House of Representatives

Explanatory Memorandum

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

Chapter 1 - Loss recoupment rules for companies: modified continuity of ownership test

Outline of chapter

1.1 Schedule 1 to this Bill reforms the loss recoupment rules for companies by:

•

introducing a new modified continuity of ownership test (COT) to replace the existing modified COT in Division 166 of the Income Tax Assessment Act 1997 (ITAA 1997);

•

removing the same business test (SBT) for companies whose total income is more than $100 million in the year of recoupment; and

•

removing certain anomalies and clarifying some aspects of the existing law.

1.2 This chapter explains the new modified COT for widely held companies that applies from 1 July 2002.

Context of amendments

1.3 If a company's deductions exceed its assessable income and net exempt income in an income year, the company has a tax loss, which it can carry forward to use as a deduction in a future income year. However, the company can only deduct the tax loss if it satisfies either the COT or the SBT.

1.4 The COT is satisfied if the same people hold more than 50 per cent of voting power and rights to dividends and capital at all times during the relevant test period. To apply the COT, a company must trace its ownership through companies, trusts and other entities to identify the people who ultimately hold (directly or indirectly) voting power and rights to dividends and capital distributions.

1.5 It is often difficult for companies to trace through entities such as listed companies, superannuation funds and managed funds to identify the ultimate individual owners. Accordingly, companies owned by these entities may incur substantial compliance costs in determining whether the COT has been satisfied. If such companies cannot determine ultimate ownership, the deductibility of their losses may be uncertain.

1.6 In addition to being a test for the recoupment of tax losses, the COT is also relevant in other contexts:

•

A company must satisfy either the COT or the SBT to apply a prior year net capital loss or deduct a foreign loss or bad debt.

•

A company must satisfy either the COT or the SBT when joining a consolidated group to transfer a loss of any sort to the head company.

•

If a company fails both the COT and the SBT in an income year, it must work out its taxable income or tax loss and net capital gain or net capital loss for that income year in a special way.

•

If a company fails the COT and has an unrealised net loss, it cannot take into account future capital losses or deductions in respect of capital gains tax assets that it owned at the time it failed the COT (to the extent of the unrealised net loss), unless it satisfies the SBT.

•

If a company fails the COT, the tax attributes of significant equity and debt interests in the company may be adjusted to prevent multiple recognition of the company's losses.

Summary of new law

1.7 These amendments replace the modified COT in Division 166 of the ITAA 1997 with a new modified COT. They simplify the application of the COT for companies that are widely held by providing tracing rules that make it unnecessary for an eligible company to trace the ultimate owners of shares held by certain intermediaries and small shareholdings. [Schedule 1, item 79, section 166-3]

1.8 The new modified COT applies to widely held companies and companies that are more than 50 per cent owned (directly or indirectly) by widely held companies, certain entities that are treated as ultimate owners, non-profit companies or charitable bodies.

1.9 Companies applying the modified COT must test for continuity of ownership at the end of each income year and at certain other specified times, rather than continuously as required by the ordinary COT.

1.10 The new modified COT contains tracing rules that assist the company in testing continuity of ownership:

•

A direct stake of less than 10 per cent is attributed to a single notional entity.

•

An indirect stake of less than 10 per cent is attributed to the top interposed entity.

•

A stake of between 10 per cent and 50 per cent (inclusive) held by a widely held company is attributed to the widely held company as an ultimate owner.

•

A stake held by an entity deemed to be a beneficial owner (a superannuation fund, approved deposit fund, special company or managed investment scheme) is generally attributed to that entity as an ultimate owner.

•

An indirect stake held by way of bearer shares in a foreign listed company is attributed to a single notional entity in certain circumstances.

•

An indirect stake held by a depository entity through shares in a foreign listed company is attributed to the depository entity as an ultimate owner in certain circumstances.

Detailed explanation of new law

1.11 The new modified COT applies to widely held companies and eligible Division 166 companies. It modifies how the ownership tests in Division 165 apply. Its key features are:

•

companies are required to test for continuity of ownership at the end of each income year and at the end of certain corporate changes; and

•

tracing rules assist companies in testing for continuity of ownership.

Eligibility for the modified continuity of ownership test

1.12 Companies that are either widely held or are eligible Division 166 companies throughout the relevant income year can apply the modified COT. A company that is widely held for part of the income year and is an eligible Division 166 company for the rest of the income year can also apply the modified COT. [Schedule 1, item 79, subsections 166-5(1), 166-20(1), 166-40(1) and 166-80(1) and section 166-220]

1.13 A company is eligible for the new modified COT if it is widely held or an eligible Division 166 company for the income year in which it seeks to deduct a tax loss. Companies that are neither widely held nor eligible Division 166 companies continue to use Division 165 to determine whether they satisfy the COT.

Widely held companies

1.14 A company is widely held if it is listed on an approved stock exchange. [Schedule 1, item 168, section 995-1]

1.15 A list of approved stock exchanges is contained in Schedule 12 to the Income Tax Regulations 1936 .

1.16 A company is also widely held if it has more than 50 members, unless:

•

at any time in the income year, 20 or fewer people hold or have the right to acquire or become the holder of shares representing 75 per cent or more of the value of shares in the company, other than shares entitled to a fixed rate of dividend only;

•

at any time during the income year, 20 or fewer people are capable of exercising 75 per cent or more of the voting power in the company;

•

in that year, 20 or fewer people receive 75 per cent or more of any dividend paid by the company; or

•

the company did not pay a dividend in that year, but the Commissioner of Taxation (Commissioner) is of the opinion that, if a dividend had been paid by the company at any time during the income year, 20 or fewer people would have received 75 per cent or more of that dividend.

[Schedule 1, item 168, section 995-1]

Example 1.1: Eligibility of widely held companies

In the income year ending 30 June 2005, Jazz Limited (Jazz) has 1,000 ordinary shareholders. The top 20 shareholders hold 60 per cent by value of the shares and may exercise 60 per cent of the voting power in the company. Jazz is not listed.

No dividend is paid during the income year. According to the company's constitution, if any dividend was declared it would have to be apportioned equally among all the shares in the company. Therefore, the top 20 shareholders would have rights to 60 per cent of dividends and the Commissioner would be satisfied that there are not 20 or fewer people who would have had the right to 75 per cent or more of any dividend that was paid.

Therefore, Jazz is a widely held company during the income year ended 30 June 2005 and can apply the modified COT in testing whether it can deduct any tax losses in that year.

In the income year ending 30 June 2006, Jazz changes its constitution and issues preference shares to 10 people. The preference shares represent only 5 per cent by value of the shares in the company and none of the voting power. However, the only dividend the company distributes during the income year is to the preference shareholders.

Accordingly, Jazz is not a widely held company for the whole of the year ended 30 June 2006, because only 10 shareholders received 100 per cent of dividends that the company paid. Jazz is ineligible to apply the modified COT in testing whether it can deduct tax losses in that income year.

Eligible Division 166 companies

1.17 A company is also eligible for the new modified COT if it is an eligible Division 166 company - that is, more than 50 per cent of the voting power, rights to dividends or rights to capital distributions are held by one or more:

•

widely held companies;

•

superannuation funds;

•

approved deposit funds;

•

special companies;

•

managed investment schemes ;

•

entities that are prescribed under the tracing rule that deems entities to be beneficial owners;

•

non-profit companies; or

•

charitable institutions, charitable funds or any other kind of charitable bodies.

[Schedule 1, item 148, section 995-1]

1.18 Superannuation funds, approved deposit funds, special companies, managed investment schemes and prescribed entities are only taken into account if they meet the certain criteria. For example, a superannuation fund must be a complying superannuation fund or a superannuation fund established in a foreign country and regulated under a foreign law. [Schedule 1, item 79, subsection 166-245(3)]

1.19 In order to qualify as an eligible Division 166 company for an entire income year, it is not necessary for the same entities to hold more than 50 per cent of voting power, dividend and capital distribution rights throughout the income year. For example, one widely held company may hold a 60 per cent interest in the tested company from 1 July until 31 January and then sell its interest to a different widely held company, which then holds the interest from 1 February to 30 June. In this case, the tested company qualifies as an eligible Division 166 company for the entire income year.

Example 1.2: Eligible Division 166 company

This example is continued from Example 1.1.

Throughout the period 1 July 2004 to 30 June 2006, Blues Limited (Blues) is 35 per cent owned by Jazz, 45 per cent owned by companies listed on the Australian Stock Exchange, and 20 per cent owned by individuals.

Jazz is a widely held company throughout the income year ended 30 June 2005. However, it is only a widely held company for part of the income year ended 30 June 2006.

Blues would be an eligible Division 166 company throughout the income year ended 30 June 2005, because it is 80 per cent (ie, 45% + 35%) owned by widely held companies. Accordingly, it would be eligible to apply the modified COT in that year.

Blues would not be an eligible Division 166 company for the whole of the income year ended 30 June 2006, because it would cease to be an eligible Division 166 company when Jazz ceased to be a widely held company. Accordingly, Blues would not be eligible to apply the modified COT in that year.

