Sections 165-15, 165-40, 165-115D, 165-115M and 165-129 117 Sections 165-15, 165-35, 165-50 and 165-90
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4.6 Loss carry-back regime
On 13 February 2013, the Tax and Superannuation Laws Amendment (2013 Measures No. 1)
Bill 2013 and accompanying explanatory memorandum were tabled in Parliament and received
Royal Assent (Act No. 88 of 2013) on 28 June 2013.118
“…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”.
These measures were originally
proposed as part of Recommendation 31 of the 2010 Australia’s Future Tax System Review,
which stated:
Subsequently, in October 2011, the Federal Government established an independent Business
Tax Working Group (BTWG) to consider the loss carry back proposal. In its Final Report on the
Tax Treatment of Losses, the BTWG endorsed the proposal, specifically recommending an
approach to loss carry back 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.
The bill seeks to give effect to the above approach, subject to compliance with appropriate
integrity measures. The explanatory memorandum accompanying the bill notes that such an
approach will enable companies to utilise their losses sooner and reduce the extent to which
they risk never being able to use those losses. This will in turn encourage companies to adapt
to changing economic conditions and take advantage of new opportunities through investment.
The explanatory memorandum also notes that the loss carry back approach will correct the
current asymmetric treatment between profits and losses under Australia’s taxation system. In
this regard, it was noted that, whilst the Federal Government collects, in terms of tax, a share of
any profits a company makes in an income year, it does not directly share in a company’s loss.
Rather, Australia’s current taxation regime allows future tax to be reduced by deducting that
loss from future profits derived by the company. This means that there is an asymmetric
118 http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r4964
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treatment of profits compared with losses. As a consequence, a company making a profit in one
year followed by 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 consistent fashion.
4.6.1 Overview of the loss carry back regime
The loss carry-back regime provides a corporate tax entity the choice of carrying back all or part
of a tax loss incurred in the current or preceding income year to offset an unutilised income tax
liability for either of the income years occurring before the current year. The regime generally
applies to assessments for the income year ending 30 June 2013 (2013 Tax Year) and later
income years. However, for the 2013 Tax Year, a transitional measure will apply which limits the
applicable loss-carry back period to one year. The loss carry-back regime will be contained in
newly inserted Division 160.
Under the loss carry-back regime, a corporate tax entity (broadly, an entity that is taxed like a
company) will be able to obtain a refundable tax offset for the losses that it chooses to carry
back against an unutilised income tax liability. The tax offset will be calculated as the lowest of
the following amounts:
• The tax value of the amount of the loss the entity chooses to carry back;
• The entity’s franking account balance at the end of the current income year;
• A quantitative cap of $300,000 (being $1 million multiplied by the applicable corporate tax
rate); and
• The entity’s unutilised income tax liability for the income year(s) to which it carries back a
loss.
In order to ensure consistency with the current treatment of net exempt income, a corporate tax
entity that carries back a loss to an income year with unutilised net exempt income must first
reduce the loss by the amount of that income before working out its offset for the remaining
loss.
The availability of the loss carry-back regime to corporate tax entities will be subject to
satisfaction of a specific anti-avoidance rule, which may apply where there is a scheme for the
disposition of membership interests in a corporate tax entity that changes the control of that
entity. In this regard, to the extent that such a scheme can be considered objectively to have
been entered into with a non-incidental purpose of enabling an entity to obtain a financial benefit
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calculated by reference to a loss-carry back offset, the loss carry-back tax offset will be denied
to the corporate tax entity.
The key features of the loss carry-back regime are discussed in further detail in the following
sections of this paper.
4.6.2 Entities eligible for loss carry-back
The loss carry-back regime is only available to corporate tax entities. Broadly speaking, a
corporate tax entity is an entity that is taxed like a company (it need not necessarily be a
company in legal form). In this regard, section 960-115 defines a corporate tax entity to be any
of the following:
• A company;
• A corporate limited partnership under Division 5A of Part III of the ITAA 1936;
• A corporate unit trust under Division 6B of Part III of the ITAA 1936; and
• A public trading trust under Division 6C of Part III of the ITAA 1936.
It should be noted that some of the above entities may be corporate tax entities for only part of
an income year (for example, a public unit trust which only carries on a trading business within
the meaning of section 102M of the ITAA 1936 for part of the income year). However, an entity
will only be entitled to claim a loss carry-back tax offset where it is a corporate tax entity
throughout the current income year. It must also have been a corporate tax entity throughout
the income year in which the loss is carried back to (and any intervening income years).
4.6.3 Choice to apply the loss carry-back regime
Application of the loss carry-back regime is optional for eligible corporate tax entities, which
mirrors the existing choice corporate tax entities have about whether to deduct their tax losses
under subsection 36-17(2) and subsection 36-17(3). A corporate tax entity will be able to
choose to carry back certain losses under the regime if all of the following requirements are
satisfied:
• It has an unutilised tax loss for the current income year or the preceding income year
(termed the “middle year”);
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• It has an unutilised income tax liability for the middle year or for the income year which
preceded the middle year (termed the “earliest year”). Note that any unutilised income tax
liability is determined after making allowance for tax offsets obtained by the corporate tax
entity in the relevant income year; and
• For the current income year and each of the previous 5 income years, it has lodged an
income tax return, was not required to lodge an income tax return or has been assessed
for income tax purposes by the Commissioner.
A corporate tax entity may choose to carry back a tax loss as it sees fit. In this regard, a
corporate tax entity can decide the quantum of tax losses to be carried back (subject to
available caps) and the allocation of those tax losses between the middle and/or earliest year.
If a corporate tax entity is able to choose to carry back its tax losses, any resulting tax offset will
be refundable to the corporate tax entity in the current income year.
4.6.4 Relationship between loss carry-back and loss carry-forward
When seeking to apply prior year tax losses in subsequent income years, corporate tax entities
must deduct such losses in the order in which they were incurred pursuant to subsection 36-
17(7). There is no comparable ordering rule under the loss carry-back regime. That is, a tax loss
need not be carried back to the earliest year, before it can be carried back to the middle year.
However, it will be a requirement under the loss carry-back regime that prior year tax losses be
deducted in the current income year prior to determining the loss-carry back tax offset. Of
course, a corporate tax entity may choose not to apply any carried forward tax losses in the
current income year, in which case, the ordering rule will have no application.
4.6.5 Losses which are subject to the loss carry-back regime
The loss carry-back regime will only be available in relation to “tax losses” incurred by a
corporate tax entity. Generally, a tax loss arises for an income year where the entity’s
deductions exceed its assessable income for that year (refer to Division 36 and section 0 of this
paper).
The regime will not be available in relation to capital losses incurred by corporate tax entities.
The rationale for excluding capital losses from the regime focuses on the fact that Australia’s
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capital gains tax rules operate on a realisation basis. Accordingly, allowing capital losses to be
carried back to produce a tax offset would mean that corporate tax entities could choose to
realise their capital losses in order to obtain a refundable tax offset, whilst continuing to defer
realisation of their capital gains.
Certain types of tax losses will be precluded from being carried back under the regime. In this
regard, a corporate tax entity will not be entitled to carry back losses that have been transferred
under Division 170 (which regulates the transfer of losses between companies in the same
foreign banking group) or under Division 707 (which regulates the transfer of losses to the head
company of a tax consolidated group by an entity that becomes a subsidiary member of that
group). Furthermore, any tax loss that is deemed to exist by virtue of section 36-55 on
conversion of a corporate tax entity’s excess franking offsets (refer to section 2.3.3.4 of this
paper) will also be ineligible for loss-carry back under the regime.
4.6.6 Franking credit cap
As discussed previously, there are a number of limitations which restrict the quantum of any
refundable tax offset under the loss-carry back regime. Most importantly, the loss carry-back tax
offset will not be able to exceed the balance of an entity’s franking account at the end of the
current income year.
Limiting the loss carry-back tax offset to the amount in the corporate tax entity’s franking
account at the end of the current income year precludes a double tax benefit arising from the
past payment of tax. Such a double benefit could otherwise arise where the shareholders in a
corporate tax entity receive franking credits attached to distributions paid by the entity, and the
entity is subsequently able to claim a tax offset with respect to any underlying tax paid. That is,
an imputation benefit could otherwise arise to the shareholders in relation to company tax that,
because of the loss carry-back regime, had effectively no longer been paid by the corporate tax
entity.
Limiting the loss-carry back tax offset in this manner also reduces the possibility that a
corporate tax entity’s franking account will be put into deficit as a result of the payment of the
loss-carry back tax offset. This minimises administrative churn in the tax system from
companies that receive a refund from the loss-carry back tax offset only to later have to return
part or all of the refund in the form of franking deficit tax.
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It should be noted that the franking account limitation will not apply to a foreign corporate tax
entity with a permanent establishment in Australia. Consequently, such an entity will be able to
obtain an offset under the regime, notwithstanding it is likely to have a nil balance in its franking
account (due to the fact that it is not tax resident in Australia and hence is not subject to
Australia’s imputation system). However, the franking account limitation will apply to loss carry-
back tax offsets claimed by New Zealand franking companies. Broadly, these are companies
that are resident in New Zealand for tax purposes but have chosen to be within the Australian
imputation system.
