The government has recently introduced draft legislation (Treasury Laws Amendment (2017 Enterprise Incentives No. 1) Bill 2017 (Bill)), which proposes to amend the Income Tax Assessment Act 1997 and Income Tax Assessment Act 1936 to create a new framework for determining whether a business can carry forward and use tax losses and bad debts that it incurred prior to a change of control or ownership of that business.
The proposed legislation introduces a new and more flexible ‘similar business test’ to supplement the existing ‘same business test’. Broadly, the similar business test gives companies (and certain trusts) more scope to innovate and expand their business without losing their tax losses.
The new laws will be relevant to businesses that have had, or are expecting to have, a change of ownership and once enacted, will apply to losses or bad debts incurred from 1 July 2015. Whilst the changes create new opportunities for businesses, there remains considerable uncertainty as to its scope and businesses will need to carefully consider their circumstances when relying on the test.
The existing framework
Under the existing regime, tax losses can be carried forward and deducted from assessable income in future income years if the company passes either:
- the ‘continuity of ownership test’ or
- the ‘same business test’.
Continuity of ownership test
A company will satisfy the continuity of ownership test unless it has undergone a substantial change in its ownership or control during the period between the beginning of the loss year and the end of the year when the company wants to use the loss (Ownership Period).
A company will ordinarily satisfy this test if the same persons have more than 50 per cent of the voting power, rights to dividends and rights to capital distributions at all times during the Ownership Period. Special rules apply for widely held companies and unit trusts.
Where a company fails the continuity of ownership test, it must rely on the same business test in order carry forward and use its losses.
Same business test
A business generally satisfies the same business test if it carries on the same business in the income year it intends to claim the losses as it carried on immediately before the change of ownership or control which caused it to fail the continuity of ownership test.
However, the test is subject to two negative limbs which, if applicable, will cause the business to fail the test. The negative limbs apply if a business;
- derives assessable income from a business of a kind that it did not carry on before the test time (new business test) or
- derives assessable income from a transaction of a kind that it had not previously entered into in the course of its business before the test time (new transaction test).
The negative limbs of the current test discourage businesses from innovating and adapting their business, and particularly, entering into new transactions or types of business given the real prospect of losing the right to carry forward and use their tax losses.
The new framework
Under the new framework, a more flexible ‘similar business test’ has been introduced to supplement the existing same business test which will ultimately improve access to tax losses and bad debt deductions for companies (and certain trusts) and encourage those entities to seek out opportunities to innovate and grow. Collectively these tests will form part of the ‘business continuity test’.
A business will pass the similar business test if its current business is similar to its ‘former business’ (which is the business prior to the change of ownership or control). As the similar business test is not subject to the negative limbs of the same business test, businesses will be able to derive assessable income from new business activities and enter into new transactions without automatically failing the business continuity test. This is a positive step to encouraging businesses to innovate and expand.
While ‘similar’ is not defined in the Bill, whether the current business is similar to the former business will be a question of fact which must be determined having regard to the following factors:
- The extent to which the assets (including goodwill) used in the current business to generate assessable income were also used in the former business to generate assessable income.
- The extent to which the activities and operations from which the current business generates assessable income were also the activities and operations from which the former business generated assessable income.
- The identity of the current business and the identity of the former business.
- The extent to which any changes to the former business resulted from the development or commercialisation of assets, products, processes, services, or marketing or organisational methods, of the former business.
The explanatory memorandum to the Bill (EM) and the ATO’s recently released draft Law Practice Guideline LCG 2017/D6 (LCG) provide some guidance on the test and, in particular, how each of the above factors will apply.
They indicate that it will not be enough if the current business is of a similar ‘kind’ or ‘type’ to the former business. Rather, a business is ‘similar’ where there is an element of continuity such that it has evolved or organically grown over time without changing its core identity or core source of income. It is not sufficient that the change in business is a reasonable business decision or one that makes commercial sense if there is no continuity of the original business.
While entering a new business or new transaction will not cause the similar business test to fail (as it does in the same business test) the test will be more difficult to satisfy if substantial new business activities and transactions do not evolve from and complement the former business.
While the LCG and EM provide guidance and examples regarding the application of the similar business test, the test is inherently broad and uncertain and it will be challenging for taxpayers to determine the exact scope of the term ‘similar’ when applying the rules to their business.