Interaction between the modified continuity of ownership test and the ordinary continuity of ownership test

1.20 The modified COT provides widely held and eligible Division 166 companies with an alternative method for testing continuity of ownership:

•

Subdivision 166-A modifies the application of Subdivision 165-A to deductions for tax losses [Schedule 1, item 79, section 166-5] .

•

Subdivision 166-B modifies the application of Subdivision 165-B, which concerns the calculation of income in a year of ownership change, and Subdivision 165-CB, which concerns the calculation of net capital gains in a year of ownership change [Schedule 1, item 79, section 166-20] .

•

Subdivision 166-C modifies the application of Subdivision 165-C to deductions for bad debts [Schedule 1, item 79, section 166-40] .

•

Subdivision 166-CA modifies the application of Subdivisions 165-CC and 165-CD in determining changeover times and alteration times for the purposes of the unrealised loss rules and inter-entity loss multiplication rules [Schedule 1, item 79, section 166-80] .

•

Subdivision 166-D explains how the ownership conditions interact with the rules in Subdivision 165-D [Schedule 1, item 79, section 166-135] .

1.21 A company applying the modified COT satisfies the COT if it has substantial continuity of ownership at each test time in the ownership test period. [Schedule 1, item 79, subsections 166-5(3), 166-20(2), 166-40(3) and 166-80(2)]

1.22 For each of Subdivisions 166-A, 166-B, 166-C and 166-CA, a widely held company or eligible Division 166 company has the right to elect that the modifications in Division 166 do not apply in relation to an income year. The choice must be made on or before the day the company lodges its income tax return for the year, or before a later day if the Commissioner allows. [Schedule 1, item 79, sections 166-15, 166-35, 166-50 and 166-90]

Tax losses

1.23 Subdivision 166-A modifies the application of the COT in relation to deductions for tax losses of earlier income years. The COT is satisfied if there is substantial continuity of ownership between the beginning of the loss year and each test time in the test period. [Schedule 1, item 79, section 166-5]

1.24 The test period runs from the start of the loss year to the end of the income year. The test times are the end of each income year in the test period and the end of certain corporate changes. [Schedule 1, item 79, subsections 166-5(2) to (4)]

1.25 The test for substantial continuity of ownership is the alternative test in Division 165, but with several modifications. The alternative test requires a company to trace its ownership through to persons who are not companies. [Schedule 1, item 79, subsection 166-145(5)]

1.26 If the company fails the modified COT, the company can nevertheless deduct the tax loss if it satisfies the SBT for the income year. [Schedule 1, item 79, subsection 166-5(5)]

1.27 The SBT compares the business carried on by the company in the income year with the business carried on immediately before the company failed the COT. If the company does have substantial continuity of ownership at a particular test time, the SBT is applied to the business carried on immediately before that test time. [Schedule 1, item 79, subsection 166-5(6)]

1.28 The SBT can only be satisfied if the company's total income is no more than $100 million in the income year for a loss that was incurred in an income year commencing on or after 1 July 2005. [Schedule 1, item 76, section 165-212A]

Net capital losses, foreign losses and film losses

1.29 Subdivision 166-A is also relevant for net capital losses, foreign losses and film losses.

1.30 A net capital loss from an earlier income year can only be applied to reduce a net capital gain if it could have been deducted were it a tax loss (section 165-96 of the ITAA 1997). Accordingly, a company applies the tests in Subdivision 165-A to determine whether it can apply a net capital loss.

1.31 Similarly, a foreign loss does not reduce foreign income if Subdivision 165-A would have prevented a deduction had the foreign loss been a tax loss (subsection 160AFD(6) of the Income Tax Assessment Act 1936 (ITAA 1936)).

1.32 Film losses are a subset of tax losses and are subject to the same rules regarding deductibility (with the addition of quarantining provisions in Subdivision 375-G).

1.33 It follows that the modifications that Subdivision 166-A makes to Subdivision 165-A are also relevant to determining whether:

•

a net capital loss can be applied;

•

a foreign loss can be taken into account; or

•

a film loss can be deducted.

1.34 The SBT applies for these types of losses if the COT is failed. However, the SBT can only be satisfied if the company's total income is not more than $100 million in the income year. [Schedule 1, item 76, section 165-212A]

Transfer of losses

1.35 Subdivision 166-A is also relevant to the transfer of losses to a head company under the consolidation regime and to the transfer of losses under Division 170 of the ITAA 1997.

1.36 The transfer of losses of any sort from a joining entity to the head company of a consolidated group depends on the joining entity being hypothetically entitled to utilise the loss in a trial year. Accordingly, in relation to a tax loss (including a film loss), a net capital loss or a foreign loss, the joining entity must meet the tests in Subdivision 165-A.

1.37 As a result, the modifications that Subdivision 166-A makes to Subdivision 165-A are relevant in determining whether losses can be transferred from a joining entity to a head company. Because the trial year is treated as if it were an income year, the end of the trial year is a test time for the purposes of the loss transfer tests.

1.38 A condition for the transfer of a loss under Division 170 is that neither company is prevented from deducting the loss by Division 165. Therefore, the modifications that Subdivision 166-A makes to Subdivision 165-A are also relevant for the purpose of Division 170 tax loss transfers.

Working out taxable income for a year of change

1.39 Subdivision 166-B modifies the operation of Subdivisions 165-B and 165-CB. Broadly, these Subdivisions require a company to divide its income year into separate periods for the purpose of calculating its taxable income, net capital gains, tax losses and net capital losses, if the company has had a change in ownership during the income year and has not satisfied the SBT.

1.40 For the purpose of Subdivision 166-B, substantial continuity of ownership is tested by comparing ownership at the beginning of the income year with ownership at the end of each corporate event during the year. [Schedule 1, item 79, subsections 166-20(2) and (3)]

1.41 A key difference between Subdivision 166-B and the application of the modified COT in other contexts, is that in Subdivision 166-B there is no test time at the end of the income year. This is because an ownership change at the end of the year is not relevant for the purposes of dividing the income year into periods.

1.42 A company does not need to calculate its taxable income, net capital gains, tax losses and net capital losses under Subdivision 165-B or 165-CB unless either:

•

there is a failure of substantial continuity of ownership at a test time during the income year; or

•

a person begins to control, or becomes able to control, the voting power in the company for a purpose of getting a benefit or advantage (whether for themselves or someone else) in relation to how the ITAA 1997 applies (see section 165-40 of the ITAA 1997).

1.43 In either case, the company only needs to calculate its taxable income, net capital gains, tax losses and net capital losses under Subdivision 165-B or 165-CB if the company does not satisfy the SBT from the time immediately before the relevant test time (or the time the person become able to control the voting power) until the end of the income year. [Schedule 1, item 79, subsections 166-20(4) and (5)]

1.44 If the company does not satisfy the SBT, the company must divide its income year into periods. Each period ends at the earliest time that either:

•

there is a failure of substantial continuity of ownership; or

•

a person begins or becomes able to control the voting power in the company for a purpose of getting a benefit or advantage (whether for themselves or someone else) in relation to how the ITAA 1997 applies.

[Schedule 1, item 79, section 166-25]

Deducting bad debts

1.45 Subdivision 166-C modifies the application of Subdivision 165-C for companies that are either widely held or eligible Division 166 companies for the entire income year in which the bad debt is written-off. [Schedule 1, item 79, subsection 166-40(1)]

1.46 A company is taken to meet the conditions in section 165-123 about maintaining the same owners if there is substantial continuity of ownership at the relevant times. [Schedule 1, item 79, subsection 166-40(3)]

1.47 If a debt is written-off as bad in the income year in which it is incurred, there must be substantial continuity of ownership between the start of the income year and each test time in the period ending at the end of the income year in which the debt is written-off. [Schedule 1, item 79, subsections 166-40(2) and (3)]

1.48 If a debt incurred in a previous income year is written-off as bad, the company has a choice as to when the test period starts. The test period may start either on the day the debt was incurred or the start of the income year in which the debt was incurred. The company must establish substantial continuity of ownership between this start time and each test time in the period ending at the end of the income year in which the debt is written-off. [Schedule 1, item 79, subsections 166-40(2) and (3)]

1.49 If the company cannot establish substantial continuity of ownership in the test period the company is not able to deduct the bad debt unless either:

•

the Commissioner exercises the discretion provided in paragraph 165-120(1)(b) because it is considered to be unreasonable to require the company to meet the COT, having regard to the entities that beneficially owned shares in the company when the debt became bad; or

•

the company satisfies the SBT for the second continuity period.

[Schedule 1, item 79, subsections 166-40(4) and (5)]

1.50 The SBT is applied to the business the company carried on immediately before the first test time on which there was no substantial continuity of ownership. [Schedule 1, item 79, subsection 166-40(6)]

Changeover times and alteration times

1.51 Subdivision 166-CA modifies the application of Subdivisions 165-CC and 165-CD in determining whether there is a changeover time or alteration time during an income year in which a company is either a widely held company or an eligible Division 166 company at all times. [Schedule 1, item 79, subsection 166-80(1)]

1.52 There is no changeover time or alteration time in a particular income year if there is substantial continuity of ownership between the reference time, the end of that income year and any other test times in that year. [Schedule 1, item 79, subsections 166-80(2) and (3)]

1.53 The reference time is the date of the last changeover time for the company for the purposes of Subdivision 165-CC and the date of the last alteration time for the company for the purposes of Subdivision 165-CD. If no changeover time or alteration time has previously occurred, the reference time is the later of 11 November 1999 and the date the company came into existence.

