Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)CHANGE OF TITLE - TAX LAW IMPROVEMENT BILL (No. 1) 1998 - SENATE - Explanatory Memorandum.
Chapter 3 - Company bad debts
Overview
This chapter covers:
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- the rewritten provisions in Subdivisions 165-C (income tax consequences of changing ownership or control of a company - deducting bad debts) and 175-C (tax benefits from bad debt deductions); and
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- the new provisions in Subdivision 166-C (income tax consequences of changing ownership or control of a listed public company - deducting bad debts).
Part A summarises these rules.
Part B explains the changes to the 1936 Act.
Part C explains the transitional provisions which set out how, and when, the new provisions apply.
Part D explains amendments that need to be made to the 1997 Act, the 1936 Act and other Commonwealth Acts as a consequence of the rewriting of the 1936 Act.
A. Summary of the new law
The 1936 Act had similar rules for companies deducting prior year and current year losses and bad debts. The 1997 Act brings these rules together in Divisions 165 (Income tax consequences of changing ownership or control of a company) and Division 175 (Use of a companys tax losses or deductions to avoid income tax). In addition to bringing the similar rules for losses and bad debts together, the rewritten law also standardises them.
Division 166 of the 1997 Act contains simplified rules for tracing beneficial ownership of shares in listed public companies. These rules require continuity of ownership requirements to be met when deducting losses and bad debts. This Bill will apply these provisions when proving ownership for the purpose of deducting bad debts.
Subdivision 165-C: Income tax consequences of changing ownership or control of a company - deducting bad debts
A company cannot deduct a bad debt unless the company retains the same majority ownership and control:
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- if the debt was incurred in an earlier year - from the time the debt was incurred until the end of that year and throughout the year in which it is deducted; or
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- if the debt was incurred in the year in which it is deducted - throughout that year;
or the company continues to carry on the same business.
Does a company have the same majority ownership?
Ownership is measured by:
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- voting power;
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- rights to dividends; and
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- rights to capital distributions.
To determine majority ownership:
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- apply the primary test ; or
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- if at least one company is a beneficial owner of shares in the company, apply the alternative test .
There are persons who, between them at all times during the relevant periods, beneficially owned shares that carry rights to more than 50% of ownership rights in the company.
After tracing through interposed entities, it is reasonable to assume, there are individuals who between them at all times during the relevant periods:
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- are able to control the voting power in the company;
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- would receive more than 50% of any dividend paid by the company; and
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- would receive more than 50% of any distribution of capital by the company.
Has the company continued to carry on the same business?
If majority ownership has changed or there is a change of control, the company must:
if the debt was incurred in an earlier year - carry on throughout the year in which it is deducted the same business as it did immediately before the change in majority ownership or control; or
if the debt was incurred in the year in which it is deducted - carry on throughout the remainder of that year the same kind of business as it did immediately before the change in majority ownership or control.
Has the company continued to carry on the same business?
If majority ownership has changed or there is a change of control, the company must:
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- if the debt was incurred in an earlier year - carry on throughout the year in which it is deducted the same business as it did immediately before the change in majority ownership or control; or
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- if the debt was incurred in the year in which it is deducted - carry on throughout the remainder of that year the same kind of business as it did immediately before the change in majority ownership or control.
Tax losses resulting from bad debts
If a company can deduct a bad debt written off after a change in majority ownership only because:
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- it carried on the same business; and
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- the company carried on the same business in order to secure the deduction;
the company cannot, in a subsequent year, deduct a tax loss or part of a tax loss caused by the bad debt unless it also satisfies the same business test in that subsequent year.
Company need not have the same majority ownership nor carry on the same business
Subject to a Commissioner's discretion, a company can deduct a bad debt without having the same majority ownership and without carrying on the same business. The Commissioner will exercise the discretion in favour of the company if he considers it would be unreasonable to deny a deduction, having regard to the persons who were beneficial owners of shares in the company when the debt became bad.
A debt incurred on the last day of the year
A company cannot deduct as bad in a year a debt that was incurred on the last day of that year.
Subdivision 166-C: Income tax consequences of changing ownership or control of a listed public company - deducting bad debts
A listed public company, or a wholly-owned subsidiary of a listed public company, is taken to have had the same majority ownership if it satisfies the test for substantial continuity of ownership in section 166-145 of the 1997 Act.
When does the company have to have substantial continuity of ownership?
