Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 8 - Applying the same business test to unrealised losses
Outline of Chapter
8.1 Schedule 6 to this Bill inserts Subdivision 165-CC into the ITAA 1997. The Subdivision will limit the extent of unrealised loss duplication by applying the same business test to company losses where there has been a substantial change in the companys ownership or control. By adopting this approach, Subdivision 165-CC will align the taxation treatment of unrealised losses with that of realised losses. [Item 6, Schedule 6]
8.2 This Chapter discusses the treatment of companies with unrealised net losses where there has been a substantial change in the companies ownership or control (Chapter 7 of the Explanatory Memorandum discusses the rules for determining whether there has been a substantial change in a companys ownership or control).
8.3 A company will be required to determine the extent of its unrealised net loss as at the time of a change in its ownership or control. The same business test will then be applied, to the extent of the companys unrealised net loss, to any losses subsequently arising in respect of the disposal of the assets owned by the company at the time of the change in ownership or control. [Subdivision 165-CC]
Context of Reform
8.4 Schedule 6 to this Bill addresses the deficiency in the current law regarding unrealised losses by aligning their treatment with that of realised losses. [Subdivision 165-CC]
8.5 Loss duplication arises where a single economic loss is recognised by the taxation system more than once. This can occur because losses realised in a company are reflected in the value of interests in that company.
8.6 Where a company has undergone a change in ownership or control, the current law reduces the scope for duplicating a tax loss or net capital loss carried forward by the company at the time of the change. This is achieved by denying the losses wherever the company has not carried on the same business throughout the income year in which a deduction for the loss is claimed, as it carried on immediately before the change.
8.7 The current law, however, has no application where a company has unrealised deductions or unrealised capital losses at the time of a change in its ownership or control. This deficiency in the law allows a company to duplicate a loss by deferring the realisation of the loss until after a change in ownership. In these circumstances, the company will then be able to claim the loss without having to satisfy the same business test.
Georgina and Lee capitalise Investco with $100. Georgina owns 60% of the shares in Investco and Lee owns the remaining 40% of the shares. Investco acquires an asset for $100 but the investment is poor and the value of the asset falls to nil. Georgina and Lee sell all of their shares in Investco to Clare while Investcocontinues to hold the asset with an unrealised loss of $100. Georgina and Lee would incur capital losses of $60 and $40, respectively, on the sale of their shares. Investco could subsequently sell the asset and realise a duplicate loss of $100.
8.8 Subdivision 165-CC is designed to remedy the deficiency in the current law and is consistent with the policy approach proposed in recommendation 6.10 of A Tax System Redesigned .
Summary of new law
8.9 The new law will address the deficiency in the current law regarding unrealised losses by disallowing a certain amount of deductions and capital losses arising in relation to the disposal of assets held by a company at the time of a change in its ownership, unless the company satisfies the same business test.
8.10 The new law will apply to a company only where the company:
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- undergoes a substantial change of ownership or control after 11:45 am AEST on 21 September 1999; and
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- has an unrealised net loss in respect of the assets that it owned at the time of the change.
8.11 The new law provides tests for establishing whether or not a company with unrealised losses has undergone a substantial change in ownership or control. Chapter 7 of the Explanatory Memorandum contains a discussion of this aspect of the Bill.
8.12 Once a substantial change of ownership or control has been established, the new law will require the company to work out the amount of its unrealised net loss. Broadly, a companys unrealised net loss is the amount of the loss that the company would make if it were to sell all of its assets at market value on the day of the change.
8.13 The new law provides that, up to the amount of the companys unrealised net loss, deductions and capital losses subsequently arising on the disposal of assets held at the time of a change in its ownership or control may be claimed only where the company satisfies the same business test.
Detailed explanation of new law
8.14 Subdivision 165-CC prescribes the conditions under which tax losses and capital losses arising in relation to CGT events that occur in respect of CGT assets held by a company at the time of a change in its ownership will be disallowed. [Section 165-115]
8.15 The object of the new law is to reduce the scope for the duplication of any unrealised losses owned by a company at the time of a change in its ownership or control. Duplication is reduced by applying the same business test to the companys pool of unrealised losses held at the time of the change. Generally those losses are duplicates of losses previously claimed at the equity level by the former owners of the company.
