House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 7 - Determining whether a transferred loss can be used by a consolidated group

Outline of chapter

7.1 This chapter explains rules that will apply in determining whether a transferred loss can be used by a head company (i.e. whether it can be deducted or applied by the head company or transferred to another group). The rules are in the form of modifications to the general loss recoupment tests for companies. The rules are contained in Subdivision 707-B.

7.2 The rules that limit the amount of a transferred loss that can be deducted or applied are discussed in Chapter 8.

Context of reform

7.3 Losses transferred to a group are taken to have been made by the head company of the group for the income year in which the transfer occurred (see paragraphs 6.98 to 6.101). This allows the head company to use those losses. That process effectively erases pre-consolidation ownership changes in the original loss entity. In the absence of any further rules, all transferred losses would be refreshed in the hands of the head company.

7.4 That outcome is inappropriate where the original loss entity is a company and the loss is transferred because the COT is passed. It would allow a faster or greater use of losses than would occur outside consolidation and would therefore place loss companies that consolidate at a considerable advantage over non-consolidated companies.

7.5 Therefore, in these cases, pre-consolidation changes in ownership of a loss company continue to count in determining whether the COT is passed in respect of the loss post-consolidation. This will preserve the effect of sections 165-165 and 166-170 of the ITAA 1997 which provide that the only shares and interests to be counted in determining whether a company has passed the COT are exactly the same shares and interests held by the same persons.

7.6 However, in other situations, things that happen before a loss is transferred to a head company are ignored in determining whether the head company can use the loss.

Summary of new law

7.7 In determining whether a head company has passed the COT in respect of a COT loss transferred to it by another company, pre-consolidation ownership changes in the company that actually made the loss are relevant (though intra-group changes post-consolidation are not). The pre-consolidation changes are measured from the start of the actual loss year. [Schedule 1, item 2, section 707-210]

7.8 Essentially in this case the COT is applied to the company that actually made the loss (called the test company ), but on the assumption that intra-group changes in the ownership of the test company post-consolidation are ignored. Passage or failure of the COT by the test company is then attributed to the head company for the purpose of proceeding to work out whether the head company can use the loss.

7.9 But in all other cases, the loss recoupment tests are applied directly to the head company in determining whether the head company can use a transferred loss. For the purpose of applying recoupment tests directly to the head company, the loss year is taken to start at the loss transfer time. This ensures that things that happened to the head company before the loss was transferred to it (and which may have already been taken into account in transfer testing the loss) are not taken into account again in determining whether the head company can use the loss. [Schedule 1, item 2, section 707-205]

7.10 This modifies the rule that a loss transferred to a head company is taken to be made by the head company for the income year in which the transfer occurred. That is, where the transfer occurs part way through the head companys income year, the loss year is taken to start at the transfer time instead of at the beginning of the transfer year.

Detailed explanation of new law

The ownership history of a company COT loss is preserved

7.11 Broadly the rule (as described in paragraph 7.12) ensures that in determining whether COT losses can be used by a head company, pre-consolidation changes in the original loss company are recognised (including those that led to it joining the group). However, the only post-consolidation changes that are relevant are those that occur to the head company (i.e. intra-group changes are ignored).

7.12 The rule applies to a loss transferred to a head company by another company because the ownership test in section 165-12 of the ITAA 1997 (i.e. the COT) was passed in respect of the loss at the transfer time. In determining whether the head company can use the loss, the head company is taken to have passed the COT only if the test company would have passed the COT assuming:

•

the test company could have used the loss; and

•

there are no changes in the groups interests in the test company after it joined the group.

[Schedule 1, item 2, subsections 707-210(1) and (2)]

7.13 The test company is generally the first company to have made the loss. That is, the company that actually made the loss or a head company that is taken to have made the loss because it was transferred to it by the trust that actually made it. The test company concept is discussed further in paragraphs 7.26 to 7.31.