4.6.7 Calculation of the loss carry-back tax offset
Mechanically, the loss carry-back tax offset available to a corporate tax entity is generally
determined by applying the following method statement:
Step Description
1 Work out the amount of the loss to be
carried back
This step involves determining the amount of
the tax loss that a corporate tax entity is
carrying back to each of the middle year and
earliest year
2 Reduce the step 1 amount by net
exempt income
This step involves reducing the amount
worked out under step 1 by any net exempt
income derived by the corporate tax entity in
the middle and/or earliest year
3 Convert the step 2 amount to a tax
equivalent amount
This step involves converting the reduced
amount determined under step 2 to a tax
equivalent by multiplying that amount by the
corporate income tax rate (currently 30%)
4 Reduce the step 3 amount so that it
does not exceed the relevant tax
liability
This step involves reducing the converted
amount determined under step 3 so that it
does not exceed the maximum tax liability in
the income years to which the tax losses are
carried back
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5 Reduce the step 4 amount so that it
does not exceed the quantitative cap
or any franking account surplus
This step involves reducing the amount
determined under step 4 to ensure that it does
not exceed the lesser of the corporate tax
entity’s franking surplus for the current income
year and the tax equivalent of $1 million
(currently $300,000 using the corporate tax
rate of 30%)
The application of the above method statement is demonstrated in the following worked
examples, which draw on the explanatory memorandum introducing the loss carry-back
measures. The below examples also touch on the exclusion applying to losses transferred by
an entity on joining a tax consolidated group.
4.6.8 Examples
Example 1 (carrying back losses to the middle year)
Argentum Pty Ltd (Argentum) derived taxable income of $500,000 in the income year ended 30
June 2014 (2014 Tax Year) and $2 million in the income year ended 30 June 2015 (2015 Tax Year). For the income year ended 30 June 2016 (2016 Tax Year), Argentum incurred a tax loss
of $5 million. Owing to previous payments of income tax (and instalments), Argentum had a
franking credit balance of $1.5 million at the end of the 2016 Tax Year. Argentum also derived
$100,000 of net exempt income during the 2014 and 2015 Tax Years. Argentum has never
failed to lodge an income tax return.
Argentum decides that it will carry back part of the tax loss incurred by it during the 2016 Tax
Year to offset some of its taxable income for the 2015 Tax Year. Argentum’s loss carry-back tax
offset would be determined as follows:
Step 1: work out the amount of the loss to be carried back
Argentum decides to carry back $1.1 million of its tax loss for the 2016 Tax Year to offset part of
its income tax liability in the 2015 Tax Year. Argentum’s step 1 amount is therefore $1.1 million.
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Step 2: reduce the step 1 amount by net exempt income
As Argentum derived net exempt income of $100,000 during the 2015 Tax Year, it is necessary
to offset this amount against the quantum of tax losses carried back by Argentum when
determining the step 2 amount. Argentum’s step 2 amount is therefore $1 million (being $1.1
million of tax losses initially carried back, reduced by net exempt income of $100,000 derived in
the 2015 Tax Year).
Step 3: convert the step 2 amount to a tax equivalent
Argentum’s step 3 amount will be the tax equivalent of the amount calculated under step 2. This
is determined by multiplying the step 2 amount by the applicable corporate income tax rate.
Assuming the corporate income tax rate is 30%, Argentum’s step 3 amount should equal
$300,000 (being $1 million multiplied by 30%).
Step 4: reduce the step 3 amount so that it does not exceed the relevant tax liability
Step 4 generally requires the step 3 amount to be reduced so that it does not exceed the
unutilised income tax liability for the income years to which the tax losses are carried back.
In the present circumstances, step 4 should not have any application as the tax equivalent value
of Argentum’s carry-back tax losses (being $300,000) is less than Argentum’s unutilised income
tax liability for the 2015 Tax Year (being $600,000)
Argentum’s step 4 amount is therefore $300,000.
Step 5: Reduce the step 4 amount so that it does not exceed the quantitative cap or any
franking account surplus
Under step 5, Argentum will be required to reduce the step 4 amount to the lesser of the
quantitative cap and Argentum’s franking account balance at the end of the 2016 Tax Year. No
adjustment will be required where the step 4 amount does not exceed either of these
thresholds.
In the present circumstances, the quantitative cap should be $300,000 (calculated as $1 million
multiplied by the corporate income tax rate) and should not serve to reduce the step 4 amount
of $300,000.
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Additionally, as Argentum had available franking credits of $1.5 million at the end of the 2016
Tax Year, the step 4 amount should not be reduced by reference to Argentum’s available
franking credits (given these exceed the tax equivalent amount determined under step 4).
Consequently Argentum’s final loss carry-back tax offset for the 2016 Tax Year will be
$300,000. As Argentum is not tax-paying in the 2016 Tax Year, this amount should be refunded
to Argentum. Argentum’s franking surplus will effectively be reduced to $1.2 million as a result
of receiving the refund pursuant to Division 205.
Argentum’s carried forward tax losses for the 2016 Tax Year should be $3.9 million (being the
tax loss of $5 million incurred during the 2016 Tax Year less the amount carried back of $1.1
million). Note that Argentum’s net exempt income for the 2015 Tax Year effectively absorbs
$100,000 of Argentum’s tax losses.
Example 2 (carrying forward and carrying back tax losses)
Assume the same facts as in example 1.
For the income year ended 30 June 2017 (2017 Tax Year), Argentum derives taxable income of
$2 million (prior to the application of carried forward tax losses) and net exempt income of
$50,000. Argentum satisfies the COT and chooses to apply its carried forward tax losses to
offset its taxable income of $2 million.
As Argentum derived net exempt income of $50,000 in the 2017 Tax Year, it must first reduce
its carried forward tax losses by this amount pursuant to paragraph 36-17(3)(a). Following this
reduction Argentum’s carried forward tax losses from the 2016 Tax Year will equal $3.85 million
(being $3.9 million initially carried forward, less net exempt income derived during the 2017 Tax
Year of $50,000). Argentum will subsequently apply part of the carried forward tax losses to
reduce its taxable income to nil in the 2017 Tax Year. After application of the tax losses in this
manner, Argentum’s remaining tax loss from the 2016 Tax Year will equal $1.85 million.
Having applied its carried forward tax losses first (consistent with the ordering rule under the
loss carry-back regime) Argentum may then choose to carry back up to $1 million of the
remaining tax losses to the 2015 Tax Year to offset its unutilised income tax liability in that year
(being $300,000). Pursuant to the method statement explained in example 1 above, should
Argentum choose to carry back its remaining tax losses to the 2015 Tax Year, Argentum will
receive a refundable tax offset of $300,000. As Argentum is not otherwise in a tax payable
position for the 2017 Tax Year, the full amount of this offset will be refundable to Argentum in
the 2017 Tax Year.
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Note: although Argentum has an unutilised tax liability in the 2014 Tax Year, Argentum will not
be able to carry back its tax losses to this year, given it is outside of the 2 year loss carry-back
period.
Example 3 (consolidated group exclusion)
Raider Limited (Raider) is the head company of a tax consolidated group in Australia. Raider
has historically derived large profits in both the 2013 and 2014 Tax Years.
During the 2015 Tax Year, Raider decides to acquire all of the shares in an Australian resident
company, Trophy Pty Ltd (Trophy). Trophy has significant tax losses of $5 million which it has
accumulated over a number of income years.
Pursuant to Division 707, upon joining the Raider tax consolidated group, Trophy transfers its
tax losses to Raider on the basis that it satisfies the modified SBT. The tax losses are
transferred subject to an available fraction.
Raider Co wishes to carry-back the tax losses it inherits from Trophy to offset part of its
unutilised income tax liability in the 2013 and/or 2014 Tax Years. However, because the tax
losses have been transferred under Division 707 to Raider, loss carry-back will not be available
in relation to the tax losses. This is the case, notwithstanding that Raider will be deemed to
have incurred the losses on transfer under section 707-140.
4.6.9 Overview of the loss carry-back integrity measure
As mentioned previously, the ability to obtain a loss carry-back tax offset is subject to
satisfaction of a specific anti-avoidance rule which denies a corporate tax entity a loss carry-
back tax offset it would otherwise be entitled to where there has been a change of control in the
entity arising from the disposition of membership interests under a scheme and, considering all
of the relevant circumstances, one or more parties entered into the scheme to obtain access to
financial benefits associated with the loss carry-back tax offset.
Where the integrity measure applies, the corporate tax entity cannot carry back a tax loss.
However, subject to meeting the usual loss integrity tests, it may nevertheless be able to deduct
that tax loss in a subsequent income year. Note that application of the integrity measure will not
have any consequences for an entity that disposed of (or acquired) membership interests in the
corporate tax entity under an applicable scheme.
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Consistent with the current administration of the integrity measures regulating the utilisation of
prior year losses in future periods, corporate tax entities will be required to self-assess whether
the loss integrity measure applies in the context of their particular circumstances.
4.6.10 Key elements of the loss carry-back integrity measure
In order for the loss carry-back integrity measure to apply, the following elements need to be
satisfied:
• There must be a scheme (which is defined widely for these purposes to include any
agreement, arrangement, understanding, promise or undertaking, whether express or
implied and whether or not enforceable);
• Under the scheme, there must be a disposition of membership interests, or of an interest
in membership interests, in a corporate tax entity. For these purposes, a scheme for the
disposition of membership interests has the same meaning as in section 177EA of the
ITAA 1936 and includes issuing or creating membership interests and entering into
contracts that affect membership interests. Note that membership interests are taken to
include non-share equity interests in the corporate tax entity;
• The disposition of membership interests must have resulted in a change in the persons
who controlled, or were able to control (whether directly or indirectly) the voting power in
the corporate tax entity;
• In the absence of the integrity measure applying, an entity (other than the corporate tax
entity) must receive a financial benefit in connection with the scheme, which is calculated
by reference to one or more loss carry-back tax offsets that could reasonably be expected
to be available to the corporate tax entity at the time the scheme was entered.
