House of Representatives

Explanatory Memorandum

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

Chapter 4 Application of same business test

Outline of chapter

4.1 Schedule 7 to this bill amends Division 165 of the ITAA 1997 to remove an anomaly that prevents a company from accessing the SBT to determine its eligibility to deduct a tax loss incurred in a previous year, or write off a bad debt, in circumstances where the company has failed the COT but is unable to identify the precise date on which that failure occurred.

Context of amendments

4.2 Under the income tax law taxpayers are entitled to deduct in an income year losses incurred in a previous income year. Special rules apply to companies.

4.3 Companies are allowed to deduct a prior year loss if they pass the COT. Broadly, more than 50% ownership of the company must be maintained from the beginning of the year of the loss until the end of the year in which the deduction is claimed. If the company does not pass this test, it can still claim a deduction if it passes the SBT. Broadly, a company must carry on the same business both immediately before the disqualifying change of ownership and during the year it claims the deduction for the loss.

4.4 Similarly, a company cannot deduct a debt that it writes off as bad in the current year unless it satisfies either the COT or the SBT.

4.5 Problems inherent in the current law have become apparent in circumstances where a company is unable to positively satisfy the COT, but is also unable to demonstrate a specific date on which it failed the COT. That is, the company is unable to establish a test time for which the SBT can be applied.

4.6 The amendments in Schedule 7 to this bill provide for a default test time at which the SBT can be applied if the company is unable to determine precisely when it has failed the COT.

Summary of new law

4.7 The new law widens the circumstances in which the SBT will be available to companies that have failed the COT. This is achieved by providing a default test time at which the SBT can be applied if the company is unable to determine precisely when it has failed the COT.

4.8 In the case of tax losses, the test time for application of the SBT is the latest time that the company can show that it has satisfied the COT.

4.9 However, if it is not practicable for the company to show that it has maintained the same owners for any period since the incurring of the loss, the default test time for application of the SBT is the start of the loss year or, if the company came into being during the loss year, the end of the loss year.

4.10 In the case of bad debts, the test time for application of the SBT is the latest time that the company can show that it has satisfied the COT.

4.11 However, if it is not practicable for the company to show that it has maintained the same owners for any period since the incurring of the bad debt, the default test time for application of the SBT will apply.

4.12 If the debt was incurred in the current year and the company was in being throughout the current year, the default test time is the start of the current year.

4.13 If the debt was incurred before the current year, or the company came into being during the current year, the default test time is the end of the day on which the debt was incurred.

4.14 The amendments proposed by this bill do not affect the rules required for satisfaction of the SBT contained in section 165-210. The amendments merely provide for a default test time in circumstances where the SBT would not otherwise be available to the company.

Detailed explanation of new law

The general rule

Restatement of current law

4.15 As part of providing a default test time for applying the SBT, the test time in the existing provisions is being restated. That is, for most companies the identifiable failure of the COT will continue to be the test time.

Extension of availability of the SBT

4.16 The new law also widens the circumstances in which the SBT can be applied, by providing a default test time at which the SBT can be applied if it is not practicable for the company to show precisely when it has failed the COT.

When is it not practicable for a company to show that it fails the COT?

4.17 Impracticability may arise where the necessary information on the beneficial ownership of shares does not exist or where the information cannot reasonably be obtained.

4.18 Also, a company may be able to identify the beneficial owners of its shares such that it may know that it has not satisfied the COT as between, say, the beginning of the loss year and the end of the income year. However, it may be impracticable to point to the time it actually failed the test.

Example 4.1

A majority shareholder in Company X is Company A, which is registered in a foreign country. Under the corporations registration laws in that country, Company A may voluntarily release the names of its shareholders or details of any change of ownership, but is not legally obliged to do so.

Company X seeks the information but Company A does not release it. Company X is not able to satisfy the COT for any period of time, as the inability of Company X to obtain details of any change of ownership of Company A means that it is not practicable for Company X to show that it has maintained the same owners.

Example 4.2

Company X is wholly-owned by a non-resident, Company A. More than 50% of the shares in Company A are bearer shares. While the information is sought Company X is unable to identify the beneficial owners.

Company X is not able to satisfy the COT for any period of time, as the inability to identify the beneficial owners of the bearer shares means that it is not practicable for Company X to show that it has maintained the same owners.

Default test time for the use of the SBT for deduction of tax losses

Current rules for applying the COT when seeking to deduct tax losses

4.19 Under the current law, the COT is satisfied if the company has maintained the same owners at all times during the period from the start of the loss year to the end of the income year. This is known as the ownership test period.