7.14 Therefore, the head company passes the COT if the test company would have passed on the basis of the assumptions. This involves applying the COT rules applicable to the test company. A failure of the COT by the test company is attributed to the head company. This enables the head company to apply the relevant SBT to determine whether it can use the loss. The control test (discussed in paragraph 6.50) is also applied to the head company (and not the test company). [Schedule 1, item 2, subsections 707-210(5) and (6)]

Which losses does the rule apply to?

7.15 The rule applies to losses transferred because the COT was passed (COT losses). The rule does not apply to a head company if the loss was transferred to it because an SBT was passed (SBT losses). This is consistent with the fact that ownership changes in the transferor company have already been considered in determining that the SBT had to be met in order to transfer the loss. Therefore, SBT losses are effectively refreshed in the hands of the transferee (head company). [Schedule 1, item 2, subsection 707-210(1)]

7.16 Also, the rule does not apply if both the section 165-12 ownership test and the SBT in subsections 165-15(2) and (3) are passed. This is the SBT that applies if the control test is failed. If the control SBT is passed then the loss is more properly categorised as an SBT loss because in the end an SBT was the reason the loss was transferred, even though the ownership test was also passed. [Schedule 1, item 2, paragraph 707-210(1)(b)]

7.17 Passage of the additional transfer SBT is discussed in paragraphs 6.75 to 6.84 and has no bearing on the application of the rule.

7.18 The rule only applies to a head company if the COT loss was transferred to it by another company . It does not apply if the loss was transferred to it by a trust. Changes in the ownership of a trust prior to it joining a consolidated group are not taken into account in determining whether the trusts losses can be used by the group (but are relevant in determining whether the trusts losses can be transferred to the group). Only changes in the head company of the group after the transfer time are relevant.

The first assumption

7.19 The first assumption, as it applies to a test company that is a subsidiary member, turns off the rule that the transferred loss is now taken to have been made by the head company. This reinstates the loss as having been made by the test company for the income year in which it was actually made (though only for the purpose of this rule). [Schedule 1, item 2, paragraph 707-210(4)(a)]

7.20 Where the test company and the head company are the same entity the assumption simply reinstates the original loss year. [Schedule 1, item 2, paragraph 707-210(4)(b)]

The second assumption

7.21 The second assumption is that, anything that happens after the transfer time to membership interests or voting power in an entity that was a subsidiary of the group at the transfer time, and that would be relevant in determining whether the test company passed the COT, is taken not to have happened. [Schedule 1, item 2, paragraph 707-210(4)(c)]

7.22 Essentially the assumption freezes the ownership structure of the group as at the transfer time. It ensures that, consistent with the single entity rule, intra-group ownership changes (and changes in voting power) are ignored in determining whether the loss can be used by the group. It effectively ignores changes to membership interests in subsidiary members that exist at the transfer time and to new membership interests in subsidiary members issued after that time.

7.23 This assumption works because at the joining time the head company must generally hold, directly or indirectly, 100% of the membership interests in the test company. By assuming there is no change in that holding post-consolidation, any changes in the ownership of the head company can be taken to be changes, in the same percentage, to the test company. This equates to only testing changes above the head company level and ignoring those below.

7.24 The second assumption will also ignore a test companys exit from the group. This ensures that the head company can use the loss even if the test company has left the group. Also, any ownership changes leading to that exit would not be counted in determining whether the head company could use the loss. This is consistent with the general consolidation model which provides that tax attributes transferred to the group at the joining time remain with the group (for use by the group) even if the entity that transferred those attributes leaves the group.

7.25 If the losses are transferred on a second or subsequent occasion, there is an additional assumption. It is that, anything that happened, after the transfer to the new head company, to membership interests or voting power in the old head company that would be relevant in determining whether the test company passed the COT, is taken not to have happened. This additional assumption essentially freezes the ownership structure of the new group after the transfer. It applies as many times as the losses are transferred. [Schedule 1, item 2, paragraph 707-210(4)(d)]

The test company

7.26 The test company is the company to which the COT is applied in determining whether the head company can use the loss. The test company is the first company to have made the loss. That is:

•

the company that actually made the loss; or

•

an earlier head company that was taken to have made the loss because the loss was transferred to that earlier head company by the trust that actually made it.

