On 11 December the Business Tax Working Group released its Interim Report on the Tax Treatment of Losses (the "Report") for public comment.
The Report is part of the Business Tax Working Group's ("BTWG") focus on improving the business tax system to allow businesses to respond to emerging challenges and create opportunities for themselves in the local and international economic landscape. The BTWG's initial focus on reforming the treatment of tax losses is an encouraging first step towards increased certainty in the tax law while also assisting the broader economy by delivering tax relief to corporate Australia.
Why do we need a reform?
A reform on the current tax treatment of losses is a first step to address the barriers within the business tax system. Under the existing rules, tax losses may become trapped in a company if it is unable to pass the often onerous integrity rules or simply because it does not make sufficient prospective profits to utilise the losses. Even if a business is able to utilise its tax losses, the real value of tax losses will be impaired by the passage of time as the quantum of the losses are not indexed to inflation.
The current rules: The continuity of ownership test ("COT") and the same business test ("SBT")
Broadly speaking in order for a company to recoup its tax losses it must be able to satisfy the COT. The COT requires that shares carrying more than 50% of all voting, dividend and capital rights must be beneficially owned by the same persons at all times during the ownership test period (i.e. the beginning of the loss year until the end of the recoupment year). If a company is unable to satisfy the COT it may still be able to recoup its losses if the SBT can be satisfied.
In order to pass the SBT the company must be able to demonstrate that immediately before the COT failure, it carried on the same business at all times until time that the loss is to be recouped. Furthermore, the company must be able to show that it did not enter into any new transaction or incur any new expenses that it did not incur prior to the COT failure.
The qualitative nature of the SBT will often result in a high compliance burden that comes with the necessary functional analysis and private rulings and will still leave some tax managers 'awake at night worrying' about the uncertainty that comes with a tax law that administratively relies on the subjective and arguably narrow interpretation of the Australian Taxation Office.
Possible options for reform
The Report considers four possible options on the reform of the tax treatment of losses:
1. Removing the COT and the SBT
The removal of COT and SBT would help eliminate uncertainty and significantly increase a company's ability to utilise its carry forward tax losses. However the BTWG suggest that such an option would require the introduction of an alternative integrity measure. The Report suggests that rules similar to the tax consolidation available fraction provisions (i.e. these provisions currently apply to limit the loss utilisation in relation the losses a tax consolidated acquires when a subsidiary joins the group) could be applied more broadly. The rules would provide a disincentive for acquiring loss companies with a purpose of accessing tax losses. Another alternative measure would be to introduce a dominant purpose test for obtaining the tax losses.
2. Refunding tax losses
Not surprisingly the BTWG considers that such option is not realistic or viable, stating that it would substantially increase the risks to Government revenue and increase the potential integrity risks to the tax system.
3. Loss carry-back
This option provides a retrospective approach of allowing current year tax losses to be offset against previous year's profit, resulting in a refund of tax previously paid. The Report adopts the recommendation made by the 'Henry Review' that the loss carry-back should be limited to one year, with the amount of any tax refund limited to a company's franking account balance.
Similar loss carry-back regimes are already operation in the US, UK and Singapore. One would imagine if such an option is adopted in Australia the rules that result may be closely modelled on these countries' regimes.
This option is aimed at addressing the issue where the real value of carry forward tax losses diminishes over time by indexing the losses by the long term (ten-year) Government bond rate. Such a model for the reform of the tax loss rules is already under consultation in relation to entities that are carrying out designated infrastructure projects (http://bit.ly/vreiXo).
Whilst this measure could ensure that historical losses will be protected against inflation, this option alone will not address the problems that companies business face with satisfying the current integrity rules.
These options for reform may be implemented individually or in combination and will likely only apply to new tax losses incurred.
The Report also considers reducing the write off period for black hole expenditure from five years to one to three years. The Report also puts forward the option that would restrict application of the black hole provision to expenditure relates to a termination of business.
It is important to highlight that the Report represents an initial analysis of the tax loss recoupment rules. In this respect whether or not the BTWG is able to recommend any of these reforms in its final report, which is expected in March 2012, will depend on whether it is able to identify any offsetting revenue savings to achieve an overall revenue neutral package.
At this early stage the path to reform for the loss recoupment rules is heading towards a positive direction and we encourage taxpayers to be involved in the reform process. You can do so by contacting Moore Stephens who is intending to present a submission which is due by 3 February 2012.
Given the Government's recent experience with the backlash resulting from retrospective introduction and subsequent repeal of the 'rights to future income' consolidation rules (see http://bit.ly/uyUKOK for further details), one would expect a fairly comprehensive consultation and revenue costing process to be performed.
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