House of Representatives

Explanatory Memorandum

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

Chapter 7 - The continuity of ownership test

Outline of Chapter

7.1 Schedule 6 to this Bill amends the ITAA 1997 to remove defects in the existing continuity of ownership test applying to companies prior and current year tax losses and net capital losses and bad debts. The Schedule will also apply the amended continuity of ownership test to companies with unrealised net losses.

7.2 This Chapter discusses the operation of the continuity of ownership test in relation to both realised and unrealised losses. (Chapter 8 discusses the treatment of companies with unrealised net losses when the test is failed.)

7.3 The continuity of ownership test will now only be satisfied if:

•

there is no substantial change in proportionate shareholding within a group of continuing owners; and

•

majority ownership is maintained throughout a period from the time a loss was incurred to the time the loss is claimed.

Context of Reform

7.4 This Bill aims to reduce the scope for loss duplication by restricting the availability of a companys realised losses (i.e. tax losses, and net capital losses) and unrealised losses (i.e. losses on assets the company is yet to dispose of). Where there has been a substantial change in the companys ownership or control, the losses are allowed only if the same business test is satisfied. Broadly, the same business test is satisfied if the nature of a companys business carried on when the losses are claimed is unchanged compared to the business carried on immediately before the change.

7.5 Broadly, loss duplication arises because losses that a company realises on its assets are reflected in the value of equity interests in the company. The losses are also reflected in the value of any indirect interests in the company. Where a substantial proportion of the equity interest in the company has been disposed of, the losses subsequently allowed to be claimed by the company, are predominantly duplicates of losses already allowed on the sale of equity interests.

7.6 The current law requires continuity of majority ownership of a company before the company can recoup a tax loss or net capital loss, or claim a deduction for a bad debt. However, the law fails to register a change in majority ownership when this occurs through a change in proportionate shareholding within a group of continuing owners. For example, the test does not recognise a change in ownership of a company when, in a company that is 99% owned by person A and 1% owned by person B, A sells more than half of its shares to B.

7.7 Further, the test under the existing law is satisfied if the majority ownership in the year a loss was incurred is the same as in the year the loss is sought to be claimed. Thus, it does not require continuous ownership in the intervening period. This allows majority ownership to be reinstated after disposal of a majority of the shares (carrying a majority of the relevant power or rights) in the intervening period between the loss year and the claim year. This results in loss duplication, as the loss would have been reflected in the price the owners received on disposal of their shares.

7.8 The proposed changes are consistent with the Reviews recommendation 6.9(a).

Summary of new law

7.9 Schedule 6 amends the continuity of ownership test in ITAA 1997 applying to companies losses, whether realised or unrealised.

7.10 Broadly, the continuity of ownership test will be satisfied if:

•

there is no substantial change in proportionate shareholding within a group of continuing owners; and

•

majority ownership by individuals is maintained throughout the period from the time a loss is incurred to the time the loss is claimed.

7.11 The amendments apply the amended continuity of ownership test to a companys:

•

tax losses, net capital losses and bad debt deductions claimed in relation to an income year ending after 21 September 1999 [item 16] ; and

•

unrealised net losses, where the test is failed after 11.45 am AEST on 21 September 1999 [item 6, paragraph 165-115A(1)(a)] .

Detailed explanation of new law

7. 12 Schedule 6 amends ITAA 1997 to remove defects in the existing continuity of ownership test applying to companies prior and current year tax losses and net capital losses and bad debts. The Schedule will also apply the amended continuity of ownership test to companies with unrealised net losses.

What are the changes to the continuity of ownership test applying in relation to losses currently subject to the test?

7.13 A company may be prevented from deducting a tax loss, a net capital loss or a deduction for a bad debt unless it satisfies the continuity of ownership test and the same control in the company is maintained throughout the ownership test period [item 1, section 165-5; item 5, section 165-93; item 7, section 165-117] . Where a company has failed to maintain continuity of ownership or control, a loss or deduction will only be available if the same business test is satisfied.