[Schedule 1, item 2, subsections 707-210(1) and (3)]

7.27 Therefore, if the loss was originally made by a trust, the test company is the head company to which the loss was first transferred.

7.28 However, if the loss was transferred by a company as an SBT loss, the transferor company is not the test company. Instead, the transferee (head) company is the test company.

7.29 If the loss is transferred on more than one occasion as an SBT loss, then the test company is the last of the companies to which the loss has been so transferred. [Schedule 1, item 2, subsection 707-210(3)]

7.30 So the test company may be a company that was previously a head company (an earlier head company) to which the loss was transferred. If the loss was transferred to such a test company part way through the test companys income year, then for the purpose of applying the COT to the test company, the test companys loss year is taken to have started at the transfer time. This ensures that things that happened to a test company before the loss was transferred to it are not taken into account. It matches the rule that applies in some cases to a head company when recoupment tests are applied to the head company (see paragraphs 7.39 to 7.42). [Schedule 1, item 2, subsection 707-210(7)]

Examples identifying the test company

7.31 Examples 7.1 to 7.4 explain how to identify the test company where a loss passes through a chain of loss owners because it is transferred on more than one occasion. Assume in each example that the loss has been transferred to each new head company as a COT loss, unless it is specifically stated that the loss was transferred as an SBT loss.

Example 7.1

H co 1 and H co 2 only pass the COT if the test company (i.e. the initial loss-maker) would have passed it on the basis of the assumptions referred to in paragraph 7.26.

Example 7.2

The rule does not apply to H co 1 (because the loss was transferred to it as an SBT loss). H co 2 only passes the COT if H co 1 would have passed it on the basis of the assumptions referred to in paragraph 7.26.

Example 7.3

The rule does not apply to H co 1 (because the loss was transferred to it by a trust). H co 2 only passes the COT if H co 1 would have passed it on the basis of the assumptions referred to in paragraph 7.26.

Example 7.4

H co 1 and 2 only pass the COT if the first test company (i.e. the initial loss-maker) would have passed it on the basis of the assumptions referred to in paragraph 7.26.

H co 4 only passes the COT if the second test company (H co 3) would have passed it on the basis of the assumptions referred to in paragraph 7.26.

A test companys COT failure is attributed to the head company

7.32 If, as a result of applying the rule, the test company would have failed the COT, then the head company is taken to fail the COT.

7.33 The time at which the head company is taken to fail the COT is relevant in applying the SBT to the head company. The time is determined by reference to the time the COT would have been failed by the test company. That time depends on whether the test company is an ordinary company to which Division 165 applied or a listed public company (or 100% subsidiary) to which Division 166 applied.

7.34 The head company is taken to have failed the COT at the time the test company would have failed if Division 165 applied to the test company. The head company is taken to have failed the COT just before the end of the test companys test time that triggered the failure if Division 166 applied. The test time will have been the time of abnormal trading in the test company or the end of the test companys income year. [Schedule 1, item 2, subsection 707-210(5)]

7.35 Regardless of whether Division 165 or 166 has applied to the test company, a further link rule is needed to ensure that the SBT can be applied if Division 166 applies to the head company. The link rule deems the time described in paragraph 7.34 to be the head companys test time for the purpose of applying the SBT in subsection 166-5(5). [Schedule 1, item 2, subsection 707-210(6)]

Interaction with the modified SBT

7.36 If the head company is applying the rule to determine whether it can transfer the loss to a new group, then the rules that determine timing of a COT failure must interact correctly with the modified SBT that applies on transfer (see paragraphs 6.52 to 6.74).

7.37 First, the timing of the head companys COT failure will be plugged into the modified SBT. This means the head company may be required to test its business for the whole of the income year in which it is taken to have failed the COT. [Schedule 1, item 2, subparagraph 707-125(4)(a)(ii) and subsection 707-125(5)]

7.38 Second, the modification to subsection 166-5(5) discussed in paragraph 7.35 will have no application to the modified SBT which makes its own (and different) modifications to the SBT test time for listed public companies. [Schedule 1, item 2, subsection 707-125(6)]

Example 7.5

The loss year is the income year starting on 1 July 2001 and ending on 30 June 2002. For the purpose of this example, assume that all shares carry equal voting, and dividend and capital distribution rights.