8.16 Losses arising in respect of CGT events that occur in relation to CGT assets held at the time of a change in a companys ownership or control will be allowed only where the company satisfies the same business test. The test will be applied only to the extent that the amount of losses subsequently realised does not exceed the amount of the unrealised net loss calculated by the company as at the time of the change in ownership or control.
Criteria for applying the provisions
8. 17 Subdivision 165-CC will apply to a company in circumstances where the company undergoes a change in ownership or control after the commencement time and has an unrealised net loss in respect of the assets owned by the company at the time of the change. [Paragraphs 165-115A(1)(a) and (b)]
8. 18 The commencement time for a company is taken to be the later of:
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- 11:45 am AEST on 21 September 1999; and
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- the time that the company came into existence.
8. 19 The time at which a company undergoes a change in ownership or control is referred to as the changeover time . [Subsections 165-115C(1) and 165-115D(1)]
Assets held at more than one changeover time
8. 20 Where a company owns an asset over a period including more than one changeover time, Subdivision 165-CC will apply in respect of that asset only in relation to the latest changeover time [subsection 165-115A(3)] . Consequently, a relevant capital loss or deduction subsequently arising in relation to a CGT asset, to the extent that it does not exceed the unrealised net loss calculated as at the most recent changeover time, will be claimable by the company subject to satisfying the same business test.
Changes in ownership and control
8.21 In order to determine whether or not to apply Subdivision 165-CC, a company must ascertain whether or not it has undergone a change in ownership or control.
8.22 There are tests for determining whether or not a company has undergone a change in ownership or control [sections 165-115C and 165-115D] . For discussion of the operation of those provisions, refer to Chapter7 of this Explanatory Memorandum.
What happens if a company makes a capital loss or is entitled to a deduction in respect of a CGT asset held at a changeover time?
Capital losses and deductions subject to these provisions
8.23 A capital loss realised as a result of a CGT event that occurs in respect of a CGT asset owned by a company at a changeover time will be subject to Subdivision 165-CC . [Paragraph 165-115A(1)(c)]
8.24 Deductions such as balancing adjustments on depreciable assets owned by a company at a changeover time will also be subject to Subdivision 165-CC. [Paragraph 165-115A(1)(c)]
Same business test to be applied
8.25 Subsequent to a change in its ownership, a company may realise a capital loss or, but for Subdivision 165-CC, become entitled to a deduction as a result of a CGT event that occurs in relation to an asset owned by the company at changeover time. Subject to an upper limit, such a realised capital loss or entitlement to a deduction will be disallowed unless the company satisfies the same business test. [Subsection 165-115B(4)]
8.26 The upper limit referred to in paragraph 8.25 is the amount of the companys residual unrealised net loss. The extent to which the same business test applies to a realised capital loss or an entitlement to a deduction (but for Subdivision 165-CC) resulting from a CGT event occurring in respect of a CGT asset owned at changeover time, will depend on whether or not the amount of the capital loss or deduction exceeds the amount of the companys residual unrealised net loss.