Consequently, the integrity measure cannot apply if the corporate tax entity does not have
an unutilised income tax liability for any income year within the loss carry-back period, or
the corporate tax entity does not have, or expect to have, a franking credit balance at the
end of the current income year; and
• Having regard to the relevant circumstances of the scheme, it would be objectively
concluded that one or more of the persons who entered into the scheme did so for a
purpose (whether or not the dominant purpose, but not including an incidental purpose) of
the corporate tax entity obtaining a loss carry-back tax offset. The assessment as to
purpose is to be undertaken at the time the scheme is entered.
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4.6.11 Relevant Circumstances
In order to objectively establish a person’s purpose under the integrity measure, it is necessary
to weigh up a number of relevant circumstances prescribed in the Tax Act. None of the
circumstances is determinative (of itself) and all must be considered collectively.
First relevant circumstance: extent to which activities remain the same
The first relevant circumstance is the extent to which the corporate tax entity continues to
undertake the same activities after the scheme for disposition of the membership interests as it
did prior to entry of the scheme. Activities in this sense are referring to the process adopted by a
corporate tax entity in deriving its assessable income.
Both the number of activities and their relevant importance to a corporate tax entity’s business
profile must be considered when examining the extent to which such activities remain
consistent. In this regard, a particular activity may have been undertaken to such an extent (or
have been of such importance) to the corporate tax entity that its termination following a change
of control under a scheme clearly demonstrates a non-incidental purpose of obtaining a loss
carry-back tax offset.
It should be noted that a corporate tax entity may continue to carry on the same activities
notwithstanding that it has expanded or varied its product lines (contrast the SBT). For example,
as noted in the explanatory memorandum, a restaurant that specialised in Chinese cuisine
which refocused its specialisation on Greek Cuisine following a change of control would still be
considered to undertake the same business activity for the purposes of the integrity measure.
Second relevant circumstance: extent to which assets remain the same
The second relevant circumstance is the extent to which the corporate tax entity continues to
use the same assets following a change in control.
If an entity that is subject to a change of control continues to utilise its existing assets following
the change, this may indicate that the purpose of the new owner in acquiring membership
interests in the corporate tax entity was to obtain access to the corporate tax entity’s assets
rather than the loss carry-back tax offset. As noted in the explanatory memorandum, this is
particularly likely to be the case where the corporate tax entity possesses assets with unique
characteristics, which would otherwise be difficult to access.
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It should be noted that the second relevant circumstance does not put a limit on the corporate
tax entity’s ability to replace existing assets in the ordinary course of its business, nor does it
impose a restriction on the use to which the assets are put by the new owner following a change
of control. Conceivably, therefore, the assets may be used in a different manner without inviting
an adverse inference under this circumstance.
Third relevant circumstance: matters referred to in subparagraphs 177D(b)(i) to (viii)
The third relevant circumstance is the matters referred to in subparagraphs 177D(b)(i) to (viii) of
the ITAA 1936. The matters referred to in these subparagraphs are matters of reference for “the
dominant purpose” test in Part IVA of the ITAA 1936. However, in the context of the loss carry-
back measures, it is expected that they will facilitate an inquiry into whether a person has a non-
incidental purpose of obtaining access to a loss carry-back tax offset.
The matters referred to in subparagraphs 177D(b)(i) to (viii) of the ITAA 1936 broadly include
the manner in which the scheme was entered into or carried out, the form and substance of the
scheme, the timing of the scheme, the financial, tax and non-tax effects of the scheme and the
nature of any connection between the taxpayer and other parties to the scheme. The matters
are designed to cover the essential facts and circumstances of a particular scheme so that its
tax and non-tax objectives can be fully assessed and compared.
4.6.12 Examples
The potential operation of the loss carry-back integrity measure is demonstrated by the
following examples which are based on the explanatory memorandum introducing the loss
carry-back measures. The examples demonstrate how the above factors may be applied in
determining the question whether a particular scheme has been entered into for the non-
incidental purpose of obtaining a loss carry-back tax offset. For ease of reference, the examples
do not address each of the above factors individually, although this may be required in practice.
Example 1 (continuation of similar business)
Knightbridge Pty Ltd (Knightbridge) is historically a profitable company. However, its profits
are in long term decline. Its business activities principally consist of growing flowers for
wholesale supply to external vendors. It owns a large property in rural New South Wales on
which it has established a flower farm and associated flower shop. Knightbridge conducts
limited retail activities directly through the flower shop to interested members of the public.
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In the 2014 Tax Year, all of the shares in Knightbridge are purchased by Gavin for $1.8 million.
At the time of purchase, Knightbridge had a franking account balance of $200,000. Recent
sales of comparable properties that had been used for agricultural (but not flower growing
purposes) suggest that a fair market value for the flower farm would be $1.5 million. However,
the properties available do not have the arterial road access that Knightbridge has and would
require substantial flower beds to be planted.
In accordance with his business plan, Gavin changes the strategy of Knightbridge and
increases its retail focus on sales through the flower shop. In this regard, Gavin refurbishes the
flower shop and adds a café. Gavin also expands the products sold from the shop to include the
work of local artists depicting native flora and fauna in the region. Taking into account the
revised strategy, Gavin anticipates Knightbridge will incur a tax loss of $600,000 in its first
income year but become profitable in the following income years. In modelling cash flows from
the business for the purposes of obtaining finance from an external lender, Gavin has included
the impact of the loss carry-back tax offset.
On the evidence available, Gavin’s purpose is to implement changes that he expects will lead to
Knightbridge being a more profitable business in the future. Whilst Knightbridge is undertaking
some new business activities, it has also continued its initial business activities of growing
flowers for sale. The company has retained most of its pre-existing assets albeit that some
have been refurbished.
Although Gavin paid a substantial premium over the fair market value of Knightbridge’s assets
(and in determining this premium, Gavin may have taken into account the availability of a loss
carry-back tax offset), other factors such as the existence of arterial road access and the
availability of existing flower beds suggest that obtaining a loss carry-back tax offset was merely
incidental in the acquisition of Knightbridge.
On balance, the integrity rule should not apply and any loss carry-back tax offset should be
allowed to Knightbridge.
Example 2 (disposal of assets)
Spurious Transport Pty Ltd (Spurious Transport) owns vehicles, plant and equipment valued
at $15 million. The company has a franking account balance of $600,000 as a result of income
tax liabilities in each of its two previous years of operation. Members of the Jones family
acquire all of the membership interests in Spurious Transport for consideration totalling $15.3
million during the 2014 Tax Year. The company is then renamed as Jones Plumbing Pty Ltd
(Jones Plumbing).
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Within a matter of days, Jones Plumbing sells all of its existing assets to a company that is
associated with the former shareholders of Spurious Transport. The assets are sold for their
market value of $15 million. Jones Plumbing subsequently commences a new business that is
expected to incur tax losses of $2 million and $1.5 million respectively in its first two years of
operation.
The Jones family is conducting a very different business to that of the former owners of what is
now Jones Plumbing. Whilst very valuable assets were acquired with the company, the quick
sale of those assets demonstrates that there was never any intention to use them in an income
earning activity. The very substantial recoupment of the purchase price for the company by
selling its assets has effectively led to a situation where the net cost to the Jones family was
$300,000 (being the excess of purchase consideration paid over the proceeds recouped on
subsequent sale of the existing assets).
As the Jones family expects the company to have trading losses of $3.5 million, they can
reasonably expect to be able to carry back losses so that Jones Plumbing will obtain tax offsets
of $300,000 in both of the first two years of operation under their control.
It is probable that the availability of the tax offset over two years was a significant purpose of the
transfer of membership interests. Both tax offsets would therefore be denied.
Example 3 (generational change)
Paladin Pty Ltd (Paladin) is a family company that is owned as to 70% by Mark and 30% by
Jarrod (Mark’s son). Paladin carries on a successful tailoring business with net assets of $2.5
million and a franking account balance of $500,000. Mark is ready to retire but desires that
100% of the shares in Paladin remain family assets. Consequently, Mark disposes of his 70%
interest in Paladin to Jarrod, who thereafter becomes the sole shareholder for the company.
Jarrod acquires the interest in consideration for a payment of $2 million.
Jarrod is appointed as Paladin’s managing director and immediately changes the business
focus of the company in a manner that Mark had previously resisted. This includes selling off
most of the company’s assets. Jarrod expects that Paladin may be unprofitable for a number of
years following these changes; however, ultimately he considers that the fundamentals of the
modified business focus are sound and that the business will increase its profitability above
current levels. Jarrod has factored in the availability of a loss carry-back tax offset in his
forecasts in relation to Paladin’s business performance.
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The business focus of Paladin has changed and very few of the assets have been retained.
The price paid for 70% of the company not previously owned could suggest that a financial
benefit was expected and calculated by reference to the loss carry-back tax offset. In this
regard, had Jarrod simply purchased the outstanding shares in Paladin without taking account
of the loss carry-back tax offset, he could have been expected to pay $1.75 million (being 70%
of the net asset balance).
However, the generational change is a significant factor that suggests that the availability of the
offset was at most an incidental purpose of Jarrod acquiring control of the company.
4.7 Proposed improvements to the company loss recoupment rules
As part of the 2011-2012 Budget, the Federal Government announced that it will improve the
operation of the company loss recoupment rules by simplifying the COT in certain
circumstances and removing some minor technical defects.
On 14 July 2011, the Treasury released a consultation paper on providing additional information
on how the proposed changes to the company loss recoupment rules might operate and to seek
feedback on their design and implementation.
Specifically, the consultation paper has identified the following areas for improvement:
4.7.1 Modifications to the continuity of ownership test
Proposed amendments to the ordinary COT will mean that a company will not be required to
trace ownership through a complying superannuation fund, a complying approved deposit fund,
a first home savers account trust, a special company or a managed investment scheme. These
proposed amendments are consistent with the scope of a similar exception that applies under
the modified COT.