As per the diagram, Head Co initially holds 80% of Loss Co. On 30 June 2002, Head Co acquires X Cos 20% interest in Loss Co. Head Co then chooses to form a consolidated group (comprising Head Co, Loss Co and Z Co) from 1 July 2002.

Transferring the loss to Head Co

On consolidation, Loss Cos loss is tested to determine whether it is transferred to Head Co. (The rule that preserves the history of a COT loss does not apply to the initial transfer of a loss so is not relevant at this point.)

Assuming Head Cos acquisition of the final 20% of Loss Co was the only change in the ultimate beneficial ownership of Loss Co since the start of the loss year, the loss is transferred to Head Co as a COT loss.

Head Co seeks to use the loss for the 2003-2004 income year

In determining whether Head Co can use the loss, the rule that preserves the ownership history of a COT loss applies. Head Co can use the loss if Loss Co could have used it assuming there were no changes in Head Cos interest in Loss Co after Loss Co joined the group.

Between the time the group was formed (1 July 2002) and the end of the loss claim year (30 June 2004) Head Co disposed of Loss Co and, as a result, Loss Co has left the group. This is irrelevant in determining whether Head Co can use the loss, because intra-group ownership changes after the loss was transferred are ignored. However , after the group formed, A sold 40% of its interest in Head Co to B. By itself, this sale would not cause Head Co to fail the COT. But because the rule requires examination of Loss Cos ability to claim the loss, the 20% change that occurred prior to consolidation (when Head Co acquired X Cos 20% interest in Loss Co) is also relevant.

When the pre-consolidation changes in Loss Co are taken into account, together with the post-consolidation changes in Head Co, it can be seen that only 48% of Loss Cos ultimate beneficial ownership has continued from the start of the loss year until the end of the loss claim year. This means that Head Co fails the COT and so can only deduct the loss if it passes the SBT.

Loss Cos ultimate shareholders - 30 June 2004

Shareholder	Shareholdings that can be counted to pass the COT	Percentage held
A	(10% * 80%)	8%
B	(50% * 80%)	40%
Total		48%

Modification of the loss year for a transferred loss

7.39 This modification applies in situations where the loss recoupment tests are being applied directly to a head company. Broadly, only things that happen to the head company after a loss has been transferred to it are relevant in determining whether the company can use that loss.

7.40 The head company to which a loss is transferred is taken to have made the loss for the income year in which the transfer occurs [Schedule 1, item 2, subsection 707-140(1)] . However, if the transfer occurs part way through the head companys income year, then the loss year is modified so that it starts at the transfer time [Schedule 1, item 2, section 707-205] .

7.41 Essentially this means that the ownership test period starts at the transfer time (i.e. changes in the ownership or control of the head company before that time are not relevant in determining whether the loss can be used).

7.42 Examples of situations where this rule will be relevant are:

•

an SBT loss is transferred to a head company part way through the head companys income year:

-

in determining whether the head company can use the loss, the ownership test period for the purpose of applying the COT starts at the loss transfer time;

•

a loss is transferred by a trust to a head company part way through the head companys income year:

-

in determining whether the head company can use the loss, the ownership test period for the purpose of applying the COT starts at the loss transfer time;

•

a head company is taken to have failed the COT because the test company failed as a result of applying the rule discussed in paragraphs 7.11 to 7.38.

-

in determining whether the head company passes the SBT it must, under subsection 165-13(2) of the ITAA 1997, identify a continuity period which starts at the loss transfer time;

•

a head company passes the COT because the test company passes as a result of applying the rule discussed in paragraphs 7.11 to 7.38:

-

in determining whether the head company also passes the control test in section 165-15 of the ITAA 1997, the loss year starts at the transfer time.

Application and transitional provisions

7.43 The consolidation regime will apply from 1 July 2002.