7.14 The term ownership test period has been changed. The new term has different meanings depending on the nature of the losses a company seeks to claim. The alternative meanings are:

•

in relation to a tax loss or a net capital loss - the start of the loss year to the end of the income year (claim year) in which the loss is deducted against taxable income (including a net capital gain) [item 2, subsection 165-12(1)] ; and

•

in relation to a bad debt deduction from the day on which the debt was incurred to the end of the claim year [item 9, subsection 165-123(1)] .

7.15 A company will only satisfy the amended ownership test where during the whole of the ownership test period:

•

the same persons beneficially owned the same shares that when taken together carried more than 50% of the voting power in the company;

•

the same persons beneficially owned the same shares that when taken together carried the rights to more than 50% of the companys dividends ; and

•

the same persons beneficially owned the same shares that when taken together carried the rights to more than 50% of any capital distributions made by the company.

[Item 2, subsections 165-12(2), (3) and (4); item 9, subsections 165-123(2), (3) and (4); item 11, subsection 165-165(1)]

Who has more than 50% of a power or right?

7.16 There are 2 tests for determining who has more than 50% of the voting power in a company the primary test and the alternative test. The relevant test in a particular case depends on the ownership structure of the company. Similarly, there are two tests for determining at a particular time, who owns shares that carry rights to more than 50% of the companys dividends or any capital distributions made by the company.

7.17 Effectively, the primary tests are applicable to a company that at the beginning of the ownership test period, was beneficially owned by persons other than companies [item 2, subsection 165-12(5); item 9, subsection 165-123(5)] .

7.18 The alternative tests, however, are applicable to a company that was at the beginning of the ownership test period, beneficially owned by individuals through interposed companies [item 2, subsections 165-12(5) and (6); item 9, subsections 165-123(5) and (6)] . This amendment reflects the amended definition of ownership test period. Under the existing law, the alternative test is to be used where a loss company is owned through an interposed company at any time during the loss year or the year in which the loss is claimed.

The primary tests

7.19 The primary tests in the existing law have been amended so that they operate to determine who owns more than 50% of a power or a right at a particular time. The existing tests make the determination in respect of the ownership test period. [Item 11, subsection 165-150(1), subsection 165-155(1) and subsection 165-160(1)]

7.20 The amendments enable the application of the primary tests in support of the continuity of ownership test for companies with unrealised losses (discussed at paragraphs 7.27 to 7.33). The amendments do not affect the overall operation of the continuity of ownership tests applying to tax losses and net capital losses (contained in section 165-12 of ITAA 1997) and bad debt deductions (contained in section 165-123 of ITAA 1997).

The alternative tests

7.21 The alternative tests in the existing law have been amended. Under an amended alternative test, the persons who have more than 50% of the voting power in a company are the individuals who beneficially own between them, directly or indirectly, shares in the company carrying more than 50% of the voting power in the company. [Item 11, subsection 165-150(2)]

7.22 Under the amended test, indirect equity interests in the company will be treated as carrying the relevant proportion of the voting power carried by the shares held directly or indirectly by the interposed entity in the company at all times during the ownership test period.

Example 7.1

Garry holds, shares in an interposed company carrying 30% of the voting power in the interposed company. The interposed company holds shares carrying 60% of the voting power in a loss company.

Garry is treated as having an indirect equity interest carrying 18% (i.e.30% * 60%) of the voting power in the loss company.

7.23 The other alternative tests apply similarly in working out the identity of the persons who held the shares that carried the rights to more than 50% of the companys dividends or capital distributions. [Item 11, subsection 165-155(2) and subsection 165-160(2)]

How will the changes affect the control test?

7. 24 The current control test will be amended as a consequence of the changes made to the continuity of ownership test. The amendment will require that the control of the voting power in a company be maintained by the same persons throughout the ownership test period in order for the company to be able to claim a loss or deduction. The current law does not require continuity during any intervening period, for example between a loss year and a claim year. A company failing to meet the continuity requirement will be subject to the same business test on its tax loss, net capital loss or bad debt deductions. [Item 4, paragraph 165-15(1)(a); item 10, paragraph 165-129(1)(a)]

How will the changes affect the same business test?