Where a capital loss or deduction does not exceed the residual unrealised net loss
8.27 In the event that a realised capital loss does not exceed the residual unrealised net loss, the entire amount of the capital loss will be taken to have been a net capital loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(1)(a)] . Additionally, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]
8.28 Consequently, by virtue of existing sections 165-10 and 165-13 of the ITAA 1997 (as it applies because of existing section 165-96), the company will not be able to apply the net capital loss unless it satisfies the requirements of the same business test. In effect, the company will be required to carry on the same business in the claim year as it carried on immediately before the changeover time. [Subsection 165-115B(4)]
8.29 In the same way, if the company becomes entitled to a deduction (but for Subdivision 165-CC) which does not exceed the residual unrealised net loss, the deduction is taken to have been a tax loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(1)(b)] . As in the case of a realised capital loss discussed in paragraph 8.27, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]
8.30 As a consequence the operation of existing sections 165-10 and 165-13 of the ITAA 1997, the company will not be able to deduct the tax loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]
Where a capital loss or deduction exceeds the residual unrealised net loss
8.31 In the event that a realised capital loss exceeds the residual unrealised net loss, the capital loss (to the extent that it does not exceed the residual unrealised net loss) will be taken to have been a net capital loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(2)(a)] . Additionally, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]
8.32 Consequently, by virtue of existing sections 165-10 and 165-13 of the ITAA 1997 (as it applies because of section 165-96), the company will not be able to apply the net capital loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]
8.33 Similarly, if the company becomes entitled to a deduction (but for Subdivision 165-CC) which exceeds the residual unrealised net loss, the deduction (to the extent that it does not exceed the residual unrealised net loss) is taken to have been a tax loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(2)(b)] . As in the case of a realised capital loss discussed in paragraph 8.31, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]
8.34 As a consequence of the operation of existing sections 165-10 and 165-13 of the ITAA 1997, the company will not be able to deduct the tax loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]
8.35 Any amount of a capital loss or deduction in excess of the companys residual unrealised net loss will be claimable by the company without the requirement to satisfy the same business test. Such an excess can be thought of as an additional loss suffered by the company after the changeover time. In relation to bad debts, however, any amount of a bad debt deduction in excess of the companys residual unrealised net loss will be subject to the existing rules for deducting bad debts . [Item 8, section 165-119]
Capital losses and deductions to be quarantined
8.36 Any capital loss treated by Subdivision 165-CC as a net capital loss for the income year immediately preceding the income year in which the changeover time occurred, cannot be applied against capital gains made before the time of the occurrence of the CGT event that resulted in the capital loss. [Subsection 165-115B(5)]
8.37 Similarly, a deduction treated by Subdivision 165-CC as a tax loss for the income year immediately preceding the income year in which the changeover time occurred, cannot be deducted from assessable income derived before the time of the occurrence of the CGT event that resulted in the deduction. [Subsection 165-115B(6)]
Calculation of residual unrealised net loss
8.38 As previously discussed, a company that undergoes a change in ownership or control will be required to calculate its residual unrealised net loss in order to determine the extent to which the same business test will be applied.
8.39 A companys residual unrealised net loss at the time of a CGT event that results in the company making a capital loss, or resulted in the company becoming entitled to a deduction, in respect of a CGT asset owned by the company at a changeover time, is equal to the amount of the companys unrealised net loss calculated as at the most recent changeover time, less any previous capital losses or deductions. [Subsection 165-115B(8)]
8.40 An explanation of the meaning of Previous capital losses or deductions is provided in subsection 165-115B(8). Where a company subsequently accrues capital losses or entitlements to deductions (but for Subdivision 165-CC) in respect of CGT assets held by the company at the changeover time, the amount of the residual unrealised net loss is successively reduced by the amount of each capital loss or deduction. Once the amount of the residual unrealised net loss is reduced to zero, any subsequent capital losses and deductions resulting from subsequent CGT events will be claimable by the company without having to satisfy the same business test. [Subsection 165-115B(8)]
8.41 Capital losses and deductions arising in relation to CGT events that occur in respect of CGT assets owned by a company at a changeover time will be subjected to the same business test generally in the order in which the CGT events occurred. [Subsection 165-115B(7)]
Calculation of unrealised net loss
8.42 In order to work out its residual unrealised net loss, a company must first calculate its unrealised net loss as at the changeover time. A companys unrealised net loss in respect of assets owned at changeover time is equal to the excess of its unrealised gross loss over its unrealised gross gain, where:
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- the companys unrealised gross loss is the sum of its unrealised capital loss and its unrealised revenue loss; and
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- the companys unrealised gross gain is the sum of its unrealised capital gain and its unrealised revenue gain.