In relation to a debt incurred in an earlier year, the company must have substantial continuity of ownership as between the day on which the debt was incurred or, if the company chooses, the commencement of the year in which the debt was incurred and:
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- each subsequent time of abnormal trading in shares in the company; and
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- the end of each subsequent year,
up to and including the year in which the debt is written off as bad.
In relation to a debt incurred and written off in the same year, the company must have substantial continuity of ownership as between the commencement of that year and:
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- each time of abnormal trading in shares in the company during the year; and
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- the end of the year.
What if the company does not have substantial continuity of ownership?
A company that fails the substantial continuity of ownership test will still be able to deduct a bad debt if it satisfies the same business test applied from immediately before it failed to satisfy substantial continuity of ownership.
Substantial continuity of ownership rules need not apply
If a company chooses that the substantial continuity of ownership rules not apply for a particular income year, the majority ownership rules will apply to that company for that year without modification.
Subdivision 175-C: Use of a company's tax losses or deductions to avoid income tax - tax benefits from unused bad debt deductions
The Commissioner can disallow some or all of a deduction for a bad debt if:
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- income or a capital gain is injected into the company because the bad debt is available (except where the continuing shareholders benefit to an extent that is fair and reasonable); or
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- someone other than the company would obtain a benefit in connection with a scheme entered into because a deduction was available for a bad debt (except a person who beneficially owns shares in the company and for whom the benefit is fair and reasonable).
Who are the continuing shareholders?
These are the majority beneficial owners of shares in the company throughout the two continuity periods.
The general rule does not apply if
The company fails to maintain majority ownership but satisfies the same business test.
B. Discussion of changes
Ways in which particular provisions relating to company bad debts have been altered are detailed in the discussion of changes following. In addition to other explanations specific to particular changes, the changes are part of the standardisation of the provisions for company bad debts and losses in the 1997 Act .
Subdivision 165-C Income tax consequences of changing ownership or control of a company - deducting bad debts
This Subdivision will set out the conditions a company must satisfy before it can deduct a bad debt.
Adopt the standardised tests that are already in the 1997 Act for determining whether a company has maintained the same majority ownership or continued to carry on the same business.
The tests have been standardised for current and prior year losses and now bad debts. This structural change does not affect the application of the tests and the outcomes for bad debts will be the same as under the 1936 Act.
Section 165-123 Company must maintain the same owners
This section sets out the conditions that must be satisfied for a company to be treated as having maintained the same majority ownership.
Require the company to maintain continuity of majority beneficial ownership throughout the period from the day on which the debt was incurred until the end of that year, as part of the requirements for deductibility of a debt incurred in an earlier income year.
The 1936 Act initially states a requirement that the company maintain continuity of majority beneficial ownership throughout the year in which the debt was incurred but then relaxes it to allow a deduction if, amongst other things, the company satisfies the Commissioner that it has maintained continuity of majority beneficial ownership from the day on which the debt was incurred until the end of that year.
Provide that when testing for beneficial ownership of a company the second, and alternative, test automatically applies where one or more companies beneficially own shares in the company claiming a deduction for a bad debt.
Under the 1936 Act, the alternative test only applies if:
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- the company requests the Commissioner to apply it; or
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- the Commissioner considers it reasonable to do so.
This is inconsistent with self-assessment.
Section 165-126 Alternatively, company must carry on same business
This section sets out when a company must satisfy the same business test.
Clarify precisely when a change of beneficial ownership has occurred that results in a company not maintaining majority ownership.
Broadly, the section requires a company to carry on the same business at all times during the period to when the bad debt is deducted as it did immediately before a change in beneficial ownership of its shares that results in it not maintaining the same majority ownership.
The 1936 Act does this but not as clearly.
Make clear that the new business or new transactions elements of the standardised same business test are triggered if a company derives assessable income from the business or transaction.
Under the 1936 Act, the new business test and the new transactions test refer to 'income'. This creates an uncertainty because that term could be taken to mean income according to ordinary concepts, both exempt and assessable. However, in the context of the same business test, having regard to its purpose, the only sensible meaning that can be given to the term is assessable income. This is the meaning given to the term as set out in the Taxation Ruling TR95/31.
Section 165-129 Same people must control the voting power, company must carry on same business
This section provides that a bad debt cannot be deducted if:
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- there is a change in control of the voting power in the company between the relevant periods; and
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- the reason for the change is to provide someone with a tax benefit.