4.7.2 Extension of the concessional tracing rules under the modified continuity of ownership test
Proposed improvements will be made to the modified COT to extend the circumstances in
which these concessional tracing rules apply (refer to Section 4.5.3 above for discussion of the
concessional tracing rules).
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4.7.3 Holding company interposed between a direct stakeholder and the tested company
Where a stakeholder has a direct stake in the tested company that carries rights to less than
10% of the voting power, dividends and capital distributions, it is not necessary to trace through
to the ultimate beneficial owners. This is achieved by treating all direct stakes of less than 10%
as being held by a single notional entity that is a person.
A similar concession applies where a stakeholder has an indirect stake in the tested company
that carries rights to less than 10% of the voting power, dividends and capital distributions. In
these circumstances, the ownership tracing rules are applied as though the top interposed entity
is a single person.
A problem arises if, during the test period, a holding company is interposed between the tested
company and a less than 10% direct stakeholder. In these circumstances, the stake will be
attributed to the interposed company under section 166-230 from that time onwards, rather than
the single notional entity to whom the stake was initially attributed to under section 166-225.
Consequently, the tested company may fail the COT, even though the interposition of the
holding company does not change the ultimate beneficial ownership of the tested company.
The proposed changes will mean that the same single notional entity will be taken to hold the
stakes in the tested company before and after the entity is interposed between the direct
stakeholder and the tested company. Therefore, the interposition of a holding company between
the tested company and a less than 10% direct stakeholder will not, of itself, cause a failure of
the COT.
4.7.4 Demerger by a top interposed entity
Where a stakeholder has an indirect stake of less than 10% in the test company, it is not
necessary to trace through to the ultimate beneficial owners of the stake in the test company.
Instead, the indirect stake of less than 10% is attributed to the top interposed entity.
If the top interposed entity demerges shares in the tested company, or interests in another entity
interposed between itself and the tested company, the legal owner of the 10% indirect stake
changes. As a result, the concessional tracing rules cease to apply as the indirect stake is either
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attributed to a different top interposed entity, or is a stake that is held directly, from that time
onwards (even though no change in the ultimate beneficial ownership of the stake arises as a
consequence of the demerger).
If the tested company applies the ordinary COT, it will need to trace ownership through to the
ultimate beneficial owners and, all other things being equal, will continue to pass the COT.
However, it will inappropriately lose access to the compliance cost benefits that arise under the
concessional tracing rules for widely held companies and eligible Division 166 companies.
It is proposed to amend section 166‐230 so that it will continue to apply where the top
interposed entity demerges. In these circumstances, section 166‐230 will apply as if, at the
times the entity that holds or is taken to hold the demerged shares or other interests is also
taken to have held that stake, the top interposed entity at all times held, or is taken to have held,
a stake in the tested company.
As a result, the same entity will be taken to hold the stakes in the tested company before and
after the demerger by the top interposed entity.
4.7.5 Entity interposed between a superannuation fund and the tested company
Concessional tracing rules also apply where a stake is held directly or indirectly by certain
specified entities (such as a complying superannuation fund or a foreign superannuation fund).
However, these concessional tracing rules cease to apply if a holding company is interposed
between the specified entity and the tested company (even though the ultimate beneficial
owners of the tested company remain the same following the interposition of the holding
company). This is because such an interposition will infringe the same share same interest rule
in subsection 166‐272(2), which requires that the only shares in the tested company that are
taken into account are exactly the same shares and are held by the same persons. The shares
in the tested company were held at the beginning of the tested company’s test period by the
specified entity, and at some point in the test period they start to be held by the interposed
holding company. To overcome this problem, the tested company must rely on the saving rule
in subsection 166‐272(8).
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The proposed changes ensure that the condition in paragraph 166‐245(1)(a) (which requires a
specified entity to directly or indirectly hold a relevant stake in the tested company) will continue
to be satisfied for the purposes of applying section 166‐245 to the specified entity, without
infringing the same share same interest rule in subsection 166‐272(2) and thus not having to
satisfy the saving rule in subsection 166‐272(8).
4.7.6 Bearer depository receipts
Bearer shares are negotiable instruments which accord ownership of shares in a company to
the person who possesses the bearer share certificate. The owners of bearer shares are not
recorded in the share register. Rather, the transfer of bearer shares occurs through the physical
handover of the share certificate. Accordingly, it is not ordinarily practicable for a company to
trace ownership through bearer shares.
Consequently, a concessional tracing rule applies to bearer shares carrying voting, dividend or
capital stakes of 50 per cent or more in a foreign listed company that has a direct or indirect
stake in the tested company, provided that certain conditions are satisfied (section 166‐255). If
the tracing rule applies, a single notional entity (being a person other than a company) is taken
to control the voting power in, and have the right to receive any dividends or capital distributions
from the tested company, that are carried by the bearer shares.
Due to regulatory requirements relating to the transfer of shares that apply in the Netherlands,
shares in a Netherlands parent company are often held by a stichting (which has some legal
features of an Australian company and some legal features of an Australian trust).
In exchange for each share in the Netherlands parent company, the stichting issues a bearer
depository receipt. The bearer depository receipt represents an economic and beneficial interest
in the Netherlands parent company and is effectively equivalent to the ownership of a share.
The bearer depository receipts are listed for quotation in the official list of an approved stock
exchange.
Bearer depository receipts are essentially equivalent to bearer shares. However, the
concessional tracing rules do not apply to bearer depository receipts because they do not
satisfy the conditions in section 166‐255.
It is proposed to modify section 166‐255 so that bearer depository receipts issued by an
interposed foreign entity that are listed for quotation in the official list of an approved stock
exchange are eligible for the same concessional tracing rules as bearer shares.
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4.7.7 Applying the modified COT following an issue of new shares
A corporate change can occur in a number of ways (section 166‐175). One way that a corporate
change can happen is if the company issues new shares resulting in an increase of 20% or
more in either the issued share capital of the company or the number of the company’s shares
on issue (paragraph 166‐175(1)(d)).
Currently, when a corporate change is brought about by the issue of shares, the corporate
change ends when the offer period for the issue of shares ends (paragraph 166‐175(2)(c)). In
some circumstances all the new shares may not have been issued before the end of the offer
period. If the test is applied before all the new shares are issued, all changes in ownership
arising from the issue of the new shares may not be captured.
It is likely that a company will have a significant change of ownership when a corporate change
happens. Therefore, the modified COT is applied at that time to determine whether it causes a
failure of the COT. Consequently, if the corporate change happens because of an issue of
shares, it is clear that all of the new shares that are issued need to be taken into account when
applying the COT.
It is proposed to amend paragraph 166‐175(2)(c) to clarify that, where a corporate change is
brought about by the issue of shares, the corporate change ends when all of the new shares are
issued.
4.7.8 Loss integrity rules – low value asset exclusion
Where a company owns CGT assets that are membership interests in another entity (such as
shares in a company or units in a unit trust), there is some doubt as to whether each
membership interest is treated as a separate asset for the purposes of applying the loss
integrity rules in Subdivisions 165-CC and 165-CD. If this is the case then the effectiveness of
the loss integrity provisions is compromised.
The proposed amendments will clarify that all membership interests in an entity which are
owned by the test company at the relevant time are treated as a single asset for the purposes of
applying the $10,000 threshold test.
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4.8 Proposed tax loss incentive for designated infrastructure projects
In the 2011-2012 Budget, the Federal Government announced that it would introduce a new tax
incentive designed to remove impediments in the tax system that discourage private investment
in infrastructure projects. In this regard, the Federal Government wanted to attract private sector
investment in nationally significant infrastructure projects by:
• Uplifting the value of carry forward tax losses by the long term bond rate;
• Exempting companies from the COT and SBT; and
• Exempting fixed trusts from the trust loss and bad debt deduction tests.
We note that draft legislation and explanatory memorandum was released on 18 April 2013.
4.9 Common errors when utilising tax losses
4.9.1 Common errors
The ATO has published common errors when taxpayers seek to utilise tax losses. Such errors
include:
• Incorrect classification of the loss on either revenue or capital account;
• Losses being used where a company doesn't satisfy either the COT and the control test or
the SBT;
• Records not being kept to substantiate the loss;
• Incorrect claiming of tax deductions, in particular finance-related claims;
• Carried-forward losses not being checked to ensure they're correctly calculated including:
– Failure to reduce amounts carried forward by amounts previously claimed; and
– Tax losses carried forward despite having utilised all losses in the previous year.
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4.9.2 ATO target areas
The ATO has stated that they are concerned with the following issues:
• Claims for losses that do not meet COT or SBT;
• Unexplained losses;
• Inappropriate creation of losses through debt forgiveness and other inter-group/entity
transactions;
• Inappropriate creation of losses through income omission or incorrect classification
(revenue or capital);
• Manipulation of loss entities in various ways, including using profitable trusts to distribute
income into loss entities;
• Inappropriate claims for losses derived from permanent establishments; and
• Claims for losses that do not reflect genuine commercial arrangements.
4.10 Record keeping
To support claims for losses, records should be retained at least until the end of the period of
review for the income year in which the relevant losses are fully applied.
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5. Modifications
5.1 Tax losses and consolidated groups
5.1.1 Overview
When an entity becomes a member of a consolidated group (whether as head company or as a
subsidiary member), carried forward losses (revenue and capital) may be transferred to the
head company of the consolidated group.
Specifically, carried forward losses of an entity may be transferred to the head company
provided the losses satisfy modified versions of the COT or the SBT. The tests are applied as
though the 12 months prior to the joining time were the loss claim year (known as the trial year).
The carried forward loss is transferred to the head company of the group if the joining entity
could have utilised the loss in the trial year assuming it had sufficient income or gains of the
relevant type.