8.43 The companys unrealised capital loss is the sum of all of its notional capital losses in respect of assets owned at changeover time. [Section 165-115E]
8.44 The companys unrealised capital gain is the sum of all of its notional capital gains in respect of assets owned at changeover time. [Section 165-115E]
8.45 The companys unrealised revenue loss is the sum of all of its notional revenue losses in respect of assets owned at changeover time. [Section 165-115E]
8.46 The companys unrealised revenue gain is the sum of all of its notional revenue gains in respect of assets owned at changeover time. [Section 165-115E]
Treatment of multiple changeover times
8.47 A company must calculate its unrealised net loss each time that it experiences a changeover time. The unrealised net loss at a particular changeover time is relevant only in respect of assets owned by the company at that time. Where one of those assets is subsequently sold, only the unrealised net loss calculated as at the most recent changeover time is relevant to that particular asset sale. [Paragraph 165-115A(1)(b)]
Calculation of notional losses and gains
8.48 For the purposes of calculating its notional gains and losses, a company is taken, at a changeover time, to have notionally disposed of all of the assets that it owned at that changeover time at market value. [Subsection 165-115F(2)]
8.49 In respect of the notional disposal of each asset held at a changeover time:
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- if the company would make a capital gain in respect of the disposal of an asset then the company will be considered to have a notional capital gain equal to the amount of the capital gain;
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- if the company would make a capital loss in respect of the disposal of an asset then the company will be considered to have a notional capital loss equal to the amount of the capital loss;
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- if the company would include an amount (other than a capital gain) in its assessable income in respect of the disposal of an asset then the company will be considered to have a notional revenue gain equal to the amount included; or
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- if the company would be entitled to a deduction in respect of the disposal of an asset then the company will be considered to have a notional revenue loss equal to the amount of the deduction.
Margaret, an Australian resident individual, owns 100% of the shares in Assetco, a private company. On the 30 June 2000, Margaret sells her entire interest in Assetco to another company, Holdco. Margaret holds no equity interests in Holdco.
Details of the assets owned by Assetco at the changeover time are provided in the following table:
| Asset | Value | ||
|---|---|---|---|
| Tax value | How calculated? | Market value | |
| Commercial office building | $5 million | Reduced cost base | $2 million |
| Portfolio of shares in Australian listed companies | $7 million | Indexed cost base | $8 million |
| Depreciable plant* | $1 million | Written-down value | $1.6 million |
| Assume that the depreciable plant was originally purchased for $3 million | |||
In accordance with Subdivision 165-CC, Assetco must work out any notional gains or losses on assets held at the changeover time, in the manner specified by section 165-115F, so as to calculate its unrealised net loss (if any).
The notional gains and losses on the assets held by Assetco at the changeover time are provided in the following table:
| Asset | Notional gain or loss | |||
|---|---|---|---|---|
| Notional capital gain | Notional capital loss | Notional revenue gain | Notional revenue loss | |
| Commercial office building | - | $3 million | - | - |
| Portfolio of shares in Australian listed companies | $1 million | - | - | - |
| Depreciable plant* | - | - | $0.6 million | - |
| * Assume that the depreciable plant was originally purchased for $3 million | ||||
In accordance with section 165-115E, Assetco must calculate its unrealised net loss in the following manner:
| unrealised gross loss = | unrealised capital loss PLUS unrealised revenue loss |
| = | $3 million |
| unrealised gross gain = | unrealised capital gain PLUS unrealised revenue gain |
| = | $1.6 million |
| EXCESS OF unrealised gross loss OVER unrealised gross gain | |
| = | $1.4 million |
Thus, at the changeover time, Assetco has an unrealised net loss of $1.4 million.