The relevant periods are:
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- if the debt was incurred in an earlier year - from the day on which the debt was incurred until the end of that year and throughout the year in which it is deducted; or
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- if the debt was incurred in the year in which it is deducted - the whole of that year.
Provide that, even if there is a change in the voting power, the company can deduct the bad debt if it satisfies the same business test.
Under the 1936 Act, if there is a change in control of the voting power in the company, the same business test does not automatically apply.
However, such a change generally precedes, or is part of, a change of majority ownership. As the same business test already applies to this outcome, it should also apply where there is a change in control. This simplifies the law by having both cases subject to the same business test.
Subdivision 166-C Income tax consequences of changing ownership or control of a listed public company - deducting bad debts
Division 166 of the 1997 Act contains a set of rules that make it easier for listed public companies (and wholly-owned subsidiaries of listed public companies) to test for continuity of majority beneficial ownership. It already contains specific provisions to apply these rules for companies to establish their entitlement to deduct losses. Subdivision 166-C contains the specific provisions necessary to apply these rules for companies to establish their entitlement to deduct bad debts. Under the 1936 Act, these simplified rules do not apply in relation to the deduction of bad debts.
Provide that, if a listed public company satisfies the test for substantial continuity of majority ownership at the end of each year and at times of abnormal trading in its shares, it is taken to have satisfied the majority ownership requirements during the intervening periods.
To deduct a bad debt under the 1936 Act, a listed public company is required to satisfy the conditions for continuity of majority ownership right throughout prescribed periods.
Provide that the test for substantial continuity of majority ownership counts all registered shareholdings of less than 1% as being held by a single shareholder.
The existing test for continuity of majority ownership requires all shareholdings to be separately taken into account.
Provide that the test for substantial continuity of majority ownership does not require ownership of shares to be traced through a superannuation fund, an
approved deposit fund, a mutual affiliate company, a mutual insurance company, a trade union, a sporting club or a company that is prescribed in regulations.
The existing test for continuity of majority ownership requires that ownership be traced through all companies.
Subdivision 175-C Use of a companys tax losses or deductions to avoid income tax - tax benefits from unused bad debt deductions
This Subdivision contains anti-avoidance measures that allow the Commissioner to reverse the effect of schemes that bring together in the same company:
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- assessable income; and
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- a deduction for a bad debt that would not otherwise be used or would be used at a later time.
Collocate the anti-avoidance provisions for bad debts with the anti-avoidance provisions for losses.
This is a structural change to clearly identify anti-avoidance provisions which, in the 1936 Act, are not identified as such and are merged with the other loss and bad debt provisions.
Omit an anti-avoidance rule that denies a deduction for a bad debt if the operations of a company are managed or conducted without paying regard to the rights of the continuing shareholders.
The rule is very difficult to apply and little understood. The circumstances it is meant to cover are clearly indicative of either a change of ownership or control, which are dealt with by other provisions.
Section 175-85 First case: income injected into the company because of an available bad debt
This section authorises the Commissioner to disallow the deduction if assessable income is injected into the company because of the availability of a bad debt.
Clarify that it is assessable income that must be injected into the company for the deduction to be disallowed.
Under the 1936 Act, the income injection test refers to income being derived because of the availability of the bad debt. This creates uncertainty because the term could be taken to mean income according to ordinary concepts, including exempt income. However, in the context of these tests,
especially having regard to their purpose, the only sensible meaning that can be given to the term is assessable income.
The change makes the law certain in its application.
Section 175-90 Second case: someone else obtains a tax benefit because of bad debt deduction available to a company
This section authorises the Commissioner to disallow the deduction if a person other than the company would obtain a tax benefit in connection with a scheme about bad debts.
Give the term tax benefit , when used in this section, the same meaning as in Part IVA of the 1936 Act.
Under the 1936 Act, the company bad debt provisions have a specific meaning for the term benefit. This meaning is slightly different from that in Part IVA of that Actie. the general anti-avoidance provision.
Broadly, the 1936 Act bad debt provisions state that a person receives a benefit in relation to the application of the income tax law to the extent that the persons income tax liability is reduced because of the scheme.
Under Part IVA the main circumstances where a person obtains a tax benefit are:
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- an amount is not included in the persons assessable income and that amount would have been included, or might reasonably be expected to be included, but for the scheme; or
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- a deduction is allowable to the person and the whole or part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, but for the scheme.