1.54 If there is not substantial continuity of ownership at a test time, the changeover time or alteration time (as the case may be) occurs at the test time. [Schedule 1, item 79, subsections 166-80(4) to (6)]

Substantial continuity of ownership

1.55 There is substantial continuity of ownership if (and only if) the company satisfies the alternative tests for voting power and rights to dividend and capital distributions. [Schedule 1, item 79, section 166-145]

1.56 Broadly, the alternative tests are satisfied if during the test period:

•

the same persons other than companies and trustees, directly or indirectly, hold more than 50 per cent of the voting power in the tested company [Schedule 1, item 79, subsection 166-145(2)] ;

•

the same persons other than companies, directly or indirectly, hold for their own benefit more than 50 per cent of the rights to any dividends the tested company may pay [Schedule 1, item 79, subsection 166-145(3)] ; and

•

the same persons other than companies, directly or indirectly, hold for their own benefit more than 50 per cent of the rights to any distributions of capital the tested company may make [Schedule 1, item 79, subsection 166-145(4)] .

1.57 When testing for substantial continuity of ownership, there are two key modifications to the alternative tests in Subdivision 165-D:

•

tracing rules can limit the tracing required by a company in determining who holds voting power or dividend and capital rights; and

•

ownership is tested at the end of each income year and at the end of certain corporate changes, not continuously.

1.58 Apart from section 165-165, the other provisions in Subdivision 165-D apply for the purposes of substantial continuity of ownership. However, provisions relating to arrangements affecting the beneficial ownership of shares (section 165-180) and variations or potential variations in rights attaching to shares (sections 165-185 and 165-190) are read as if a reference to a particular time were a reference to the ownership test time. [Schedule 1, item 79, section 166-165]

Test times

1.59 To satisfy the COT in Division 165 of the ITAA 1997, a company must maintain the same owners continuously from the start of the loss year to the end of the income year.

1.60 This rule is modified for widely held and eligible Division 166 companies by requiring substantial continuity of ownership between the start of the test period and certain specified times. There is no need to satisfy the modified COT continuously.

1.61 The end of each income year in the test period is a test time, other than for the purposes of Subdivision 166-B. The end of a corporate change in the test period is also a test time. [Schedule 1, item 79, subsections 166-5(3), 166-20(2), 166-40(3) and 166-80(2)]

1.62 The following are the end of a corporate change:

•

the end of the bid period of a takeover bid for the company (whether or not the takeover bid is successful) [Schedule 1, item 79, paragraphs 166-175(1)(a) and (2)(a)] ;

•

the end of a court approved scheme of arrangement involving more than 50 per cent of the company's shares [Schedule 1, item 79, paragraphs 166-175(1)(b) and (2)(b)] ;

•

the end of any other arrangement involving the acquisition of more than 50 per cent of the company's shares, regulated under either the Corporations Act 2001 or a foreign law [Schedule 1, item 79, paragraphs 166-175(1)(c) and (2)(b)] ; and

•

the end of an offer period for an issue of shares in the company that increases the issued capital or the number of shares by 20 per cent or more [Schedule 1, item 79, paragraphs 166-175(1)(d) and (2)(c)] .

1.63 There is also a corporate change if one of those events happens to another company that holds more than 50 per cent of voting power, or dividend or capital rights in the tested company. [Schedule 1, item 79, paragraph 166-175(1)(e) and subsection 166-175(2)]

1.64 In relation to the transfer of losses to a consolidated group, continuity of ownership is tested for a trial year ending just after the joining time (section 707-120). Because continuity of ownership is tested as if the trial year were an income year, the end of the trial year is a test time even if it does not correspond to the end of an actual income year. The same principle is relevant to other consolidation provisions that refer to trial years (see Division 715) or debt test income years (see Subdivision 709-D).

Example 1.3: Testing continuity of ownership

In the income year ended 30 June 2006, Loss Company is eligible for the modified COT because it is a widely held company.

Loss Company incurred a tax loss in the year commencing 1 July 2002 and tests to determine whether it can deduct the tax loss in the year ended 30 June 2006.

On 1 November 2003, Loss Company issued further shares that increased its share capital by 30 per cent. It has had no takeover bids, schemes of arrangement or any other events in the nature of a takeover during the ownership period.

Loss Company will satisfy the modified COT if it can establish substantial continuity of ownership between 1 July 2002 and each of 30 June 2003, 1 November 2003, 30 June 2004, 30 June 2005 and 30 June 2006.

Tracing rules

1.65 The following tracing rules make it easier for companies to test for substantial continuity of ownership:

•

A direct stake of less than 10 per cent is attributed to a single notional entity [Schedule 1, item 79, section 166-225] .

•

An indirect stake of less than 10 per cent is attributed to the top interposed entity [Schedule 1, item 79, section 166-230] .

•

A stake of between 10 per cent and 50 per cent (inclusive) held by a widely held company is attributed to the widely held company as an ultimate owner [Schedule 1, item 79, section 166-240] .

•

A stake held by an entity deemed to be a beneficial owner (a superannuation fund, approved deposit fund, special company or managed investment scheme) will generally be attributed to that entity as an ultimate owner [Schedule 1, item 79, section 166-245] .

•

An indirect stake held by way of bearer shares in a foreign listed company is attributed to a single notional entity in certain circumstances [Schedule 1, item 79, section 166-255] .

•

An indirect stake held by a depository entity through shares in a foreign listed company is attributed to the depository entity as an ultimate owner in certain circumstances [Schedule 1, item 79, section 166-260] .

Direct stakes of less than 10 per cent

1.66 The tracing of small ownership interests gives rise to high compliance costs for widely held companies. The modified COT is designed to reduce compliance costs by removing the need to trace ownership interests of less than 10 per cent.

1.67 For all registered shareholdings carrying less than 10 per cent of voting power, the voting power is taken to be controlled by a single notional entity. The same rule applies in relation to rights to dividends and distributions of capital. [Schedule 1, item 79, section 166-225]

1.68 The single notional entity is taken to be a person (other than a company), and is therefore regarded as an ultimate owner for the purpose of the alternative test. The persons who actually hold the power or rights attributed to the single notional entity are taken not to hold those rights for the purposes of the alternative test. This prevents double counting of the voting power and rights to dividends and capital. [Schedule 1, item 79, paragraph 166-225(2)(c) and section 166-265]

1.69 Voting power and rights to dividends and capital are dealt with separately. For example, if a particular shareholding represents 5 per cent of voting power, but 15 per cent of dividend rights, the voting power attached to the shareholding is allocated to the single notional entity, but not the dividend rights.

Nominee shareholders

1.70 If a nominee company is the registered shareholder, but holds the shares for more than one other entity, the tested company may treat the parcels of shares held by the nominee company as separate stakes for the purpose of this tracing rule. This means that if the nominee company's registered shareholding carries 10 per cent or more of voting power or rights, but the entities for which it holds the shares each have less than 10 per cent of voting power or rights, each of the stakes of less than 10 per cent can be attributed to the single notional entity. [Schedule 1, item 79, subsection 166-235(7)]

Example 1.4: Nominee shareholders

Beta Nominees Limited is the registered holder of 30 per cent of shares in the tested company. It holds these shares on behalf of 5 different entities, each of which beneficially own 6 per cent of the tested company's shares.

Each stake of 6 per cent may be attributed to the single notional entity.

1.71 The separation of stakes held by nominee companies is optional. If the nominee company's registered shareholding is less than 10 per cent, its stake could be attributed directly to the single notional entity. In such a case, there would be no need for the tested company to inquire as to the identity of underlying stakeholders, provided the company is satisfied that the controlled test companies rule would not apply.

Indirect stakes of less than 10 per cent

1.72 A tested company does not need to trace the beneficial owners of indirect interests in the company that carry less than 10 per cent of the voting power and rights to dividends and capital. This rule will reduce the compliance costs incurred by companies identifying their indirect ownership. [Schedule 1, item 79, subsection 166-230(1)]

1.73 In relation to an indirect stake of less than 10 per cent, the top interposed entity is taken to hold the relevant voting stake, dividend stake or capital stake. The top interposed entity is the entity in which the stakeholder with a less than 10 per cent interest has a direct interest. This entity need not be a company. [Schedule 1, item 79, subsection 166-230(2)]

1.74 For example, a stakeholder may have an 8 per cent voting stake in the tested company, which is held through a chain of interposed companies. The top interposed entity is the company in which the stakeholder is a shareholder. If a stakeholder holds an indirect interest in a company as a beneficiary in a trust, the trust would be the top interposed entity.