8.50 A company may have a notional revenue loss or a notional revenue gain in respect of an item of trading stock.
8.51 A company will have a notional revenue loss in respect of an item of trading stock on hand at a changeover time equal to any excess of the tax value of the item determined by the company, over its market value. [Paragraph 165-115F(4)(a)]
8.52 Similarly, a company will have a notional revenue gain in respect of an item of trading stock on hand at a changeover time equal to any excess of the market value of the item over its tax value determined by the company. [Paragraph 165-115F(4)(b)]
8.53 The tax value of an item of trading stock determined by the company is the items latest valuation under Division 70. If there is no valuation under that Division for an item of trading stock, then the tax value is its cost at changeover time. [Subsection 165-115F(4)]
Assemblyco, a small Australian resident manufacturing company experiences a substantial change in ownership on 1 July 2000. At the changeover time, Assemblyco owns several items of trading stock with the following valuations:
| Item of Stock | Quantity | Tax value (per item) | How calculated? | Market value (per item) | Notional revenue loss |
|---|---|---|---|---|---|
| Zippers | 10 | $1 | cost | $2 | -$10 |
| Hinges | 25 | $3 | replacement | $4 | -$25 |
| Fasteners | 5 | $7 | market selling value | $7 | $0 |
| Latches | 60 | $5 | cost | $2 | $180 |
For each item of stock listed in the table above, the notional revenue loss or gain is determined by comparing the items market value as at the changeover time with the tax value determined by Assemblyco in the manner discussed in paragraph 8.53.
Where there are many units of a particular item of stock, the notional revenue gain or loss for that particular type of item is simply the sum of the individual notional revenue gains or losses for each item.
Industrialco, a June-balancing Australian resident company, undergoes a substantial change of ownership on 1 December 2000. At the changeover time, Industrialco owns the following three assets:
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- shares in an Australian listed public company;
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- a commercial property; and
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- an item of depreciable plant
As at the changeover time, Industrialco calculates the following values:
| Asset | Tax value* | Market value | Notional loss |
|---|---|---|---|
| Shares | $150,000 | $200,000 | -$50,000 |
| Property | $800,000 | $600,000 | $200,000 |
| Depreciable plant# | $100,000 | $120,000 | -$20,000 |
| Unrealised net loss | 130,000 |
As highlighted by the table above, Industrialco has an unrealised net loss of $130,000 at the changeover time.
Suppose that Industrialco disposes of the commercial property on 1March 2001 and realises a capital loss of $115,000. At that time, the residual unrealised net loss equals the unrealised net loss of $130,000.
Given that the residual unrealised net loss exceeds the amount of the capital loss realised by Industrialcoon disposal of the commercial property, the entire amount of the realised capital loss, as discussed in paragraph 8.27, will be taken to be a net capital loss for the 1999-2000 income year, and Industrialcowill be taken to have failed to satisfy the requirements of the continuity of ownership test. [Section 165-12]
Consequently, as discussed in paragraph 8.28, Industrialco will not be able to apply the net capital loss unless it satisfies the requirements of the same business test.
Suppose also that Industrialco disposes of the item of depreciable plant on 1 September 2001 and realises a balancing deduction of $40,000. At the time of the disposal, the residual unrealised net loss is $15,000 the result of subtracting the previous capital loss of $115,000 from the unrealised net loss calculated at the changeover time of $130,000.
As discussed in paragraphs 8.33 to 8.35, the consequences for the deduction under Subdivision 165-CC are:
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- the amount of the deduction up to the amount of the residual unrealised net loss ($15,000) will be taken to be a tax loss for the 1999-2000 income year;
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- Industrialco will be taken to have failed to satisfy the requirements of the continuity of ownership test in regard to the loss;
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- the tax loss will only be deductible if Industrialco satisfies the requirements of the same business test; and
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- the excess of the deduction over the residual unrealised net loss will be deductible by Industrialco without having to satisfy the requirements of the same business test.
In the event that Industrialco makes a capital loss on the disposal of the shares owned at the changeover time, the entire amount of that capital loss will be allowed to be applied without having to satisfy the same business test, because the residual unrealised net loss will have already been reduced to zero.
Application and transitional provisions
8.54 Subdivision 165-CC will apply to any company that:
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- undergoes a changeover time after 11:45 am AEST on 21September 1999; and
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- has an unrealised net loss in respect of the assets owned at the time of the change.
[Paragraphs 165-115A(1)(a) and (b)]
8. 55 Following the application of Subdivision 165-CC to a company for the first time, the measures will subsequently apply on each occasion where there are substantial changes in the ownership profile of the company compared to its profile as at its last changeover time.