In addition, the rate at which transferred losses can be used by the head company of a
consolidated group is generally restricted to approximate the rate of use that the joining entity
would have experienced had it remained outside of the consolidated group. This is achieved
via the “available fraction”.
5.1.2 Transfer of carried forward tax losses
There are generally three steps to be followed by a joining entity seeking to transfer losses to
the head company of a consolidated group:
Step 1: The entity works out its taxable income or loss for the period up to the time it joins
the consolidated group;
Step 2: The entity identifies the amount of its carried forward losses as at the joining time;
and
Step 3: The entity then determines whether those losses satisfy the modified tests for using
them in the context of the trial year.
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Thus, where the entity joins the consolidated group as a subsidiary member, it is required to
consider the general loss provisions in the course of establishing its income tax liability (if any)
to the point of tax consolidation, and to then consider them again as transfer tests (modified as
required) in the context of the trial year (which is defined in subsection 707-120(2)).
The tests generally require the joining entity:
• To have maintained a majority of the same ownership and control for the period between
the start of the loss year and just after the joining time (the continuity of ownership and
control tests); or
• In certain cases, to have carried on the same business as between the end of the loss
year and, at least, throughout the 12 months before the joining time (the SBT).119
A joining entity’s eligible losses are transferred to the head company at the joining time.
120 The
head company is then treated as having made the loss itself in the income year of the
transfer.121
Losses that have been transferred can be utilised (subject to limitations) for all income years of
the head company following consolidation, until the losses are either exhausted or rendered
non-utilisable.
Accordingly, the head company is then the only entity capable of utilising the loss.
For completeness, where carried forward losses of an entity are not transferred (whether
because the entity does not satisfy the transfer tests or the loss is cancelled by the head
company pursuant to section 707-145), the loss cannot be used by any entity for income years
after the entity became a member of the consolidated group.122
5.1.3 Utilisation of tax losses by head company of consolidated group
The eligible losses of a joining entity are transferred to the head company at the joining time.
The head company is then treated as having made the loss in that income year. This is
described as the “refreshing” of the losses. However, the head company must still test the
119 Sections 707-105, 707-120 and 707-125 120 Sections 707-105 and 707-120 121 Sections 707-105 and 707-140 122 Sections 707-105, 707-140 and 707-150
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ownership of the loss entity from the beginning of the actual loss year if the loss entity is a
company and the loss was transferred because the COT was passed.
The head company is the only entity that can use the loss.123
Transferred losses can only be used after “group losses” (that is, losses incurred by the
consolidated group).
Losses that have been transferred
can be deducted, applied or taken into account (subject to some limitations) for all income years
following consolidation, including the transfer year, until they are either exhausted or rendered
unusable.
If the joining entity ceases to be a member of the consolidated group, all losses remain with the
head company of the consolidated group.124
If in respect of a particular year of income the head company of a consolidated group has failed
the COT, then the SBT in section 165-210 will be relevant when calculating taxable income to
determine the income tax liability of the head company. The single entity rule therefore will
apply in this context.
125
Under the single entity rule of subsection 701-1(1), subsidiary members of a consolidated group
are taken for the purposes of the SBT (among other purposes), to be parts of the head
company. In this context, the principles set out in TR 1999/9 in respect of the application of the
SBT to a single company apply equally to the head company of a consolidated group.
The Commissioner sets out his views on the application of the same business test to
consolidated and multiple entry consolidated groups in Taxation Ruling TR 2007/2.
When determining the one overall business carried on by the head company of a consolidated
group for the purposes of subsection 165-210(1) it is necessary to have regard to the activities
of the subsidiary members of the group. Applying the principles of TR 1999/9, one overall
business of the head company 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
123 Subsection 707-140(1) 124 Section 707-410 125 See subsection 701-1 and TR 2004/11
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• By all entities during that part of the SBT period when they were members of the
consolidated group.
When applying the new business test and new transaction test to the head company regard
must be had to the enterprises, undertakings and transactions that were carried on or entered
into before the test time by entities while they were members of the consolidated group. These
activities are then compared with the enterprises, undertakings and transactions carried on or
entered into by all entities while they are members of the consolidated group during the SBT
period. This comparison determines whether the enterprises, undertakings and transactions
before the test time and during the SBT period are different in kind.
In relation to the new business and new transaction tests, it is not necessary that a business
carried on or a transaction entered into during the SBT period by an entity in the group be of a
kind carried on by that same entity before the test time. In accordance with the operation of the
single entity rule, where an entity within the group undertook a business or transaction of that
kind before the test time when that entity was a member of the consolidated group, the new
business or new transaction test will be satisfied.
Activities, undertakings and enterprises taking place within a consolidated group (not involving
the derivation of income through dealings outside the group) will be relevant for characterising
the business of the head company. This will be the case notwithstanding the fact that individual
transactions between group members will not be recognised as happening under the SBT
because of the single entity rule which treats group members as parts of the head company for
the purpose of determining its income tax liability.
Note that section 165-212E and the entry history rule in section 701-5 operate in such a way
that the activities of an entity during any period when that entity was not a member of a
consolidated group are ignored when determining either the “business” of the head company of
a consolidated group, or whether the new business test or the new transaction test have been
satisfied.
For the avoidance of doubt, the Federal Government introduced proposed modifications to
section 165-212E on 4 September 2009 clarifying that the entry history rule will be effectively
disregarded when applying the SBT to the head company of a consolidated group. Therefore,
where a subsidiary member joins a consolidated group, the head company will not need to take
into account the history of the subsidiary member (for example, in relation to certain pre-joining
time transactions undertaken by the subsidiary member) in assessing compliance with the SBT.
The modifications are proposed to apply from 1 July 2002.
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6. Foreign Losses
Former section 79D of the ITAA 1936 required foreign income deductions to be “quarantined”
from domestic assessable income. This meant that these deductions could only be offset
against assessable foreign income. Originally, the section also required foreign income
deductions to be further quarantined into four foreign income classes:
• Interest income;
• Modified passive income;
• Offshore banking income; and
• Other assessable foreign income.
Accordingly, foreign deductions could only be offset against foreign income of the same class.
For example, foreign interest deductions could only be offset against foreign interest income. It
should be noted, however, that with the advent of the revised thin capitalisation regime in 2001,
interest income was effectively removed from the ambit of former section 79D.
The section, which had applied in various forms since the 1989 income year, was repealed with
effect for income years, statutory accounting periods and notional accounting periods starting
on or after 1 July 2008 (with the introduction of the foreign income tax offset rules).
The effect of the removal of these restrictions is that in utilising deductions, no distinction now
needs to be drawn between foreign and domestic income earning activities. The general rule,
under Division 36, is simply that where the combined foreign and domestic deductions exceed
assessable income, the excess is a tax loss that may be carried forward for deduction against
assessable income of subsequent income years in accordance with the general loss
recoupment rules.
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7. Trusts
Trusts, though not taxpayers (with the exception of public trading trusts and corporate unit
trusts), are subject to specific restrictions set out in Schedule 2F of the ITAA 1936. These
restrictions then affect the amount which beneficiaries of the trust must include in their
assessable income.
Public trading trusts and corporate unit trusts are treated as companies for most income tax
purposes, but are subject to the trust loss rules in Schedule 2F of the ITAA 1936.
References to sections of the Tax Act in this section are to sections in Schedule 2F of the ITAA
1936, unless otherwise indicated.
7.1 A summary of the trust loss rules
Schedule 2F of the ITAA 1936 contains rules which restrict the utilisation of losses by a trust in
certain circumstances (referred to generally as the “trust loss rules”). In this regard, the trust
loss rules only apply to revenue losses, and not to capital losses. This is an important
distinction and one that has been mooted as being subject to review.
The trust loss rules apply differently depending on the type of trusts. The relevant types of
trusts, together with the applicable rules, are summarised in the following table:
Trust 50% Stake Non-fixed Trust Stake
Same Business
Pattern of Distribution
Control Income Injection
Fixed trust
other than a
widely held
unit trust
Yes Yes Yes
Unlisted Yes, on Yes
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Trust 50% Stake Non-fixed Trust Stake
Same Business
Pattern of Distribution
Control Income Injection
widely held
trust
abnormal
trading and
at end of
each
income
year
Unlisted
very widely
held trust
Yes Yes
Listed
widely held
trust
Yes, on
abnormal
trading
Yes Yes
Wholesale
widely held
trust
Yes Yes
Non fixed
trust
Yes Yes Yes Yes
Family trust Yes
Excepted
trust (other
than a
family trust)
None applicable
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7.2 Important definitions
There are several important definitions used in the trust loss rules that readers should first be
familiar with.
7.3 Fixed trust
A fixed trust is a trust where persons have fixed entitlements to all of the income and capital of
the trust.126
Broadly speaking, a trust will be a “fixed trust” under the current definition if persons have “fixed
entitlements” to all of the income or capital of the trust, which in turn requires that those persons
have “vested and indefeasible” interests in all of the income and capital of the trust. However,
as highlighted by the decision of the Federal Court in the Colonial First State Investments
Limited v Commissioner of Taxation
127
In recognition of this issue, the Treasury released a discussion paper on the meaning of “fixed
trust” in July 2012. The discussion paper aims to assist in developing a more workable
definition of what trusts will constitute a “fixed trust” for Australian income tax purposes. Very
broadly, the paper suggests that the current definition of a fixed trust could be replaced by
either:
, practically, very few trusts will satisfy this requirement
because beneficiary entitlements are commonly able (at least theoretically) to be defeated by
the exercise of a power in the trust instrument or by a statutory power. Accordingly, in order to
qualify as a “fixed trust”, almost all trusts currently need to rely on the Commissioner’s discretion
to treat them as such (as per subsection 272-5(3) of Schedule 2F of the ITAA 1936).