1.75 The tested company may treat a nominee company as holding a separate indirect stake in respect of each entity for which the nominee company holds shares. The effect is that each of these stakes of less than 10 per cent may be attributed to the company in which the nominee company holds shares as the top interposed entity. Separation of stakes for the purpose of the top interposed entity rule is optional. [Schedule 1, item 79, subsection 166-235(7)]

1.76 The top interposed entity is taken to be a 'person (other than a company)' and is therefore regarded as the ultimate owner of the stake. [Schedule 1, item 79, paragraph 166-230(2)(d)]

1.77 The persons who actually hold the power or rights attributed to the top interposed entity are taken not to hold that power or those rights for the purposes of the alternative test. This prevents double counting of the voting power and rights to dividends and capital. [Schedule 1, item 79, section 166-265]

1.78 Voting, dividend and capital stakes are dealt with separately. For example, if an entity holds a voting stake of less than 10 per cent and dividend and capital stakes of 10 per cent or more, the voting stake would be attributed to the top interposed entity, but not the dividend or capital stakes.

Example 1.5: Direct and indirect stakes of less than 10 per cent

Loss Company is a listed company which is 40 per cent owned by John Pty Ltd. Thirty other shareholders hold 2 per cent each of its remaining shares. All shares in Loss Company carry equal rights in relation to voting, dividends and capital distribution.

The voting power, rights to dividends and rights to capital attaching to each of the 2 per cent shareholdings will be attributed to the single notional entity. This is because they are each direct stakes of less than 10 per cent in Loss Company. In total, the single notional entity will be taken to hold 60 per cent of voting power and rights to dividends and capital.

John Pty Ltd owns more than 10 per cent of Loss Company and is not a widely held company. Accordingly, it will be necessary to trace through John Pty Ltd.

John Pty Ltd is owned 20 per cent each by Omar Pty Ltd and Kevin Pty Ltd and 60 per cent by Jason Pty Ltd. The stakes of Omar Pty Ltd and Kevin Pty Ltd represent 8 per cent each of Loss Company (20% x 40%). Because the stakes of Omar Pty Ltd and Kevin Pty Ltd are each less than 10 per cent of Loss Company they will be attributed to the top interposed entity, which is John Pty Ltd.

The indirect stake of Jason Pty Ltd in Loss Company is 24 per cent (60% x 40%). Jason Pty Ltd is not a widely held company. Accordingly, it will be necessary to trace through Jason Pty Ltd.

Shares in Jason Pty Ltd are owned equally by 6 individual shareholders, each of those shareholders will have a 4 per cent indirect stake in Loss Company (16.7% x 60% x 40%). Because their stakes in Loss Company are less than 10 per cent, they will be attributed to Jason Pty Ltd as the top interposed entity.

The outcome of tracing is that the single notional entity is taken to hold 60 per cent of voting power and dividend and capital rights, John Pty Ltd is taken to hold 16 per cent of voting power and dividend and capital rights and Jason Pty Ltd is taken to hold 24 per cent of voting power and dividend and capital rights.

Interposition of a holding company between stakeholders and a top interposed entity

1.79 Ownership of a top interposed entity could be restructured after the start of the test period so that a holding entity is inserted between the top interposed entity and the less than 10 per cent stakeholders. Without any modification, this would be recognised as an ownership change and may lead to a failure of the modified COT because the new interposed entity would become the top interposed entity.

1.80 In such circumstances, provided certain conditions are met, the new top interposed entity can be regarded as having held the stake at all times the old top interposed entity did. The relevant conditions are:

•

the new entity must acquire all the shares in the old entity;

•

the new entity must have the same classes of shares or other interests as the old entity (eg, if the old entity is a unit trust, the interests in the new entity must be units in a unit trust);

•

if the new entity is a company, its shares must not be redeemable; and

•

each stakeholder must hold the same proportion of voting stakes, dividend stakes or capital stakes in the new entity just after the restructure as it did in the old entity just before the restructure.

[Schedule 1, item 79, subsection 166-230(3)]

1.81 The impact of introducing a new holding entity on the same share same interest rule is disregarded, except for the purpose of determining whether there is an alteration time. The introduction of a new holding entity may lead to an alteration time. [Schedule 1, item 79, subsection 166-230(4)]

Stakes held by widely held companies

1.82 A widely held company is treated as the ultimate owner of a direct or indirect stake in a tested company, if the stake is between 10 per cent and 50 per cent (inclusive). The rule only applies if the company is a widely held company for the whole of the income year in which the ownership test time occurs. [Schedule 1, item 79, section 166-240]

1.83 Voting, dividend and capital stakes are treated separately. For example, if a widely held company's voting stake in the tested company is 40 per cent and its dividend stake is 55 per cent, it is treated as an ultimate owner in relation to its voting stake, but not its dividend stake.

Example 1.6: Widely held company

Listed Co holds interests in the tested company through 2 or more different shareholdings. Listed Co owns a 20 per cent interest in Loss Company through A Co and a 35 per cent interest in Loss Company through B Co.

The shareholdings of Listed Co are aggregated to determine its stake. Listed Co's stake in Loss Company is 55 per cent and therefore the widely held company tracing rule will not apply.

1.84 Stakes of less than 10 per cent are not subject to the widely held company tracing rule. Instead they are attributed to the single notional entity or the top interposed entity under those tracing rules.

1.85 The persons who hold power or rights in the tested company indirectly through the widely held company are taken not to hold that power or those rights for the purposes of the alternative test. This prevents double counting of the voting power and rights to dividends and capital. [Schedule 1, item 79, section 166-265]

Interposition of a widely held holding company above an existing widely held company

1.86 If ownership of a company that is widely held is restructured after the start of the test period by inserting a holding company between the widely held company and its shareholders, the existing company would cease to be widely held, but the holding company may become widely held (eg, if it is listed).

1.87 The new widely held company is taken to hold the same stake at all times as the existing widely held company if the following conditions are met:

•

the new company acquires all the shares in the widely held company;

•

immediately before the acquisition, the shares of the widely held company were listed on an approved stock exchange;

•

immediately after the acquisition, shares of the new company are listed on an approved stock exchange;

•

the new company has the same classes of shares as the widely held company (which are not redeemable); and

•

each entity that held stakes in the widely held company immediately before the acquisition holds stakes in the new company in the same proportions just after the acquisition.

[Schedule 1, item 79, subsection 166-240(4)]

1.88 The impact of introducing a holding entity on the same share same interest rule is disregarded, except for the purposes of determining whether there is an alteration time. The introduction of a new holding entity may lead to an alteration time. [Schedule 1, item 79, subsection 166-240(5)]

Entities deemed to be beneficial owners

1.89 Generally, the COT requires a company to trace through all corporate shareholders and trusts until it identifies the ultimate individual holders of voting power and rights to dividends and capital.

1.90 However, in the modified COT, a tracing rule treats some types of entities as ultimate owners if they meet particular conditions. [Schedule 1, item 79, subsection 166-245(1)]

1.91 The relevant entities are:

•

superannuation funds;

•

approved deposit funds;

•

managed investment schemes; and

•

special companies.

[Schedule 1, item 79, subsection 166-245(2)]

1.92 In addition, other entities may be prescribed by the Income Tax Regulations 1997. [Schedule 1, item 79, paragraph 166-245(2)(e)]

1.93 If an entity deemed to be a beneficial owner has more than 10 members, the modified COT in Division 166 applies as if the entity were a person (other than a company) who held the relevant rights. [Schedule 1, item 79, subsection 166-245(6)]

1.94 If such an entity has 10 or fewer members at a test time, each of the members is taken to hold the voting, dividend and capital stakes in the entity equally. Each member is also treated as a person (other than a company), regardless of whether the member is actually an individual or other kind of entity. [Schedule 1, item 79, subsection 166-245(4)]

1.95 However, if each member's stake in the tested company is less than 10 per cent, it is attributed back to the entity that is deemed to be a beneficial owner. [Schedule 1, item 79, paragraph 166-245(5)(b)]

1.96 The stakes of individuals who hold interests in the tested company through an entity treated as an ultimate owner are disregarded. [Schedule 1, item 79, section 166-265]

1.97 This tracing rule does not apply to stakes of less than 10 per cent in the company. Instead, the tracing rule about direct stakes of less than 10 per cent or indirect stakes of less than 10 per cent will apply. [Schedule 1, item 79, paragraph 166-245(1)(b)]

Superannuation funds

1.98 A superannuation fund is treated as an ultimate owner if it is a complying superannuation fund. [Schedule 1, item 79, subparagraph 166-245(3)(a)(i)]

1.99 A superannuation fund is also treated as an ultimate owner if it is established in a foreign country and regulated under a foreign law relating to the supervision of superannuation funds. [Schedule 1, item 79, subparagraph 166-245(3)(a)(ii)]

Approved deposit funds

1.100 Approved deposit funds are deemed to be beneficial owners if they are complying approved deposit funds. [Schedule 1, item 79, paragraph 166-245(3)(b)]

Special companies

1.101 Special companies are deemed to be beneficial owners. [Schedule 1, item 79, paragraph 166-245(3)(c)]

1.102 Mutual insurance companies, mutual affiliate companies, trade unions registered under an Australian law and sporting clubs are 'special companies'. In addition, the regulations may prescribe certain companies to be special companies (see subsection 995-1(1) of the ITAA 1997).