The effect of adopting the Part IVA definition is to narrow the focus of the benefit to income not being assessed or deductions being allowed. Also, the concept of reasonable expectation is introduced.
The adoption of the Part IVA definition increases consistency in the income tax law. Taxpayers will no longer need to take account of slight variations to what is essentially a single concept.
The rewrite includes in the Dictionary (section 995-1 of the 1997 Act) definitions of first continuity period , minimum continuity period and second continuity period . [Schedule 9, items 58, 83 and 124] . These are concepts for defining the periods to be taken into account when testing for continuity of majority ownership and continuity of business.
C. Transitional arrangements
The rewritten bad debt rules for companies have effect for the 1998-99 and subsequent income years.
D. Consequential amendments
Amendment of the Income Tax Assessment Act 1997
The rewrite amends the 1997 Act to:
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- update references to provisions in the 1936 Act that have been rewritten in Subdivisions 165-C, 166-C and 175-C; and
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- insert definitions in the Dictionary in section 995-1.
Section 12-5 of the 1997 Act lists all the provisions of the current law (in both the 1936 and 1997 Acts) that contain rules about specific types of deduction. The rewrite updates these lists so that they refer to the newly rewritten provisions about company bad debts and losses being inserted in the 1997 Act, instead of the provisions in the 1936 Act that they replace. [Schedule 3 Part 2 items 3 and 4]
Subsection 25-35(5) of the 1997 Act identifies provisions of the current law that contain rules about entitlement to deductions for bad debts. References in items 1 and 2 of subsection 25-35(5) to sections in the 1936 Act are updated so that they refer to provisions in the 1997 Act that replace them. [Schedule 3 Part 2 items 5 and 6]
Section 165-1 is amended to indicate that the coverage of Division 165 has been extended to include company deductions for bad debts. [Schedule 3 Part 2 item 7]
Section 165-195, which excludes redeemable shares from tests for continuity of majority beneficial ownership of a company, is amended so that it does not apply to shares allotted before the first date from which continuity of ownership is required in order to deduct any particular bad debt. [Schedule 3 Part 2 item 8]
Amendment of the Income Tax Assessment Act 1936
The rewrite amends the 1936 Act to:
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- close off the application of provisions of the 1936 Act that have been rewritten in Subdivisions 165-C and 175-C, so that the existing provisions generally apply only up to 30 June 1998; and
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- deal with references to provisions that have been rewritten by those Subdivisions.
Closing off the application of existing provisions
The rewrite inserts new provisions into the 1936 Act that close off the application of provisions that have been rewritten.
Sections 63A, 63B, 63C and 63CA need to be closed off so that they dont apply to bad debts deducted in 1998-99 or later income years because Subdivisions 165-C and 175-C now apply to those transactions. [Schedule 3 Part 2 items 13, 14, 15 and 16]
Dealing with existing references
Subsections 63A(14), 63B(11) and 63C(4) of the 1936 Act extend the application of the continuity of beneficial ownership, anti-avoidance and same business rules that apply to deductions for bad debts to deductions for debts that are extinguished in a debt/equity swap. The rewrite replaces these subsections with a new subsection in the 1936 Act (subsection 63E(5A)) that makes deductions for debts that are extinguished in a debt/equity swap subject to the rewritten bad debt provisions in the 1997 Act. [Schedule 3 Part 2 item 17]
The Commissioner can amend assessments within six years to give effect to provisions in the 1997 and 1936 Acts that are identified in subsection 170(13) of the 1936 Act. The reference to section 63B of the 1936 Act is removed as this section has been rewritten in Division 175 of the 1997 Act, which is already identified in subsection 170(13). [Schedule 3 Part 2 item 18]
Section 427 of the 1936 Act identifies provisions that are to be disregarded in calculating the attributable income of a Controlled Foreign Corporation. The reference in this section to section 63CA of the 1936 Act is replaced by a reference to the corresponding rewritten provision, ie. section 165-120 of the 1997 Act. [Schedule 3 Part 2 items 19 and 20]
Amendment of Commonwealth Acts
Commonwealth Acts (other than the 1936 Act and the 1997 Act) are amended as a result of the rewrite of the 1936 Act bad debts provisions.
The amendments consisting of items 21 to 24 in Schedule 3 update the Commonwealth Bank Sale Act 1995 and the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 . These items replace existing 1936 Act references with reference to the 1997 Act equivalents.