7.25 The provision containing the conditions for applying the same business test will be amended as a consequence of the changes made to the continuity of ownership test. The amendment will effectively redefine the continuity period as a period that starts at the beginning of the ownership test period, and ends when at least one of the conditions in section 165-12 ceases to be satisfied. [Item 3, subsection 165-13(2)]

7.26 Broadly, a company seeking to claim a loss after having failed the continuity of ownership test must carry on the same business in the claim year as it carried on immediately before the end of the continuity period, as redefined.

How will the continuity of ownership test apply in relation to a companys unrealised losses?

7.27 A company that has failed the continuity of ownership test or has experienced a change in its control may, in some circumstances, be prevented from claiming a loss on an asset owned at the time of failure or change [item 6, subsection 165-115A(1)] . An example would be where, at the time of change, there was an overall unrealised loss (having regard to all of the assets of the company) that exceeded the loss on the particular asset. In these circumstances, a loss or deduction on such an asset will only be available if the same business test is satisfied. (Chapter 8 of this Explanatory Memorandum contains a detailed discussion of the treatment of a companys assets in certain circumstances where the company has failed the continuity of ownership test or experienced a change of control.)

7.28 This Bill extends the application of the amended continuity of ownership test to companies with unrealised net losses. This Chapter discusses how the continuity of ownership test will apply to companies in these circumstances.

Changeover time

7.29 A changeover time occurs when the company either fails the continuity of ownership test or experiences a change in the control of the companys voting power [item 6, subsection 165-115C(1) and section 165-115D] . A changeover time occurs whether or not the company has an unrealised net loss at the time.

7.30 For a company to be allowed to carry forward its unrealised losses, the ownership of and control in a company must be maintained throughout the period from one changeover time to another. Where a company has not experienced a changeover time, then ownership and control must be maintained from the commencement of these measures on 21September1999. The reference time is the time at which the ownership profile is tested for comparison purposes to determine whether or not there is a subsequent changeover time. [Item 6, subsections 165-115C(1) and (4)]

Continuity of ownership

7.31 A company fails the continuity of ownership test at a particular time when:

•

the persons who beneficially owned shares at the reference time that when taken together carried more than 50% of the voting power in the company, stopped beneficially owning those shares; or

•

the persons who beneficially owned shares at the reference time that when taken together carried the rights to more than 50% of the companys dividends, stopped beneficially owning those shares; or

•

the persons who beneficially owned shares at the reference time that when taken together carried the rights to more than 50% of any capital distributions made by the company, stopped beneficially owning those shares.

[Item 6, subsections 165-115C(1); item 11, subsection 165-165(1)]

7.32 The rules supporting the continuity of ownership test apply for unrealised losses in the same way that they do to realised losses. For instance, there are 2 tests for determining at a particular time, who has more than 50% of a companys voting power, or rights to dividends or capital distributions the primary test and the alternative test. The relevant test, as for realised losses, depends on the ownership structure of a company. [Item 6, subsections 165-115C(2) and (3)]

7.33 The primary tests and the alternative tests are the same tests as those applying to a companys realised losses.

General rules affecting the operation of the tests

7.34 The current law contains general rules that affect the operation of a test. These rules apply not only to tax losses, net capital losses and bad debt deductions (dealt with by current rules) but also to unrealised losses (dealt with under new Subdivision 165-CC). Various provisions have been amended to reflect the changes made to the continuity of ownership test. The changes are discussed at paragraphs 7.35 to 7.44

Exactly the same shares at all times

7. 35 When applying a test, a persons share in a company may be counted only if the person owns the same share throughout the relevant period [item 11, subsection 165-165(1)] . As reflected in the current law, a public company is taken to have satisfied the test if it is reasonable to assume that the test is satisfied [item 11, subsection 165-165(1)] .