Managed investment schemes

1.103 A 'managed investment scheme' is deemed to be a beneficial owner if it has more than 20 members and it is either registered under Part 5C of the Corporations Act 2001 or is regulated as a managed investment scheme under a foreign law. [Schedule 1, items 79 and 151, paragraph 166-245(3)(d) and subsection 995-1(1)]

Regulations

1.104 There is a regulation-making power to add other entities to the list of those deemed to be beneficial owners. This will allow other entities to be treated as ultimate owners if it is demonstrated that there is difficulty in tracing ownership through particular types of entities and there is little risk of loss trafficking in deeming such entities to be beneficial owners. [Schedule 1, item 79, paragraphs 166-245(2)(e) and (3)(e)]

Example 1.7: Entities deemed to be beneficial owners

The shareholding of Loss Co Pty Ltd is:

XYZ Managed Investment Fund	12%
Australia-wide Insurance Ltd (a mutual insurance company)	25%
A Co Pty Ltd	40%
Mr Jones	23%

All shares in Loss Co Pty Ltd carry equal voting, dividend and capital rights. Loss Co Pty Ltd is an eligible Division 166 company.

XYZ Managed Investment Fund is registered under Part 5C of the Corporations Act 2001 and has more than 20 members. Accordingly, it will be treated as the ultimate owner of its 12 per cent stake.

Australia-wide Insurance Ltd has more than 10 members and is a mutual insurance company. Therefore, it will be treated as the ultimate owner of its 25 per cent stake.

A Co Pty Ltd is 50 per cent owned by the North Doncaster Softball club, which is a sporting club with more than 10 members. The other 50 per cent of A Co Pty Ltd is owned by Mr Smith. North Doncaster Softball club is a sporting club, a type of special company. Hence it will be treated as the ultimate owner of its 20 per cent indirect stake in Loss Co Pty Ltd.

Accordingly, the result of applying the Division 166 tracing rules to Loss Co Pty Ltd is that the following owners are identified:

XYZ Managed Investment Fund	12%
Australia-wide Insurance (a mutual insurance company)	25%
North Doncaster Softball Club	20%
Mr Smith	20%
Mr Jones	23%

Bearer shares

1.105 Bearer shares are negotiable instruments which accord ownership of shares in a company to the person who possesses the bearer share certificate. The owners of bearer shares are not recorded in a register. Rather, the transfer of bearer shares occurs through the physical handover of the share certificate. Accordingly, it is not ordinarily practicable for a company to trace ownership through bearer shares.

1.106 Bearer shares are common in many countries, although Australian companies are prohibited from issuing bearer shares (section 254F of the Corporations Act 2001 ).

1.107 A tracing rule applies to bearer shares carrying voting, dividend or capital stakes in a foreign listed company which has a direct or indirect stake in the tested company if the following conditions are satisfied:

•

There are persons (or it is reasonable to assume there are persons), other than companies or trustees, who have a voting stake, dividend stake or capital stake in the tested company. (This condition would always be met because there would be persons who hold voting stakes, dividend stakes or capital stakes in the tested company, even if such persons cannot be identified.)

•

No other tracing rule has applied in relation to the stake.

•

A foreign listed company is interposed between those persons and the tested company.

•

The principal class of shares of the foreign listed company is listed for quotation in the official list of an approved stock exchange. The principal class of shares is the ordinary or common shares of the company provided they represent the majority of voting power and value of the company. If there is no single class that represents the majority of voting power or value it is the aggregate of those classes that together do represent such a majority.

•

Fifty per cent or more of the voting, dividend or capital stakes in the foreign listed company are held by way of bearer shares.

•

The beneficial owners of some or all of the bearer shares have not been disclosed to the foreign listed company.

[Schedule 1, items 79 and 159, subsections 166-255(1) and 995-1(1)]

1.108 If the tracing rule applies, a single notional entity is taken to control the voting power in the tested company that is carried by the bearer shares and to have the right to receive any dividends and distributions of capital in the tested company that those shares carry. [Schedule 1, item 79, subsection 166-255(2)]

1.109 However, this concession only applies to shares whose beneficial owners have not been disclosed to the foreign listed company. For example, if a foreign listed company received a notice that disclosed substantial shareholdings, the tracing rule would not apply in relation to those shares, even if the disclosure was required under the corporate law of the relevant jurisdiction. [Schedule 1, item 79, subsection 166-255(2)]

1.110 The single notional entity that is taken to hold the voting power and dividend and capital rights is a different single notional entity to that which is taken to hold direct ownership interests of less than 10 per cent in the tested company. [Schedule 1, item 79, subsection 166-255(3)]

Example 1.8: Bearer shares

Beer Importers Pty Ltd is 60 per cent owned by German Beer International GmbH, a company listed on the Frankfurt Stock Exchange. All of the shares in German Beer International GmbH are held by way of bearer shares that carry equal rights to voting, dividends and capital.

German Beer International GmbH has not been informed directly of the identities of its bearer shareholders, but it is aware that one of its directors, Mr Schwarz, owns 40 per cent of the German Beer International GmbH shares. Mr Schwarz became a director after he acquired his 40 per cent stake.

The other 40 per cent of shares in Beer Importers Pty Ltd are held by a variety of individuals and companies and no shareholding is 10 per cent or more.

German Beer International GmbH is listed on an approved stock exchange and more than 50 per cent of its shares are held as bearer shares. Accordingly, the bearer shares are taken to be owned by a single notional entity. However, the shareholding of Mr Schwarz is known to German Beer International GmbH and therefore this interest is not included in the shareholding attributed to the single notional entity.

Voting power and dividend and capital stakes of Beer Importers Pty Ltd are attributed as follows:

•

twenty-four per cent to Mr Schwarz;

•

forty-per cent to a single notional entity (the interests of less than 10 per cent); and

•

thirty-six per cent to a different single notional entity (the bearer shares, minus Mr Schwarz's interest).

Depository entities

1.111 A depository entity is a central securities repository, which provides custody of share certificates and services relating to the exchange of shares. The Depository Trust Company in the United States is an example of a depository entity. [Schedule 1, item 79, subsection 166-260(5)]

1.112 If a law of the country in which a depository entity is based prohibits the disclosure of shareholder information by the depository entity, it may be impossible for an Australian company to trace its ownership through the depository entity. If these shareholders hold 50 per cent or more of shares in the company, then the company would not be able to establish whether it satisfies the COT.

1.113 A tracing rule applies to shares in a foreign listed company held by a depository entity if the following conditions are satisfied:

•

There are persons (or it is reasonable to assume there are persons), other than companies or trustees, who have a voting stake, dividend stake or capital stake in the tested company. (This condition would always be met because there would be persons who hold voting stakes, dividend stakes or capital stakes in the tested company, even if such persons cannot be identified.)

•

No other tracing rule has applied in relation to the stake.

•

A foreign listed company is interposed between those persons and the tested company.

•

The 'principal class of shares' of the foreign listed company is listed for quotation in the official list of an approved stock exchange. The principal class of shares is the ordinary or common shares of the company provided they represent the majority of voting power and value of the company. If there is no single class that represents the majority of voting power or value it is the aggregate of those classes that together represent such a majority.

•

Fifty per cent or more of the voting power or dividend or capital rights in the foreign listed company are held through one or more depository entities.

•

A law of the foreign country, or part of the foreign country in which the approved stock exchange is located, prevents the disclosure of the beneficial owners of some or all of the shares that are held by the depository entity.

•

The beneficial owners of some or all of the shares held by the depository entities have not been disclosed to the foreign listed company.

[Schedule 1, items 79 and 159, subsections 166-260(1) and 995-1(1)]

1.114 The tracing rule provides that the depository entity is taken to be a person (other than a company) who holds all of the voting power and dividend and capital rights carried by the relevant shares. The rule does not apply to the extent that the beneficial owners of the relevant shares have been disclosed to the foreign listed company. For example, in a particular jurisdiction a depository entity may be allowed to provide to the foreign listed company the names of the beneficial owners who have advised the depository entity that they do not object to their details being revealed to the company. The stakes held by such shareholders would not be attributed to the depository entity. [Schedule 1, item 79, subsection 166-260(2)]

1.115 If one depository entity replaces another, the new depository entity is taken to have held at all relevant times the stakes that were held by the old depository entity. This rule ensures that a change in the entity who has custody of the share certificates which is not accompanied by a change in underlying beneficial ownership does not cause failure of the modified COT. [Schedule 1, item 79, subsection 166-260(4)]

Example 1.9: Depository entities

Loss Company Pty Ltd is 60 per cent owned by Worldwide Holdings Inc, a company listed on the New York Stock Exchange. Fifty-five per cent of shares in Worldwide Holdings Inc are held by the Depository Trust Company. A law of the relevant jurisdiction prohibits the Depository Trust Company from disclosing the names of the beneficial owners of the shares which it holds.

All shares in Loss Company Pty Ltd and Worldwide Holdings Inc carry equal rights to voting, dividends and capital.

The Depository Trust Company will be treated as holding 33 per cent (60% x 55%) of Loss Company Pty Ltd.

However, if Worldwide Holdings Inc was aware that 50 per cent of the interests held through the Depository Trust Company were held by Mr Jones, the Depository Trust Company would not be attributed the interests of Mr Jones. In such a case, Mr Jones would be attributed the 16.5 per cent interest that he holds (50% of 33%), and the Depository Trust Company would be attributed the remaining 16.5 per cent interest.