• “The clearly defined rights” test: whereby trusts with no material discretionary elements
would be considered fixed trusts for Australian income tax purposes; or
• “The vested and not defeated” test: whereby trusts with interests that are vested in
possession but have not been defeated at a particular test time would be considered fixed
trusts for Australian income tax purposes.
126 Section 272-65 of Schedule 2F of the ITAA 1936 127 2011 ATC 20-235
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The paper also considers removing the concept of “fixed trust” completely from certain sections
of the Tax Act.
7.4 Non-fixed trust
A non-fixed trust is any trust other than a fixed trust. Such trusts are commonly referred to as
discretionary trusts.128
Example
The trust deed for ABC Trust provides discretion to the trustee to determine capital and income
distributions. ABC Trust is a non-fixed trust.
7.5 Closely held trust
A trust is closely held if either:
• No more than 20 individuals have; or
• No individuals have,
fixed entitlements to a 75% or greater share of the income or capital of the trust, directly or
indirectly, for their own benefit.129 An individual, her/his relatives and their nominees are taken
to be a single person for the purpose of this test.130
Example
John holds A class units in Trust XYZ. 49 other unitholders hold B class units. A class units
carry the right to 100% of the capital distributions of the trust and rank equally with B class units
for income distributions. As John holds fixed entitlements to at least 75% of capital distributions
from the trust, XYZ is a closely held trust.
128 Section 272-70 of Schedule 2F of the ITAA 1936 129 Section 272-105 of Schedule 2F of the ITAA 1936 130 Subsection 272-105(3) of Schedule 2F of the ITAA 1936
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7.6 Widely held trust
A trust is a widely held unit trust if it is a unit trust that is a fixed trust and is not closely held
unless there is power (whether or not it is in fact exercised) to vary the rights attaching to any of
the units in such a way that the trust would become closely held.131
Widely held trusts (and their variants) are not considered further in this paper (apart from the
definitions below).
7.6.1 Unlisted and listed widely held trusts
An unlisted widely held trust is a widely held trust whose units are not listed for quotation on
the official list of an approved stock exchange132 and a listed widely held trust is one whose
units are so listed.133
7.6.2 Unlisted very widely held trust
An unlisted very widely held trust is a trust:134
• That is an unlisted widely held trust;
• That has at least 1,000 unit holders;
• Whose units all carry the same rights (that is, only one class of units);
• Whose redeemable units (if any) are redeemable for a price determined on the basis of its
net asset value; and
• That engages in an activity that is an investment or business activity conducted in
accordance with the trust deed (and any prospectus) and is conducted at arm’s length.
This can apply retrospectively in certain situations.135
131 Section 272-105 of Schedule 2F of the ITAA 1936
132 Section 272-110 of Schedule 2F of the ITAA 1936 133 Section 272-115 of Schedule 2F of the ITAA 1936 134 Section 272-120 of Schedule 2F of the ITAA 1936
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7.6.3 Wholesale widely held trust
A trust is a wholesale widely held trust if:136
• It is an unlisted widely held trust but not an unlisted very widely held trust;
• At least 75% of its units are held by one or more of the following:
– Listed widely held trusts;
– Unlisted very widely held trusts;
– Life assurance companies;
– Complying approved deposit funds;
– Complying superannuation funds; or
– Pooled superannuation trusts;
• All units carry the same rights;
• Redeemable units (if any) are redeemable for a price determined on the basis of its net
asset value;
• The amount subscribed for units by each unit holder is at least $500,000; and
• The trust engages in an activity that is an investment or business activity conducted in
accordance with the trust deed (and any prospectus) and is conducted at arm’s length.
7.6.4 Family trust
A family trust is a trust that has a family trust election in force in respect of the trust.137
135 Section 272-120 of Schedule 2F of the ITAA 1936 136 Section 272-125 of Schedule 2F of the ITAA 1936 137 Section 272-75 of Schedule 2F of the ITAA 1936
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7.6.5 Excepted trust
An excepted trust is a trust that is:138
• A family trust;
• A complying superannuation fund, complying approved deposit fund or pooled
superannuation trust;
• In respect of certain deceased estates;
• A fixed trust that is a unit trust and exempt entities have fixed entitlements to all of the
income and capital of the trust, directly or indirectly; or
• A FHSA trust.
Broadly, an excepted trust is not subject to the loss rules in Schedule 2F of the ITAA 1936.
Accordingly, this paper does not focus on these trusts (even though family trusts may be the
most common trusts on which readers advise).
7.7 Fixed trusts, not widely held unit trusts or excepted trusts
A fixed trust that is not a widely held unit trust or an excepted trust must remain such a fixed
trust throughout the period starting at the beginning of the loss year and ending at the end of the
income year.139
In addition, the fixed trust must pass the 50% stake test or the non-fixed trust stake test in order
to be able to use its losses.
140 If these tests are not passed, the trust must calculate its taxable
income and tax loss for the income year as described in section 266-30 of Schedule 2F of the
ITAA 1936.141
138 Section 272-100 of Schedule 2F of the ITAA 1936
139 Section 266-25 of Schedule 2F of the ITAA 1936 140 Section 266-25 of Schedule 2F of the ITAA 1936 142 Section 266-50 of Schedule 2F of the ITAA 1936
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The trust may still be able to deduct part of the loss.142
7.7.1 50% stake test
The 50% stake test requires that the same individuals have, directly or indirectly, fixed
entitlements to more than 50% of the income and capital of the trust (although different persons
may hold the entitlements to income from those who hold the entitlements to capital) from the
start of the loss year to the end of the income year.143
7.7.2 Non-fixed trust stake test
To satisfy the non-fixed trust stake test, the following conditions must be satisfied:144
• At all times between the start of the loss year and the end of the income year, non-fixed
trusts (other than family trusts) must hold fixed entitlements to a 50% or greater share of
the income or capital of the trust, or a fixed trust must hold all of the fixed entitlements to
the income or capital of the trust and non-fixed trusts must in turn hold fixed entitlements
to 50% or more of the income or capital of that fixed trust;
• The same persons holding fixed entitlements to the income and capital of the trust (or the
interposed fixed trust) must hold their entitlements at all times during the period;
• At the beginning of the loss year, individuals must not have had more than a 50% stake in
the income and capital of the trust; and
• Each non-fixed trust (other than an excepted trust) that holds a fixed entitlement must
itself not be prevented from utilising a loss and must not be required to work out its
taxable income and tax loss as described in section 266-30 of Schedule 2F of the ITAA
1936.
142 Section 266-50 of Schedule 2F of the ITAA 1936 143 Sections 269-50 and 269-55 of Schedule 2F of the ITAA 1936 144 Section 266-45 of Schedule 2F of the ITAA 1936
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7.8 Non-fixed trusts
A trust that was a non-fixed trust at any time during the period commencing from the start of the
loss year to the end of the income year and was not an excepted trust can deduct losses only if
it satisfies all of the following:145
• The pattern of distributions test if the trust distributed income or capital in the income year
or within 2 months of its end and in at least one of the previous six income years;
146
• The pattern of distributions test in any prior income year in which the trust sought to use
tax losses;
147
• If there are individuals with more than a 50% stake in the income or capital of the trust,
those individuals must have held more than a 50% stake in the trust from the start of the
loss year to the end of the income year;
148
• A group must not begin to control the trust before the end of the income year.
and
149
If these tests are not passed, the trust must calculate its taxable income and tax loss for the
income year as described in section 267-60 of Schedule 2F of the ITAA 1936.
150
The trust may still be able to deduct part of the loss.
151
7.8.1 50% stake test
The 50% stake test is the same as described in above.
7.8.2 Pattern of distributions test
The pattern of distributions test is set out in Subdivision 269-D.
145 Section 267-20 of Schedule 2F of the ITAA 1936 146 Section 267-30 of Schedule 2F of the ITAA 1936; see also ATO Interpretive Decision 2003/174 147 Section 267-35 of Schedule 2F of the ITAA 1936 148 Section 267-40 of Schedule 2F of the ITAA 1936 149 Section 267-45 of Schedule 2F of the ITAA 1936 151 Section 267-50 of Schedule 2F of the ITAA 1936 151 Section 267-50 of Schedule 2F of the ITAA 1936
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A trust passes the pattern of distributions test if:
• The trust distributed directly or indirectly to the same individuals, for their own benefit, a
greater than 50% share of all income distributed by the trust over a period commencing no
more than six years before the start of the income year; and
• The trust similarly distributed to the same individuals a greater than 50% share of all
capital distributed by the trust over a period commencing no more than six years before
the start of the income year,
where the persons receiving income and capital need not be the same. Expressed more
simply, the test is seeking to ensure that the majority of each distribution made by the trust in
the six year period was ultimately received by the same individuals (using this as a proxy for
majority ownership of a non-fixed trust).
If the share of income distributed to each individual varies from year to year, only the smallest
percentage distribution is taken into account.152
Example
Year 7 is the current income year. The loss year is Year 6. The trust made distributions of
income in Years 1, 2, 3, 4 and 7. It made no capital distributions. The income distributions
were made as follows:
Beneficiary % of income received
Year1 Year 2 Year 3 Year 4 Year 7
Jackie 30 60 20 50 10
Jerry 30 40 20 40 10
Mel 30 0 20 10 10
Bill 10 0 40 0 70
152 Section 269-70 of Schedule 2F of the ITAA 1936
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The end year is Year 7 plus two months (the current income year). The start year is Year 4,
being the year in which a distribution was made, closest to the loss year. The test year
distributions are accordingly as follows:
Beneficiary % of income received
Year 4 Year 7
Jackie 50 10
Jerry 40 10
Mel 10 10
Bill 0 70
To determine whether the pattern of distributions test has been passed, take into account, for
each beneficiary, only the lowest percentage distribution received — 10% each for Jackie, Jerry
and Mel, and 0% for Bill. As the final step, aggregate the minimum percentage distributions —
the aggregate, in this case, being 30%. On this basis, the trust fails the pattern of distributions
test, which calls for aggregated minimum percentage distributions to exceed 50%.