4.20 This bill does not amend the current rules for applying the COT when seeking to deduct tax losses.

Practicable to show that the company can satisfy the COT for some period

4.21 Where it is practicable for the company to show that it can satisfy the COT for some period of time, but not for the entire ownership test period, the test time for application of the SBT is the latest time that the company can demonstrate that it has satisfied the COT. [Schedule 7, item 1, subsection 165-13(2), item 1 in the table]

4.22 For a company that is able to point to the actual time of failure of the COT as required under the current provisions, the time of failure will equate to the latest time it is practicable to show that the company has satisfied the COT. There is no change in the test in this case. Companies that can demonstrate failure of the COT, or indeed satisfaction of it, will continue to be required to do so.

4.23 For a company that is able to demonstrate some period where it satisfies the COT but is unable to point to the actual time it failed the test, then the test time for application of the SBT is the latest point at which the company can show it satisfied the COT.

Impracticable to show failure of the COT

4.24 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the loss year, the default test time for application of the SBT is the start of the loss year. [Schedule 7, item 1, subsection 165-13(2), item 2 in the table]

Example 4.3

Company X, which came into being in 1997, incurs a tax loss during the 1999-2000 year and wishes to deduct this tax loss against income earned in the 2001-2002 year.

At all times Company X was wholly-owned by a non-resident, Company A and 75% of the shares in Company A are bearer shares. Company X is at no time able to determine the beneficial owner of these bearer shares.

As Company X is unable to determine the owner of the bearer shares, it is not practicable for Company X to demonstrate that there is a period for which it has maintained the same owners. Company X therefore has access to the SBT under subsection 165-13(2), item 2 in the table.

In order to deduct the loss, Company X must satisfy the SBT for the 2001-2002 income year by reference to the business Company X carried on immediately before the start of the loss year (i.e. 1 July 1999).

Impracticable to demonstrate failure of the COT and the company came into being during the loss year

4.25 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the loss year, and the company came into being during the loss year, the default test time for application of the SBT is the end of the loss year. [Schedule 7, item 1, subsection 165-13(2), item 3 in the table]

Example 4.4

Company X, which came into being on 1 September 1999, incurs a tax loss during the 1999-2000 year and wishes to deduct this tax loss against income earned in the 2001-2002 year.

At all times Company X was wholly-owned by a non-resident, Company A and 75% of the shares in Company A are bearer shares. Company X is at no time able to determine the beneficial owner of these bearer shares.

As Company X is unable to determine the owner of the bearer shares, it is not practicable for Company X to demonstrate that there is a period for which it has maintained the same owners. Company X therefore has access to the SBT under subsection 165-13(2), item 3 in the table.

In order to deduct the loss, Company X must satisfy the SBT for the 2001-2002 income year by reference to the business Company X carried on immediately before the end of the loss year (i.e 30 June 2000).

Default test time for the use of the SBT for deduction of bad debts

Current rules for applying the COT when seeking to deduct bad debts

4.26 The current law provides for a 'first continuity period' and a 'second continuity period'.

•

If the debt was incurred prior to the current year, the first continuity period is the period from the day the debt was incurred to the end of that income year, and the second continuity period is the current year.

•

If the debt was incurred in the current year, the first continuity period is the period from the start of the current year to the day the debt was incurred, and the second continuity period is the period from the day after the debt was incurred to the end of the current year.

4.27 Under the current law, the COT will be satisfied if the company can demonstrate that it has maintained the same owners at all times from the start of the first continuity period to the end of the second continuity period.

Practicable to show that the company can satisfy the COT for some period

4.28 Where it is practicable for the company to show that it can satisfy the COT for some period of time from the start of the first continuity period but not for the entire period through to the end of the second continuity period, the test time for application of the SBT is the latest time that the company can demonstrate that it has satisfied the COT. [Schedule 7, item 16, subsection 165-126(2), item 1 in the table]

4.29 For a company that is able to point to the actual time of failure of the COT as required under the current provisions, the time of failure will equate to the latest time it is practicable to show that the company has satisfied the COT. There is no change in the test in this case. Companies that can demonstrate failure of the COT, or indeed satisfaction of it, will continue to be required to do so.

4.30 For a company that is able to demonstrate some period where it satisfies the COT but is unable to point to the actual time it failed the test, then the test time for application of the SBT is the latest point at which the company can show it satisfied the COT.

Debt incurred before the current year

4.31 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the debt was incurred before the current year, the default test time for the application of the SBT is the end of the day on which the debt was incurred. [Schedule 7, item 16, subsection 165-126(2), subitem 2(a) in the table]

Example 4.5

Company X incurs a debt on 14 September 1999 and writes off the debt as bad during the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the bad debt, Company X must demonstrate that it satisfies the SBT for the current year (i.e. 2001-2002) by reference to the business the company carried on immediately before the end of the day on which the debt was incurred (i.e. 14 September 1999).

The company came into being during the current year

4.32 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the company came into being during the current year, the default test time for the application of the SBT is the end of the day on which the debt was incurred. [Schedule 7, item 16, subsection 165-126(2), subitem 2(b) in the table]

Example 4.6

Company X comes into being on 2 August 2001. Company X incurs a debt on 28 October 2001 and writes off the debt as bad during the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the debt, Company X must demonstrate that it satisfies the SBT for the period from 29 October 2001 to the end of the 2001-2002 year by reference to the business the company carried on immediately before the end of the day on which the debt was incurred (i.e. 28 October 2001).