Same share same interest rule

1.116 In applying the normal COT, a company can only take account of interests held by persons if they are the same interests and are held by the same persons throughout the test period. The rule ensures that a loss is not available for deduction if it has been substantially duplicated through CGT events happening to direct or indirect interests in the company.

1.117 The new modified COT contains a comparable rule, but it is only applicable in respect of shares or other interests held by a top interposed entity, a widely held company, an entity deemed to be a beneficial owner or a depository entity [Schedule 1, item 79, section 166-272] . The purpose is to ensure that a loss or deduction is not available if it has been substantially duplicated through capital gains tax (CGT) events happening to interests held directly or indirectly by top interposed entities, widely held companies, entities deemed to be beneficial owners or depository entities.

1.118 For example, if a top interposed entity holds shares directly in the tested company, those shares must be the same shares at each test time to be taken into account for the modified COT. Similarly, if a top interposed entity holds shares in another company that holds shares in the tested company, both the shares held by the top interposed entity and the interposed company must be the same shares and held by the same persons at each test time. [Schedule 1, item 79, subsection 166-272(2)]

Example 1.10: Same share same interest rule

Loss Company incurs a tax loss in the income year ending 30 June 2006. At the start of the loss year, Loss Company is 60 per cent owned by Glass Supplies Pty Ltd. Glass Supplies is a wholly-owned subsidiary of Glass Holdings Limited. No entity holds a 10 per cent or greater stake in Loss Company through Glass Holdings. Accordingly, Glass Holdings is attributed stakes totalling 60 per cent by the top interposed entity tracing rule.

Before the next test time, Glass Holdings undertakes a group restructure. Shares in Loss Company are transferred from Glass Supplies to Blown Glass Productions Pty Ltd, another 100 per cent subsidiary of Glass Holdings Limited.

At the second test time, the same share same interest rule prevents the attribution of the stake to Glass Holdings Limited. This is because Glass Holdings Limited no longer holds its interest in Loss Company through the same shares.

However, if there is no substantial duplication of losses, the savings provision may apply.

1.119 The same share same interest rule does not require that shares or interests held by persons in a top interposed entity, widely held company, entity deemed to be a beneficial owner or depository entity be the same shares or interests. Nor does the rule require that stakes attributed from less than 10 per cent stakeholders to a top interposed entity, for example be the same at each test time. Provided that the top interposed entity itself holds the same shares or other interests, all stakes attributed to it through the top interposed entity tracing rule can be taken into account.

Example 1.11: Same share same interest rule and attribution of stakes

Alpha Pty Ltd holds 30 per cent of shares in the tested company throughout the test period. At the start of the period, the top interposed entity tracing rule attributes stakes totalling 15 per cent to Alpha. At the second time in the test period, the top interposed entity tracing rule attributes stakes totalling 30 per cent to Alpha.

Provided Alpha continues to hold the same shares, the fact that the stakes attributed to it have increased from 15 per cent to 30 per cent is irrelevant to the same share same interest rule. It is also irrelevant that the people whose stakes have been attributed to Alpha may have changed.

1.120 The same share same interest rule contains provisions that ensure that share splits, unit splits, share consolidations and unit consolidations do not affect continuity of ownership. [Schedule 1, item 79, subsections 166-272(3) to (6)]

Savings provision

1.121 The same share same interest rule is subject to a savings provision. The savings provision in effect negates the same share same interest rule if there is not substantial duplication of the tax loss, notional loss, bad debt or unrealised net loss (as the case may be) through CGT events occurring in respect of direct or indirect interests in the tested company during the test period. [Schedule 1, item 79, subsections 166-272(8) and (11)]

1.122 Although the savings rule does not directly refer to net capital losses or foreign losses of the tested company, the effect of section 165-96 of the ITAA 1997 and subsection 160AFD(6) of the ITAA 1936 is that it will also apply if there is not substantial duplication of these types of losses.

1.123 In determining whether loss duplication has occurred the only interests taken into account are those held by top interposed entities, widely held companies, entities deemed to be beneficial owners and depository entities, as well as entities interposed between them and the tested company. The duplication of a loss at the level of persons who hold stakes of less than 10 per cent, for example will not prevent the savings provision applying.

1.124 A loss can only be reflected in ownership interests to the extent that it represents an economic loss. Therefore, the savings provision would apply if the relevant loss is predominantly a non-economic loss.

1.125 Similarly, the savings provision would apply if losses (or reduced gains) on the sale of shares were disregarded because the shares were pre-CGT assets.

1.126 The savings provision will not apply if the loss will be duplicated in the future because of a CGT event during the period. This might occur if a capital loss has been recognised, but deferred by Subdivision 170-D.

1.127 The savings provision does not apply for the purpose of determining whether an alteration time occurs [Schedule 1, item 79, subsection 166-272(9)] . Accordingly, in some cases the modified COT may be failed because of the application of the same share same interest rule for the purposes of Subdivision 165-CD, but not failed for other purposes. Subdivision 165-CD can result in a reduction of the reduced cost base of certain direct or indirect interests in the tested company. This may be sufficient to prevent the substantial duplication of a loss and therefore result in the savings provision applying for other purposes.

Example 1.12: Savings provision

In Example 1.10, the savings provision may, however, apply so that Loss Company can continue to satisfy the modified COT in respect of its carry-forward tax loss.

The savings rule would apply if the tax loss is not reflected in deductions, capital losses or reduced assessable income for Glass Holdings, Glass Supplies or Blown Glass Productions. This could be the case if:

•

Glass Holdings, Glass Supplies and Blown Glass Productions are part of a consolidated group, so no CGT event occurs on the transfer of the shares; or

•

the application of Subdivision 165-CD prevents a capital loss arising for Glass Supplies on the transfer of its shares to Blown Glass Productions.

Minimum interests rule

1.128 The same share same interest rule does not apply in respect of stakes held by a single notional entity. The application of the same share same interest rule to direct interests in the tested company of less than 10 per cent would be inappropriate because it would be contrary to the policy of allowing the tested company to disregard interests of less than 10 per cent.

1.129 Instead, a minimum interests rule applies to stakes taken to be held by a single notional entity under the tracing rule relating to direct stakes of less than 10 per cent or the tracing rule relating to bearer shares.

1.130 The minimum interests rule restricts the total proportion of voting power, dividend rights and capital rights attributed to the single notional entity to the proportion attributed to it at the beginning of the test period. [Schedule 1, item 79, section 166-270]

1.131 Changes among the less than 10 per cent stakeholders are not relevant to the operation of the minimum interests rule. It is only an increase in the aggregate proportion that is taken to be held by the single notional entity that is prevented.

1.132 Further, an increase in the number of shares that carry voting power or rights is not relevant if it does not correspond to an increase in the proportion of voting power or rights. For example, the tested company may raise capital during the test period by issuing shares to existing shareholders. This may substantially increase the number of shares holding voting power or dividend or capital rights that are attributed to the single notional entity. However, unless it causes an increase in the proportion of voting power or rights, the minimum interests rule has no operation.

Example 1.13: Minimum interests rule

At the start of the test period, there are 3 shareholders with a less than 10 per cent stake in the tested company. Simon holds 8 per cent, Natalie holds 6 per cent and Tim holds 5 per cent. The tracing rule concerning direct stakes of less than 10 per cent operates to attribute their stakes, totalling 19 per cent, to the single notional entity.

At the next test time, Simon continues to hold 8 per cent, Natalie holds 9 per cent and Fiona holds 7 per cent. Tim no longer holds an interest in the tested company. Their total interest of 24 per cent would be attributed to the single notional entity. However, because this exceeds the proportion at the start of the test period, the minimum interests rule operates to reduce the amount taken into account to 19 per cent.

No detrimental operation of tracing rules

1.133 The purpose of the tracing rules is to assist a company trace its ownership interests to determine whether it satisfies the COT. However, there may be cases where these rules make it more difficult for a company to satisfy the COT. While the company could choose not to apply the modified COT, that would not allow the company to use any of the tracing rules.

1.134 The modified COT allows a tracing rule to be disregarded in respect of a particular stake if it would cause the company to fail the ownership tests. A company is taken to satisfy the relevant conditions if the company believes on reasonable grounds that it would not fail the conditions if the tracing rule did not apply in respect of that stake. [Schedule 1, item 79, section 166-275]

1.135 The rule does not prevent other tracing rules potentially applying to the relevant stake or the same tracing rule applying in respect of other stakes. It merely allows tracing rules to be disregarded in these circumstances to the extent that they would cause a failure of the modified COT.

1.136 The company must hold a reasonable belief that it would not fail the tests if the tracing rule did not apply. In most cases a company would be expected to form this view by applying the test for substantial continuity of ownership in the normal way, this is without the use of that tracing rule in respect of the particular stake. However, it is recognised that in some cases, despite its best endeavours, a company may be unable to obtain sufficient information to determine with certainty that it would pass the ownership tests without the tracing rule. In such a case, the modified COT allows a company to draw a conclusion about whether it would satisfy the ownership tests based on any information that it has reasonably been able to obtain. [Schedule 1, item 79, section 166-275]

1.137 Circumstances where the operation of a tracing rule could cause the ownership tests to be failed and, therefore, might trigger the operation of this rule include:

•

a direct shareholder's interest in the tested company rises to 10 per cent or more or drops below 10 per cent during the test period;

•

an indirect stakeholder's interest in the tested company rises to 10 per cent or more or drops below 10 per cent during the test period;

•

a widely held company's interest in the tested company rises above 50 per cent or drops to 50 per cent or less during the test period;

•

a company that has not more than a 50 per cent interest in the tested company either becomes a widely held company or ceases to be a widely held company during the test period; or

•

the holders of bearer shares or of interests through depository entities become known to the tested company during the test period.

