On 13 April 2012, the Treasurer released the Business Tax Working Group's ("BTWG") Final Report on the Tax Treatment of Losses ("the Final Report").
The Final Report should provide taxpayers with a degree of comfort that the Government is heading in a positive direction towards a comprehensive review of the tax losses provisions. It is the first of two reports commissioned for the BTWG to identify ways to improve Australia's business tax system. The second report due for release later this year will focus on longer-term tax reforms.
The interim report initially raised the following four possible options to reform the tax treatment of losses:
- Removing the carry forward loss integrity rules, i.e. the continuity of ownership test ("COT") and the same business test ("SBT")
- Refunding tax losses (although this was raised not to be a viable option for reform)
- Loss carry-back
- Indexing losses
For our discussion on the interim report please see http://bit.ly/sVfK8g.
In arriving at the Final Report, the BTWG considered the above options in light of the submissions from various stakeholders. The Final Report discussed the losses indexation option and ruled it out.
The recommendations emerging from Final Report will benefit only small loss-making companies. These are summarised as follows:
Limited loss carry-back for small companies
Broadly, this option allows current year tax losses to be retrospectively offset against previous year's profit, resulting in a refund of tax previously paid.
Out of all the four possible options for reform on tax losses, the BTWG considered that loss carry back would be a worthwhile reform in the near term. If adopted, the model would consist of the following design and implementation measures:
- The refund of the previously paid taxes would be effected by way of a refundable tax offset in the year of loss rather than requiring amendments of prior year tax returns.
- A two-year period time limit is recommended for losses carried back.
- A quantitative cap on the amount of losses carried back is limited to the lesser of:
- previously paid taxes in the loss carry back period;
- the amount of the loss in the current year;
- the company's franking account balance; and
- a quantitative cap – the BTWG suggested a cap of $1 million would be appropriate. In our view, this threshold should be $6 million to coincide with the small business maximum net asset value test threshold.
This measure would greatly assist companies that face periods of temporary downturns as the tax offset would bring immediate cash flow relief when most needed. However, given the quantitative and time limit restrictions, the measure would also be limited in its application and of little value to taxpayers in a start-up or a winding up phase.
The BTWG considered that a start date of 1 July 2013 for the measure was a realistic target for implementation by the Government. However in its first year, the loss carry back should be limited to one year, i.e. any loss incurred in the 2013-14 income year can only be carried back against taxable income from the 2012-13 income year.
Reforming the SBT provisions
The Final Report also addressed the BTWG's concerns regarding the appropriateness of the existing COT and SBT integrity rules in order to utilise carry forward losses. The BTWG was reluctant to promote the removal of COT. In its view, the current COT is effective and necessary to provide disincentives for acquiring loss companies with a purpose of accessing tax losses. In support for its view, the BTWG drew reference to OECD countries where a similar provision to COT is used as a component of their loss integrity rules.
While the BTWG was very adamant not to remove COT, not the same can be said about their views on SBT. It is not surprising that the BTWG agreed with many in the tax profession that the SBT rule is too narrow in its current application and recommended that reform of the SBT be a priority for the Government.
The report considered the following models for addressing deficiencies in the SBT:
- Introduction of a dominant purpose test to assess the purpose of a transaction. However the BTWG acknowledged that adopting this model will not resolve the uncertainties in the SBT provisions.
- Modifying the SBT so that it better aligns with the modern business environment. This will ensure that the SBT will take into account an appropriate measure of commerciality without unfairly denying the availability of losses to these companies. This may involve the removal of the two existing (and very restrictive) negative tests being the new business and new transaction tests.
- As an alternative or replacement to the SBT, a statutory drip-feed mechanism akin to the available fraction rule used for tax consolidation would be introduced to allow companies to recoup losses over an extended period of time. A recovery rate of 10% p.a. was deemed reasonable.
The BTWG considered that adopting the statutory drip-feed mechanism alone will not resolve the deficiencies in the SBT as it is based on an arbitrary rate of loss utilisation and is unlikely to minimise the incentive for tax-motivated trading in companies with tax losses. The BTWG considered that there is more merit to modify the SBT provisions and to complement this model, to also introduce the statutory drip-feed mechanism as an opt-in basis for companies that fail the COT.
The Final Report also raised further issues and changes required to the business tax system as part of its task in identifying offsetting tax savings to deliver a revenue neutral package. Treasury had highlighted a number of proposed cost-saving measures, including:
- Changes to the thin capitalisation rules by restricting business access to deduct debt interest; and
- Reducing the research and development non-refundable tax offset available to companies with a turnover of $20 million or more.
It appears from the above that to implement the recommendations proposed in the Final Report and achieve tax savings for the small business sector, these measures will have to be funded by restricting tax savings in the larger market. As the corporate tax revenue is already lower than what Treasury had initially forecasted, the above changes could discourage in-bound investments or cause businesses to relocate out of Australia. This would in turn defeat the goal of achieving tax neutrality. The BTWG noted that further consultation is required before it can recommend any of Treasury's proposed cost-saving measure.
The BTWG had also not recommended any changes to the black hole provision in section 40-880 of the ITAA 1997, which was raised as an issue in the interim report. The BTWG has stressed however that the tax treatment of black hole expenditure warrants further attention and will give it further consideration as part of its consideration on longer term reforms to the tax system.
It seems that the BTWG was pressured to deliver its final report within a short timeframe and restricted within its term of reference to focus on reducing taxes on new investment. It is therefore not so surprising that the BTWG was unable to fully consider the fiscal benefits and downsides of the various reform options. The Final Report also lacked sufficient consideration associated with the offsetting tax savings measures, in particular the possible tightening of the thin capitalisation rules.
We are pleased however that the reform on the tax treatment of losses is given the amount of importance it deserves and is heading towards a positive direction. The responsibility now rests with the Government to implement any of the recommendations put forth by the BTWG in the Final Report.
One would expect that in the current economic climate, the Government will be more compelled to introduce legislative changes to assist struggling small businesses. However, any reforms to be implemented will highly depend on achieving offsetting tax savings given the political imperative for the Government to bring the Federal budget back to surplus by the next financial year.
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