Note that as there were no capital distributions by the trust in Year 7, it was not possible to
apply the test to capital distributions.
7.8.3 Control
A group (comprising a person and her/his associates) is taken to control a non-fixed trust if,
directly or indirectly:153
• The group has power, by means of exercising a power of appointment or revocation or
otherwise, to obtain the beneficial enjoyment of the capital or income of the trust;
• The group is able to control the application of the income or capital of the trust;
153 Section 269-95 of Schedule 2F of the ITAA 1936
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• The group is capable of obtaining the beneficial enjoyment or control referred to above;
• The trustee is accustomed, under an obligation or might reasonably be expected to act in
accordance with the directions, instructions or wishes of the group;
• The group is able to remove the trustee; or
• The group acquires more than a 50% stake in the income or capital of the trust.
These concepts are very broad and, in most closely held trusts, there is some element of
control as defined above. So, the control test is looking to see whether such control changes
and is taken as a proxy for a change of ownership.
7.8.4 Income injection test
7.8.4.1 Introduction
Family trusts broadly have no restrictions on their ability to use losses. Excepted trusts (which
include family trusts) also have no restrictions on their use of losses.
However, an anti-avoidance test (the income injection test) in Division 270 applies to family
trusts to prevent income being injected into a trust in order to enable deductions to be claimed
as a means of obtaining a tax benefit, but not to other excepted trusts. The test also applies to
all other types of trusts.
7.8.4.2 Elements of the test
Broadly speaking, the income injection test will apply where an “outsider” to the trust that has
losses seeks to take advantage of the losses by providing a benefit to the trust (the injection of
income) in exchange for which the outsider receives a benefit (the generation of a deduction).
The income injection test does not apply to income injection schemes that take place wholly
within a family group. It also does not apply to complying superannuation funds, complying
approved deposit funds, pooled superannuation trusts, fixed unit trusts where all direct or
indirect unit holders are exempt from income tax, and deceased estates within a reasonable
administration period.
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There are a number of elements that need to be met before the test applies. These are
explained below.
7.8.4.3 The trust must have an allowable deduction
The first element is that the trust must have an allowable deduction in the income year being
examined. This can include a deduction for a prior-year loss as well as current-year
deductions.154
7.8.4.4 There must be a scheme
For the test to apply, there also has to be a scheme under which the things set out below
happen.155
• The trust must derive assessable income in the income year (the “scheme assessable
income”).
• A person not relevantly connected with the trust (the outsider) must directly or indirectly
provide a benefit to the trustee or a beneficiary (or their associates).
• The trustee or a beneficiary (or associates) must directly or indirectly provide a benefit to
the outsider or an associate of the outsider. However, if the test is being applied to a
family trust and this return benefit is being provided only to an associate who is not an
outsider to the trust, this element will not be satisfied.
154 Paragraph 270-10(1)(a) of Schedule 2F of the ITAA 1936 155 Paragraph 270-10(1)(b) of Schedule 2F of the ITAA 1936
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7.8.4.5 There must be a connection between the deduction and one or more of the things that happen under the scheme
The final element is that it must be reasonable to conclude that any one or more of the following
has happened under the scheme:156
• The scheme’s assessable income has been derived wholly or partly, but not merely
incidentally, because the deduction is allowable;
• The benefit has been provided to the trustee or beneficiary (or their associates) wholly or
partly, but not merely incidentally, because the deduction is allowable; or
• The benefit has been provided by the trustee or a beneficiary (or associate) wholly or
partly, but not merely incidentally, because the deduction is allowable.
Whether a benefit has been provided merely incidentally because a deduction is allowable to
the trust depends on the particular facts and circumstances surrounding the scheme entered in
to. Many of the terms used above are similar to the phrases used in the general anti-avoidance
rules in Part IVA of the ITAA 1936 and would have the same meanings as in those rules.
7.8.4.6 Examples
The following example is drawn from the ATO’s website on the application of the income
injection test. The ATO provides other examples, which readers may refer to for further
elaboration.
156 Paragraph 270-10(1)(c) of Schedule 2F of the ITAA 1936
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Example
The Farmer Family Discretionary Trust No. 1 was established to undertake a sheep grazing
business with the primary purpose of selling wool. The trustee is Mr Merino Farmer and the
beneficiaries include himself, his wife, their children and grandchildren. Other beneficiaries
include any other entities that may provide benefits from time to time to these persons.
The No. 1 Trust (income trust) has a history of profitable operations.
Merino's eldest son Zenith wants to expand the business by becoming a manufacturer of
woollen clothes. However, the business venture carries some potential risks and high start-up
costs in the early years. As a result of the potential risks and the expected losses in the early
years from the high start-up costs, it was decided to establish a separate trust (The Farmer
Discretionary Trust No. 2) to undertake the manufacturing business. The beneficiaries of this
trust include the same beneficiaries of the No. 1 Trust, as well as the No. 1 Trust.
The No. 2 Trust (loss trust) incurs losses in its first year of trading. During the same year, the
No. 1 Trust (income trust) derived assessable income leaving it with sufficient taxable income to
cover the losses of the No. 2 Trust.
Losses cannot be distributed from the No. 2 Trust to the No. 1 Trust. However, since the No. 2
Trust is a beneficiary of the No. 1 Trust, distributions of income from the No. 1 Trust can be
made to the No. 2 Trust to absorb losses it incurs.
Will the distribution be treated as an injection of income into the No. 2 Trust and, therefore, fail
the income injection test?
The first element is satisfied since a deduction is available to the No. 2 Trust for the income
year.
For the second element to be satisfied, there must be a scheme under which the following
happen:
• The loss trust must derive an amount of assessable income. The No. 2 Trust has derived
an amount of assessable income by way of the distribution it received from the No. 1
Trust;
• An outsider to the loss trust must provide, directly or indirectly, a benefit to the trust. The
No. 1 Trust is an outsider to the No. 2 trust as per the definition in subsection 270-25(2)
and has provided a benefit by way of an allocation of a distribution to the No. 2 Trust; and
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• The loss trust must provide a benefit, directly or indirectly, to the outsider or to an
associate of the outsider. If the allocation of the net income from the No. 1 Trust to the
No. 2 Trust is used by the No. 2 Trust to fund a distribution to its beneficiaries, this
element will be satisfied. That is, a benefit has been provided to associates of the No. 1
Trust (same beneficiaries) by way of a tax-free (tax-preferred) distribution. (See also
paragraph 10.31 of the Explanatory Memorandum.)
If the distribution from the No.1 Trust was not used to make a distribution to the beneficiaries of
the No. 2 Trust, but instead was accumulated, the income injection test would not apply since
no benefit would have been given to an outsider, or associate of the outsider. However, if a
benefit did subsequently flow out of the No. 2 Trust under the same scheme, the income
injection test may apply. There is no time limit on the benefits flowing to the outsider.
If the beneficiary had a fixed entitlement in the loss trust and the net income distribution it
received was accumulated in the trust, there could be said to be a benefit provided to those
beneficiaries because of the increase in value of the beneficiaries’ interest in the trust – see
paragraph 10.32 of chapter 10 of the Explanatory Memorandum of Schedule 2F to the ITAA
1936 - Taxation Laws Amendment (Trust Loss and other Deductions) Act 1998.
The third element is whether it is reasonable to conclude that the No. 1 Trust distributed to the
No. 2 Trust, wholly or partly, but not merely incidentally because the No. 2 Trust had losses and
they would be deductible against the income distribution. This reasonable conclusion will
ultimately depend on the particular facts and circumstances of each individual case.
If, for example, distributions made to the No. 2 Trust are sufficient only to absorb losses
incurred by it, before any consideration is given to making distributions to any of the other
beneficiaries of the No. 1 Trust, (so that effectively it is a means of distributing the income of the
No. 1 Trust to its beneficiaries in a tax-free form by passing that income through the No. 2
Trust), it would be reasonable to conclude the distribution was made because a deduction was
available. Therefore, the No. 2 Trust would fail the income injection test.
If they fail the income injection test, the scheme’s assessable income is fully assessable to the
No. 2 Trust, but its losses will still be available to be carried forward to be offset against income
it may derive in a later year.
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8. Restricting tax deductions for related party debt
In the 2011-2012 Budget, the Federal Government announced that it would amend the current
income tax treatment in relation to bad debts which are written off between related parties
outside of a consolidated group.
The announcements followed a number of high profile decisions of the Full Federal Court which
allowed significant revenue deductions for inter-company related party debts written off as
bad.157
As a consequence of the announcements, the Treasury released a discussion paper entitled,
Improving the tax treatment of bad debts in related party financing, on 16 July 2012, which
detailed the Federal Government’s proposed amendments and called for feedback from
interested stakeholders. The discussion paper highlighted the asymmetry that exists where a
related party debt is written off as bad and the creditor obtains a revenue deduction in respect of
the write off. In this regard, the discussion paper noted that, whilst the creditor may obtain a
revenue deduction for the write-off, no amount is generally included in the debtor’s assessable
income. Rather, the commercial debt forgiveness rules in Division 245 ordinarily apply to reduce
the debtor’s tax attributes in accordance with Subdivision 245-E.
The proposed amendments are designed to redress this perceived asymmetry.