Share splits and share consolidations

7.36 Notwithstanding the rule, a persons share (original share) may continue to be counted if the share is split into several shares and the person continues to beneficially own all of the split shares. For the purposes of establishing whether the required voting power or dividend or capital rights have been maintained, the power or rights that attached to the original share and that continue to be carried by the split shares will be counted. [Item 11, paragraph 165-165(2)(a)]

7.37 Where a persons original share in a company is consolidated with other shares in the company that the person beneficially owns, the person will be treated as continuing to own the original share as long as the person continues to beneficially own the consolidated share. Effectively, to qualify as a consolidated share for these rules, the powers and rights carried by the consolidated share must be the sum of all the powers and rights carried by the individual shares that have been consolidated. [Item 11, paragraph 165-165(2)(b)]

Arrangements affecting the beneficial ownership of shares in a company

7.38 Notwithstanding a persons legal or beneficial ownership of shares in a company, the Commissioner may, in certain conditions outlined in the current law, ignore a persons beneficial ownership of the shares at a particular time . The reference in the current law to the ownership test period has been removed to enable this provision to also apply to companies with unrealised net losses. [Item 12, subsection 165-180(1)]

7.39 For the Commissioner to be able to apply the provision, a condition in the current law is that there must be an arrangement entered into before or during a year in which a loss is claimed. The provision reflects the test in the law where a company was only required to maintain continuity of majority ownership throughout the loss year and the claim year but not during any intervening period.

7.40 The provision may now be invoked where an arrangement (with the necessary features) is entered into at any time. The amendment reflects the new requirement under the continuity of ownership test to maintain majority interest throughout the test period. [Item 13, subsection 165-180(2)]

Changes to rights attaching to shares

7.41 The existing section 165-185 and section 165-190 of ITAA 1997 are concerned with ensuring that the continuity of ownership test is failed where there has effectively been a substantial change in the rights attaching to shares that occurred as a result of an arrangement made during the claim year.

7.42 To reflect the change to the continuity of ownership test requiring a continuous period of majority ownership, the test will now be failed where there has effectively been a substantial change in the rights occurring because of an arrangement made at any time during the ownership test period. [Item 14, subsection 165-185(1) and subsection 165-190(1)]

7.43 In addition, new provisions will ensure that the continuity of ownership test is failed in relation to a companys unrealised losses where there has effectively been a substantial change in the rights attaching to shares. The provision may be invoked where a change in the rights occurred as a result of an arrangement entered into at any time. [Item 14, subsection 165-185(2) and subsection 165-190(2)]

Redeemable shares

7. 44 Section 165-195 of ITAA 1997 disregards certain redeemable shares in applying the continuity of ownership test. The provision has been amended so that it operates to disregard the relevant redeemable shares beneficially owned by a person at a particular time . The existing provision which effectively refers to shares beneficially owned during the claim year is inconsistent with the application of these general rules to companies with unrealised losses. The amendment does not affect the overall operation of the continuity of ownership test applying to tax losses, net capital losses and bad debts. [Item 15, subsection 165-195(1)]

Application provisions

7. 45 The measures will apply differently to the following two groups of losses:

•

tax losses, net capital losses and bad debt deductions; and

•

unrealised net losses.

7. 46 While the measures are new in the context of unrealised losses, they amend current tests in relation to tax losses, net capital losses and bad debt deductions.

Tax losses, net capital losses and bad debt deductions

7.47 The measures will apply to tax losses, net capital losses and bad debt deductions claimed in relation to an income year ending after the measures were announced on 21 September 1999 [item 16] .

7.48 A company could effectively be denied either a tax loss or a net capital loss of an income year before the announcement if the company experienced a substantial change in its ownership or control during the period between the loss year and the claim year. This could occur even if the change in ownership or control happened before the announcement.

7.49 The measures will not apply to a loss or a deduction claimed in an income year that ended on or before 21 September 1999.

Unrealised losses

7.50 The measures will apply to a companys unrealised net losses where there is a substantial change in the companys ownership or control after the announcement of the measure at 11.45 am AEST on 21September1999 [item 6, paragraph 165-115A(1)(a) and paragraph 165-115A(2)(a)] .

7.51 An existing company will be affected by these measures for the first time only if its ownership or control substantially changes by reference to its ownership or control profile at 11.45 am AEST on 21September1999. After that time, the measures will apply where there are substantial changes by reference to the last change time.

7.52 The measures will apply to a newly incorporated company where the ownership or control in the company substantially changes by reference to the ownership and control profile on incorporation [item 6, paragraph 165-115A(1)(a) and paragraph 165-115A(2)(b)] .