1.138 In each of these cases, the application of the tracing rule may imply a larger change in ownership than actually occurs.

Example 1.14: Increase of shareholding to more than 10 per cent

At the start of the ownership test period Lisa owns 9 per cent of the shares in the tested company. In the following year, Lisa increases her shareholding in the tested company to 11 per cent.

At the start of the test period, the rule in section 166-225 about direct stakes of less than 10 per cent in the tested company, would operate to attribute Lisa's interest to the single notional entity. However, in the following year, section 166-225 would not apply to the stake held by Lisa because it exceeds 10 per cent. Accordingly Lisa, rather than the single notional entity, would hold that stake for the purpose of Division 166.

If the operation of section 166-225 in relation to the stake held by Lisa at the start of the test period would cause the tested company to fail the COT in the following year, then the concessional tracing rule, section 166-275, would apply. The effect of section 166-275 is to ignore the operation of section 166-225 to Lisa's stake at the start of the test period. Accordingly, the tested company could treat Lisa herself as owning the 9 per cent interest at the start of the test period and the 11 per cent interest at the later point in the test period.

Controlled test companies

1.139 A tracing rule does not apply to modify how the ownership tests apply in respect of voting power or dividend or capital rights held directly or indirectly by an entity that sufficiently influences the tested company. [Schedule 1, item 79, subsection 166-280(1)]

1.140 Broadly, a company is sufficiently influenced by an entity if the company, or its directors, are accustomed or under an obligation to act in accordance with the directions, instructions or wishes of the entity or would reasonably be expected to do so.

1.141 A minority shareholder would not generally be regarded as having sufficient influence over a company merely because it is assertive about how the company or its directors should act, or because it has a representative on the company's board of directors. In contrast, a shareholder may have sufficient influence where under a formal or informal arrangement with other shareholders it is able to control the majority of appointments to the company's board of directors.

1.142 In addition, if the tested company is a widely held company, the tracing rule does not modify how the ownership tests apply in relation to the voting power of the tested company if:

•

a natural person, together with any associates, directly or indirectly, controls more than 25 per cent of the total voting power in the tested company; or

•

a company or trust, together with its associates, directly or indirectly, controls more than 50 per cent of the total voting power in the tested company.

[Schedule 1, item 79, subsection 166-280(2)]

1.143 The controlled test companies rule requires a company to trace its ownership through to the entity who has sufficient influence, the natural person who (with associates) controls more than 25 per cent of the voting power, or the company or trustee which (with associates) controls more than 50 per cent of the voting power.

1.144 The controlled test companies rule prevents the strict operation of the tracing rules hiding significant interests in the tested company. For example, if a company indirectly holds more than 50 per cent of the tested company, but does so through a number of stakes in entities which directly hold less than 10 per cent of the tested company, in the absence of the controlled test company rule, the rule about direct stakes of less than 10 per cent would attribute these interests to a single notional entity.

1.145 The controlled test companies rule only prevents tracing rules applying to:

•

stakes held by controlling entities (ie, entities with sufficient influence or with associate inclusive voting power of more than 25 per cent or 50 per cent, as the case may be); and

•

stakes held by entities interposed between the tested company and controlling entities.

Tracing that is unaffected by controlled test companies rule

1.146 The controlled test companies rule does not prevent the tracing rules applying in relation to stakes held indirectly through a controlling entity. This is the case even if the operation of the tracing rule causes the stake to be attributed to the controlling entity.

Example 1.15: Controlled test companies rule

A widely held company holds 40 per cent of the tested company and its associates hold 20 per cent. Because the widely held company together with its associates holds more than 50 per cent of the tested company, the tracing rule regarding stakes of 50 per cent or less held by widely held companies cannot apply.

In tracing through the widely held company the tested company finds that all shareholders in the widely held company have a less than 10 per cent stake in the tested company. Those stakes can be attributed to the widely held company through the application of the rule for indirect stakes of less than 10 per cent.

1.147 Similarly, the controlled test companies rule does not affect the operation of the bearer shares rule merely because the foreign listed company referred to in that section holds more than 50 per cent of the shares in the tested company. Generally, the controlled test companies rule could not apply in the context of bearer shares, because the identity of bearer shareholders would not be known.

1.148 The controlled test companies rule does not affect the operation of the tracing rule for depository entities merely because a depository entity holds more than 50 per cent of the shares in a tested company. This is because the depository entity does not control voting power in the tested company - it only has custody of shares on behalf of other entities. Generally, the controlled test companies rule could not apply in relation to stakes held through a depository entity because the identity of stakeholders would not be known.

Example 1.16: Controlled test company

Brooms and Brushes Limited is a listed company that has incurred tax losses. Twenty per cent of the shares in Brooms and Brushes Limited are held directly by Cleaning Products Pty Ltd. Household Investments Limited holds 35 per cent of shares in Brooms and Brushes Limited and also 60 per cent of shares in Cleaning Products Pty Ltd. Household Investments Limited is also a listed company.

All shares referred to in this example carry equal rights to voting, dividends and capital.

Household Investments Limited holds 2 stakes in Brooms and Brushes Limited - a 35 per cent direct stake and a 12 per cent indirect stake through Cleaning Products Pty Ltd. If the controlled test companies rule in section 166-280 did not apply, Household Investments Limited could be treated as the ultimate owner of its 2 stakes in Brooms and Brushes Limited because it is a widely held company with stakes of not more than 50 per cent.

Cleaning Products Pty Ltd is an associate of Household Investments Limited. This is because Housing Investments Limited holds a majority voting interest in Cleaning Products Pty Ltd (see subsection 318(2) of the ITAA 1936).

Household Investments Limited together with its associate controls 55 per cent of Brooms and Brushes Limited (ie, 35% + 20%). Accordingly, the controlled test companies rule prevents application of the tracing rule for stakes of 10 per cent to 50 per cent held by widely held companies that would otherwise operate to treat Household Investments Limited as the ultimate owner of its stakes in Brooms and Brushes Limited.

Instead, Brooms and Brushes Limited must trace through Household Investments Limited in respect of the 35 per cent direct stake and 12 per cent indirect stake.

The controlled test companies rule does not prevent the tracing rules applying to stakes held indirectly through Household Investments Limited. Stakes of less than 10 per cent in Brooms and Brushes Limited which are held by shareholders of Household Investments Limited will be attributed to Household Investments Limited through the operation of the tracing rule for indirect stakes of less than 10 per cent.

Example of the new modified continuity of ownership

1.149 Example 1.17 illustrates the operation of the new modified COT.

Example 1.17

In the year ending 30 June 2005, Loss Company incurs a tax loss of $10 million.

In the year ending 30 June 2006, Loss Company has sufficient assessable income (net of deductions), against which to deduct its $10 million loss. In determining whether it can deduct the loss it needs to satisfy the COT.

Firstly, it must determine whether it is eligible to apply the modified COT in Division 166.

At 30 June 2006 its ownership structure is:

Eligibility of Loss Company for the modified COT

Loss Company is not a widely held company because it is not listed and has less than 50 members.

Loss Company will nevertheless be eligible for the modified COT if more than 50 per cent of the relevant rights in Loss Company are owned (either directly or indirectly) by widely held companies or entities deemed to be beneficial owners at all times in the year ended 30 June 2006.

At 30 June 2006:

•

Listed Company A directly owns shares carrying 60 per cent of the voting power and dividend and capital distribution rights and, because it is a listed company, meets the definition of 'widely held company';

•

Listed Company B indirectly owns shares carrying 17.5 per cent (50% of 35%) of voting power and dividend and capital rights and, because it is a listed company, meets the definition of 'widely held company'; and

•

Complying super fund indirectly owns shares carrying 17.5 per cent (50% of 35%) of voting power and dividend and capital rights and is an entity deemed to be a beneficial owner.

Although 5 per cent of the relevant interests are held by a natural person (Bob) this does not disqualify the company from eligibility for the modified COT.

Because more than 50 per cent of the rights are held by widely held companies, entities deemed to be beneficial owners, non-profit companies or charitable bodies at all times in the income year ending 30 June 2006, Loss Company is eligible for the modified COT.

Application of tracing rules at 1 July 2004

At 1 July 2004 (the start of the loss year), shareholdings in Loss Company were as follows:

All shares carry equal voting power, rights to dividends and rights to capital. Accordingly, this example refers to shares and stakes in the Loss Company and does not separately refer to voting power or rights to dividends or capital distributions.

Listed Company A is listed on the Australian Stock Exchange and accordingly is a widely held company. However, it will not be regarded as the ultimate beneficial owner under section 166-240 because its stake in Loss Company is more than 50 per cent. Accordingly, Loss Company will need to trace through the interest held by Listed Company A:

•

Julie's stake in Loss Company is 24 per cent (60% x 40%) and is attributed to her.