Debt incurred in the current year and the company in being through the current year

4.33 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the debt was incurred in the current year, and the company was in being throughout the current year, the default test time for the application of the SBT is the start of the current year. [Schedule 7, item 16, subsection 165-126(2), item 3 in the table]

Example 4.7

Company X incurs a debt on 15 December 2001 and writes off the debt as bad during the 2001-2002 income year. Company X is in being throughout the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the debt, Company X must demonstrate that it satisfies the SBT for the period from the day after the debt was incurred (i.e. 16 December 2001) to the end of the 2001-2002 year by reference to the business the company carried on immediately before the start of the current year (i.e. 1 July 2001).

Effect of amendments on listed public companies

4.34 The amendments in this bill do not affect the operation of Division 166, which deals with the income tax consequences of changing ownership or control of a listed public company.

4.35 Subsection 166-5(3) provides that a listed public company is taken to have failed to meet the conditions in section 165-12 if there has been no substantial continuity of ownership of the company between the start of the loss year and the end of any income year, or any time of abnormal trading, that occurs during the ownership test period. As the subsection provides a specific deemed failure of the COT, listed public companies in this situation have automatic access to the SBT by virtue of the test time specified in subsection 166-5(5).

4.36 A company's ability to choose under section 166-15 that Subdivisions 165-A is to apply to it without the modifications made by Subdivision 166-B is not affected in any way by the amendments to Division 165 made by this bill. Consequently, listed public companies can access the default times in section 165-13 by making the choice under section 166-15.

4.37 A company's ability to choose under section 166-50 that Subdivision 165-C is to apply to it without the modifications made by Subdivision 166-C is not affected in any way by the amendments to Division 165 made by this bill. Consequently, listed public companies can access the default times in section 165-126 by making the choice under section 166-50.

Effect of amendments on existing Subdivision 165-F

4.38 Subdivision 165-F contains special provisions applying an alternative COT to companies owned by non-fixed trusts. These special provisions provide that if a company does not meet the conditions in section 165-12 for satisfaction of the COT, the company is nevertheless taken to meet those conditions if it satisfies the conditions under section 165-210 in Subdivision 165-F.

4.39 Subdivision 165-F applies both for the purposes of sections 165-12 and 165-123 in their own right and for the purposes of the notional application of those sections by sections 165-13 and 165-126 respectively.

4.40 The amendments to sections 165-13 and 165-126 apply in any circumstance where there is a failure, or deemed failure, of the COT under the ITAA 1997.

4.41 A company that is substantially owned by non-fixed trusts may be able to satisfy the requirements of Subdivision 165-F for some period after the commencement of the loss year but not for the whole of the ownership test period. In that case that company will be able to access the SBT by reference to the business carried on by the company immediately before the last time, during the ownership test period, it was practicable to show the requirements of Subdivision 165-F were satisfied.

Application and transitional provisions

4.42 The amendments relating to the use of the SBT to deduct prior year losses applies for the 1997-1998 income year and all later income years, however an amendment affecting a provision does not apply to anything to which the provision did not apply before the amendment.

4.43 The amendments relating to the use of the SBT to deduct bad debts written off applies for the 1998-1999 income year and all later income years.

4.44 Note that section 4 of this bill ensures that section 170 does not prevent amended assessments that may be required to give effect to these measures.

Consequential amendments

4.45 A technical correction is necessary to amend subsection 166-40(5) to remove an incorrect reference to paragraphs 2(a) and (b) and replace with a reference to the correct paragraphs 2(c) and (d). However, this technical correction does not affect the substance of the amendments proposed by this bill.

4.46 As a result of the reformatting of the SBT test time in table format, consequential amendments are necessary so as to make reference to the single 'condition' in each of sections 165-13 and 165-126. [Schedule 7, item 2, paragraph 165-10(b); item 4, subsection 165-115B(4); item 5, subsection 165-115BA(4) and (5); item 7, paragraph 707-125(1)(b); item 8, subsection 707-125(2); item 12, note to subsection 719-260(2); item 17, paragraph 165-120(1)(c)]

4.47 As a result of the change in terminology from 'continuity period' to 'test time', consequential amendments are necessary so as to make reference to the test time established by sections 165-13 and 165-126 and to amend the definitions. [Schedule 7, item 3, subsection 165-115B(3); item 6, paragraph 165-115BA(5)(c); item 9, subparagraph 707-125(2)(a)(ii); item 10, note to subsection 707-125(2); item 11, subsection 715-90(2); items 13, 14 and 21, definition of 'test time' in subsection 995-1(1); items 18 and 19, section 165-132; item 20, definition of 'minimum continuity period' in subsection 995-1(1)]