8.1 Current Law
In order to appreciate the impact of the proposed amendments, it is first necessary to examine
the current position in relation to obtaining revenue deductions for writing off a debt as bad. In
this regard, the current position differs depending on whether the debt is subject to Australia’s
Taxation of Financial Arrangements (TOFA) regime.
157 See Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49; Commissioner of Taxation v BHP Billiton Finance Limited [2010] FCAFC 25
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8.1.1 Debts which are outside of the TOFA regime
Outside of the TOFA regime, a creditor may currently obtain a revenue deduction in respect of
the write-off of a related party debt under section 25-35 or section 8-1.
Relevantly, a revenue deduction should be available under section 25-35 for a debt that is
written off as bad where either:
• The creditor has included an amount in its assessable income in respect of the debt;
and/or
• The debt is in respect of money that the creditor lent in the ordinary course of its business
of lending money.
A revenue deduction may also be available under section 8-1 to the extent that any loss arising
on the write-off of the debt was incurred in gaining or producing the creditor’s assessable
income, or was necessarily incurred by the creditor in carrying on a business for the purpose of
gaining or producing assessable income. This will be the case unless the loss is considered
capital or capital in nature.
Practically, the existence of the above sections means that a creditor who is engaged in the
ordinary business of providing loans or financial accommodation may be entitled to a revenue
deduction in respect of debts that are written off as bad (whether or not those debts are with
related parties). This was highlighted in the case of Commissioner of Taxation v BHP Billiton
Finance Limited [2010] FCAFC 25, where Edmonds J (with whom the other members of the
Federal Court concurred) allowed revenue deductions in respect of loans that had been
advanced by a dedicated in-house finance vehicle to a number of related parties in order to
facilitate the acquisition of depreciating assets.
Note
The Commissioner sets out his general views in relation to revenue deductions for bad debts in
Taxation Ruling TR 92/18 (TR 92/18). Relevantly, the Commissioner notes that a debt may be
written off as bad where, on an objective view of the facts, or on the probabilities existing at the
time the debt is alleged to have become bad, there is little or no likelihood of the debt being
recovered.
TR 92/18 also provides guidance as to the circumstances in which a debt may be considered to
arise in the ordinary course of a taxpayer’s business of money-lending. In this regard, the ruling
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states that a taxpayer will be considered to carry on a business of money-lending where the
taxpayer lends money to certain classes of borrowers and does so in a businesslike manner
with a view to yielding a profit from its lending activities. Importantly, TR 92/18 indicates that it is
not necessary for a taxpayer to be ready and willing to lend to the public at large in order to be
treated as a money-lender.
However, it also appears that lending activities which are merely incidental or ancillary to some
other principal enterprise carried on by the taxpayer will not be sufficient to characterise the
taxpayer as a money-lender.
8.1.2 Debts which fall within the TOFA regime
Certain taxpayers may be subject to Australia’s TOFA regime in relation to some or all of their
financial arrangements (including related party debts). Where the TOFA regime applies, gains
and losses on financial arrangements are generally taxed exclusively under that regime.158
In the context of deductions for bad debts owing by related parties, the TOFA regime generally
preserves the requirements in section 25-35. Accordingly, in circumstances where such debts
are written off as bad by the creditor, a deduction should only be available under the TOFA
regime to the extent that:
• The amount which is written off was previously included in the creditor’s assessable
income; and/or
• The relevant debt was made in the ordinary course of the creditor’s business of money-
lending.
Notwithstanding the above, if the creditor elects to apply the fair value method under the TOFA
regime, a deduction may be allowed for losses incurred in restating related party bad debts to
their fair market value (or otherwise impairing such debts) in accordance with an applicable
accounting framework. The availability of this deduction is not affected by similar requirements
to those contained in section 25-35.
158 Section 230-15
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For completeness, where the debtor is subject to the TOFA regime in respect of the relevant
debt, any gain arising to the debtor on forgiveness of the debt under the TOFA regime will
generally be reduced by the net forgiven amount picked up under Division 245.159
8.2 Impact of the proposed amendments
That is,
Division 245 effectively takes precedence over the TOFA regime.
Under the proposed amendments, a creditor will be denied a tax deduction on revenue account
for writing off a debt as bad where:
• The borrower is a related party of the creditor and is not a member of the same tax
consolidated group; and
• The amount that gives rise to the bad debt has not previously been included in the
creditor’s assessable income.
If the above requirements are satisfied, the deduction will be denied, irrespective of whether it is
being claimed under section 8-1, section 25-35 or the TOFA regime. Deductions for losses
relating to the impairment of bad debts under the fair value method will also be denied where
the borrower is a related party and the amount that is impaired has not previously been included
in the creditor’s assessable income.
Where an amount of a deduction is denied, a capital loss will be available to the creditor in
respect of the bad debt. The creditor will be able to offset this loss against capital (but not
revenue) gains derived by the creditor.
Additionally, the debtor will not be required to recognise any amount of assessable income if the
bad debt is subsequently forgiven by the creditor. In this regard, it is proposed to amend the
commercial debt forgiveness provisions in Division 245 such that these provisions will apply in
lieu of any provision which would otherwise include an amount in the debtor’s assessable
income on forgiveness of the debt. The only exception to this will be for cases where
adjustments to the debtor’s taxable income are required under Division 243 (which deals with
limited recourse debts that are used to fund depreciating assets).
159 Section 230-470
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8.2.1 What is a related party?
As discussed above, the proposed amendments will only apply to deductions for bad debts in
respect of loans with a related party. For these purposes, it is proposed to insert a definition of
related party which includes:
• An associate (as defined in section 318 of the ITAA 1936); and
• An associate entity (as defined in section 820-905).
Specifically, the definition of related party is intended to ensure that the proposed amendments
will apply to debts arising in the context of the following relationships:
• The creditor is a partner of the debtor;
• One party, whether the creditor or the debtor (together with that party’s affiliates) is able to
sufficiently influence, directly or indirectly, the affairs of the other party; or is entitled to
acquire a majority voting interest in the other party; and
• An entity (together with its affiliates) is able to sufficiently influence the affairs of both the
creditor and debtor; or is entitled to acquire a majority voting interest in the creditor and
debtor.
The principle of this approach is to exclude immaterial relationships (for example, where a
person has a very insignificant shareholding) from the scope of the proposed amendments but
include situations where a party has significant ownership and control over another party.
Note
In its submission on the proposed amendments, the Institute argued (amongst other things) that
the related party test applicable under the proposed amendments is too broad. In this regard, it
was argued that a test based on majority voting interest sets too low a threshold for application
of the rules, and the concept of sufficient influence could inappropriately treat lenders as related
parties merely because of influence they hold in that capacity.
Consequently, the Institute advocated for the proposed amendments to apply only in
circumstances where the creditor and the debtor are 100% common owned. Alternatively, in the
event 100% common ownership is considered to be prohibitive, the Institute suggested the
related party test could be limited such that it would only apply where significant common
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ownership exists between the creditor and debtor. Significant common ownership implies an
ownership interest of at least 80% (as under the scrip for scrip rules in Subdivision 124-M).
The detailed submissions made by the Institute in relation to this and other aspects of the
proposed amendments are available via the following link:
http://www.charteredaccountants.com.au/Industry-Topics/Tax/Exposure-drafts-and-
submissions/Submissions/Treasury/140812-Submission-on-improving-the-tax-treatment-of-bad-
debts-in-related-party-financing.aspx
8.2.2 Application date
As announced, the proposed amendments are intended to have effect for related party debts
which are written off as bad from 7.30 pm (AEST) on 8 May 2012.
Example
Fin Co is a company incorporated in Australia. Fin Co’s principal business involves the provision
of loans to external and related party debtors on interest-bearing terms.
Fin Co has not chosen to form a tax consolidated group for Australian income tax purposes but
has a number of wholly-owned Australian subsidiaries which conduct money lending activities in
continental Europe via their foreign branches. Fin Co has funded one of these subsidiaries,
Liberty Co, with an interest-bearing loan of $10 million. Interest accrues annually in respect of
the loan and is calculated at an arm’s length interest rate. Since the provision of the loan by Fin
Co, accrued interest of $1,600,000 has been included in Fin Co’s assessable income in relation
to the loan.
During the 2013 Tax Year, Fin Co determined that the loan (and the amounts of accrued
interest) would not be recoverable due to the significant downturn in the European lending
market. Accordingly, Fin Co decided to write off the loan principal and accrued interest
components as bad debts (in compliance with the approach set out in TR 92/18). Fin Co
subsequently sought to claim revenue deductions under section 25-35 in relation to the write-
offs.
Given that the write-offs occurred post 8 May 2012, the proposed amendments should apply to
the write-offs. Consequently, Fin Co should only be entitled to a revenue deduction in respect of
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the write-off of the accrued interest component (on the basis that this component has previously
been assessed to Fin Co). Any revenue deduction arising in respect of the write off of the loan
principal would be denied under the proposed amendments as the loan is between related
parties that are not members of the same tax consolidated group and the amount of the loan
principal has not otherwise been included in Fin Co’s assessable income.
However, pursuant to the proposed amendments, Fin Co should still be entitled to claim a
capital loss in respect of the write-off of the loan principal component. Furthermore, no amount
should be included in Liberty Co’s assessable income where the loan is subsequently forgiven
by Fin Co. Rather, the commercial debt forgiveness regime under Division 245 should apply to
reduce the Australian tax attributes of Liberty Co by reference to the value of the debt forgiven.
This should be the case, irrespective of the fact that Liberty Co is itself engaged in the business
of lending money and may ordinarily be regarded as deriving a revenue gain in connection with
the forgiveness of the loan.160
160 See for example the discussion in Federal Commissioner of Taxation v Unilever Australia Securities Ltd 95 ATC 4117