•

The other shareholders in Listed Company A have indirect stakes in Loss Company. Each of these indirect stakes is less than 10 per cent (60% x 16.6%). Accordingly these stakes will be attributed to the top interposed entity pursuant to section 166-230. The top interposed entity is Listed Company A. Therefore, Listed Company A is taken to hold a 36 per cent stake in Loss Company.

Bob holds exactly 10 per cent of shares in Loss Company. As stakes of less than 10 per cent are attributed to the single notional entity under the tracing rule in section 166-225, this rule will not apply to Bob's stake. Consequently, Bob is taken to hold his 10 per cent stake in Loss Company.

Australian Operations Pty Ltd holds 30 per cent of shares in Loss Company. It is not a widely held company and therefore Loss Company will need to trace its beneficial ownership through Australian Operations Pty Ltd.

•

Australian Operations Pty Ltd is wholly-owned by Holdings Inc, a company which is listed on the New York Stock Exchange. Holdings Inc is a widely held company because it is listed on an approved stock exchange. Since it has a not more than 50 per cent indirect stake in Loss Company, Holdings Inc will be treated under the tracing rule in section 166-240 as a person other than a company that holds the stake. It will not be necessary to trace beneficial ownership through Holdings Inc.

In conclusion, at 1 July 2004, the ownership of the tested company is attributed as follows:

*	Julie	24%
*	Listed Company A	36%
*	Bob	10%
*	Holdings Inc	30%

Application of tracing rules at 30 June 2005

The ownership of Loss Company at 30 June 2005 is the same as at 1 July 2004. Accordingly, the tracing of ownership at 30 June 2005 would give the same outcome as above.

Application of tracing rules at 30 June 2006

As at 30 June 2006, shareholders in Loss Company are as follows:

For the reasons discussed above, Loss Company needs to trace through the shareholding of Listed Company A:

•

Frank's indirect interest in the Loss Company is 12 per cent (60% x 20%) and is attributed to him.

•

All other shareholders have an interest in the interposed Listed Company A less than 16.6 per cent, representing less than 10 per cent stakes in Loss Company. Hence these stakes, totalling 48 per cent (60% x 80%), are attributed to Listed Company A.

Bob's 5 per cent interest is deemed to be held by a single notional entity, as it is a direct interest amounting to less than 10 per cent of total rights.

As Company C is not a widely held company or an entity deemed to be a beneficial owner, beneficial ownership must be traced through it:

•

As Listed Company B is a widely held company which indirectly owns between 10 per cent and 50 per cent of relevant rights in Loss Company, it is deemed to be the beneficial owner of the 17.5 per cent interest.

•

As Complying super fund is an entity deemed to be a beneficial owner with more than 10 members, it is deemed to be the beneficial owner of the 17.5 per cent interest.

At 30 June 2006, the following stakes are identified:

*	Frank	12%
*	Listed Company A	48%
*	Listed Company B	17.5%
*	Complying super fund	17.5%
*	Single notional entity	5%

Conclusion

Listed Company A is the only entity that was a stakeholder at both points in time. The interest of Listed Company A at the start of the test period was 36 per cent. However, its full 48 per cent interest at the second test time can be taken into account because it continues to hold the same shares in Loss Company in the same way.

Bob's interest was attributed directly to him at the start of the test period, but attributed to the single notional entity pursuant to section 166-225 at 30 June 2006. If this operation of section 166-225 causes Loss Company to fail the COT, it can be ignored by Loss Company (under section 166-275 because it would cause Loss Company to fail the COT) and Bob's 5 per cent stake at 30 June 2006 can be attributed directly to him.

Putting aside Bob's stake, the same people (ie, Listed Company A) owns 36 per cent at 1 July 2004 and 48 per cent at 30 June 2006. Accordingly, there is not substantial continuity of ownership.

If Bob's stake is attributed to him rather than the single notional entity, continuity of ownership in Loss Company would be 46 per cent at the start of the period and 53 per cent at the later time. Even with Bob's stake there is not substantial continuity of ownership because the same persons do not hold more than 50 per cent of voting power or relevant rights at each test time.

Accordingly, Loss Company fails the modified COT.

Application and transitional provisions

1.150 The new modified COT applies to:

•

tax losses incurred in income years commencing on or after 1 July 2002;

•

net capital losses made in income years commencing on or after 1 July 2002;

•

deductions for bad debts that are claimed in income years commencing on or after 1 July 2002; and

•

determine whether a changeover time or alteration time occurs at any time on or after 1 July 2002.

[Schedule 1, subitem 170(1)]

1.151 The new modified COT also applies in relation to an earlier tax loss or net capital loss if:

•

the tax loss could have been deducted (in accordance with the loss recoupment rules in force at that time) in the first income year commencing after 30 June 2002; or

•

the net capital loss could have been applied (in accordance with the loss recoupment rules in force at that time) in the first income year commencing on or after 1 July 2002.

[Schedule 1, subitem 170(4)]

1.152 In determining whether a tax loss could have been deducted in the first income year commencing after 30 June 2002, the fact that it can only be deducted to the extent the company has sufficient income (section 36-17) is ignored. [Schedule 1, subparagraph 170(4)(a)(ii)]

1.153 In determining whether a net capital loss could be applied in the first income year commencing after 30 June 2002, the fact that a net capital loss may only be used to reduce capital gains is ignored. [Schedule 1, subparagraph 170(4)(b)(ii)]

1.154 The effect of the amendments for a company with a substituted accounting period is that the modified COT applies for the first accounting period that commences after 1 July 2002.

1.155 For example, a company with a substituted accounting period of 1 April to 31 March, will not be eligible for the modified COT in respect of losses incurred in its income year commencing 1 April 2002, unless it could have deducted those losses under the existing rules in its income year commencing 1 April 2003.

1.156 The new modified COT will apply to a foreign loss in the same way as it would apply to a tax loss incurred in the same year (subsection 160AFD(6)).

1.157 If a pre-1 July 2002 loss is eligible for the modified COT (ie, it could have been deducted in an income year commencing on or after 1 July 2002), the new modified COT rules apply at all test times. For example, if the loss was incurred in 1998-99 income year and the company is seeking to deduct it in 2006-07 income year, the modified COT tracing rules are used to test ownership in 1998-99 and 2006-07 (as well as intervening years).

1.158 The new modified COT cannot apply to deductions for bad debts written-off before 1 July 2002. Unlike losses, deductions for bad debts can be claimed in the income year the debt is written-off. If the company's deductions for that income year exceed its income, the bad debt deduction merely contributes to the loss (subject to the application of section 165-132).

1.159 In some cases, a tax loss or a net capital loss is taken to have been made in the income year immediately before a changeover time (section 165-115B). The modified COT will not apply to a loss that is treated as having been made in an income year before 1 July 2002 unless the loss could have been used in the first income year commencing on or after that date.

Consolidation interactions

1.160 Section 707-140 treats the head company of a consolidated group as having made a loss of any sort that is transferred to it in the income year in which it is transferred. Therefore, if a loss is transferred to the head company of a consolidated group on or after 1 July 2002, the loss will be eligible for the modified COT if the income year in which the transfer occurred commenced on or after 1 July 2002.

1.161 The assumptions contained in subsection 707-210(4) and section 709-215 do not affect the application of the modified COT. This is because these provisions do not deem the relevant loss or bad debt to be incurred at a different time.

1.162 If a subsidiary company with losses joins a consolidated group on 1 July 2002, it cannot use the new modified COT to determine whether it can transfer its losses to the head company of the group because it does not have an income year commencing after 30 June 2002. It is not recognised as a stand-alone company for tax purposes after this date. However, if a company joins a consolidated group later in that year, the modified COT can apply as a transfer test to pre-1 July 2002 losses if the relevant company has at least part of an income year (ie, a non-membership period under section 701-30) in which it could have utilised those losses commencing after 30 June 2002.

Choice to disregard amendments for prior years

1.163 If a tax loss was incurred, a net capital loss made or a deduction claimed in respect of a bad debt, or if a changeover or alteration time occurred in an income year that ends before the date the Bill receives Royal Assent, the company may choose not to apply the amendments made to the COT for those income years. [Schedule 1, subitem 170(2)]

1.164 The company must make this choice before its first income tax return is lodged after the Bill receives Royal Assent, or within such further time as the Commissioner allows. Accordingly, companies that have traced their ownership under the existing modified COT for prior years are not required to apply the new tracing rules unless they choose to do so. [Schedule 1, subitem 170(3)]

Consequential Amendments

1.165 Notes are inserted to alert readers of Division 165 or Division 707 to the modifications made by the new modified COT. [Schedule 1, items 14, 28, 42, 54 and 113]

1.166 Definitions that were relevant to the operation of the old modified COT, but are not used in the new modified COT are repealed. [Schedule 1, items 142, 146, 150, 153, 154, 155, 157, 158 and 166]

1.167 Definitions of 'test period' and 'test time' in the Dictionary are updated to take into account changes resulting from the new modified COT provisions. [Schedule 1, items 162 and 163]