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Company Losses
An Old Issue for a New Era
Taxation Institute of Australia
25th National Convention
March 2010
Martin Fry
Allens Arthur Robinson
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Company Losses – An Old Issue for a New Era
The theme of this presentation is that the utilisation of company losses is an 'old issue for a new
era'. Certainly, the Australian tax laws have regulated the utilisation of companies losses for many
years. In 1944 provisions were introduced to address loss trafficking amongst private companies
when subsections 80(5) and (6) of the Tax Act 1936 were introduced by the Income Tax
Assessment Act 1944. Section 80A was then introduced in 1964 to require public companies to
satisfy a continuity of ownership test before losses of prior years were able to be recouped.
Section 80A, which is the genesis of section 165-12, Subdivision 165-D and Division 166 of the Tax
Act 1997, was introduced by the Income Tax and Social Services Contribution Assessment Act
(No 3) 1964. As such, the regulation of the utilisation of company losses can certainly be viewed
as a 'old issue'.
However, what is most interesting is to consider how the utilisation of losses is affected by the 'new
era'. The 'new era' must of course be a reference to the severe economic downturn experienced
in the world economy over the last few years. The 'new era' is also a reference to the significant
developments in the laws relating to the utilisation of losses in recent years.
Economic Downturn
In relation to the downturn in the world economy it is relevant to note that the Commissioner of
Taxation is, quite appropriately, conscious of the potential for the downturn to impact on the
recognition of losses and ultimately on the collection of tax revenue. The Commissioner's
concerns on this issue has naturally translated into a focus on the question of whether corporate
taxpayers have satisfied the provisions of the tax law which allow for the recognition and utilisation
of losses.
Hence in October and November 2009 the Australian Taxation Office (ATO) embarked on a project
under which letters were sent to tax practitioners who had clients with an annual turnover of
$2 million to $10 million. The letters discuss the tests which must be satisfied under the tax laws
for the utilisation of losses and highlight certain areas of concern for the ATO.
In February 2010 Deputy Commissioner Jim Killaly gave a speech to the 7th Annual Corporate Tax
Summit in which he made the following relevant points:
Returning for a moment to company tax payments, the trend in payments by large businesses shows
some changes. In contrast to increases of around $2.5 billion in the 2005 finance year, $5.5 billion in
2006 and $5.3 billion in 2007, the trend has been fairly flat in recent years with $37 billion for 2007,
$37.9 billion in 2008 and $37.76 in 2009. Some of the late balancing companies would have been
impacted in 2009 by the financial crisis and economic crisis which will continue to impact payments in
2010, but the trend over the last three years is notable.
…
Over the 2005 to 2008 financial years more than 40% of the company income tax returns lodged by
large business taxpayers had a tax payable of zero and around half those were showing losses.
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Over that same period of 2005 to 2008, depending on the particular financial year, between 540 and
580 economic groups had an entity that filed a company income tax return with a tax payable of zero;
and there were between 130 to 160 that returned a tax payable of zero for the entire economic group.
…
A specific part of our compliance strategy is to focus on losses. Our case selection process identifies
cases where taxpayers claim to be in loss year after year. Some of our audit cases involve market
leaders who have been growing considerably over the years, are recognised as well performing
companies, but have paid little or no tax in Australia.
We also follow up on cases where the company has reported a significant accounting profit but has
claimed a significant tax loss in respect of the transaction.
The revenue losses reported in the large business sector exceed the losses utilised each year.
There is no observable pattern of losses across the large business sector, it is more enterprise
specific. The utilisation of losses appears to be affected by enterprise profitability, the availability of
credits and offsets that would otherwise be wasted if losses were used, the way that the 'available
fraction' works in the context of tax consolidation and limitations imposed by the continuity of
ownership and same business tests.
…
We have disallowed over $21 billion in revenue and capital losses over the last five years, $12 billion
of this amount relating to capital losses. Given that pattern and trend, loss cases will continue to be
an ongoing focus in our compliance activities.
In short, Deputy Commissioner Killaly's comments make it clear that the utilisation of loses in the
tax system will continue to be an area of focus for the ATO in the near future.
Recent Developments
The balance of this paper discusses some critical recent developments in the laws which regulate
the utilisation of company losses.
(a) First, there is a discussion of key aspects of Division 166 of the Tax Act 1997. The
introduction of Division 166 was an extremely important development because it provided
taxpayers with a meaningful set of rules (primarily being the tracing concessions) by which
to test for the continuity of ownership. The introduction of the tracing concessions marked
a dramatic improvement in the laws on the utilisation of losses. However the practical
application of the tracing concessions is not without its difficulties.
As such, Part A of this paper provides a broad outline of Division 166 and then discusses
the key pitfalls that can arise when seeking to apply the tracing concessions to prove
continuity of ownership.
(b) Second, Part B of this paper discusses three decisions of the courts in the last three years
in relation to the same business test. These are the decisions in Lilyvale Hotels, Coal
Developments (German Creek) and R&D Holdings, which can each be described as
decisions on the application of the Same Business Test.
(c) Third, in Part C of this paper there is a discussion of the exposure draft legislation released
by the Government in September 2009. This draft legislation is directed at addressing
three areas of uncertainty in the laws which regulate loss utilisation, being
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• the treatment of shares with variable rights to dividends and capital distributions
under the continuity of ownership test;
• the treatment of shares with variable voting power under the continuity of
ownership test; and
• the application of the same business test when a company joins a consolidated
group or a MEC group.
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PART A: DIVISION 166, TAX ACT 1997
1. The role of Division 166
According to section 166-3, the object of Division 166 is to make it easier for widely held
companies and other eligible Division 166 companies to apply many of the continuity of
ownership rules contained in Division 165. In very brief terms, this object is sought to be
achieved by:
(a) in relation to the basic continuity of ownership rule contained in section 165-12:
(i) modifying the 'continuity of ownership threshold' so that it is determined by
reference to 'substantial continuity of ownership' as defined in section 166-
145;
(ii) requiring continuity of ownership to be tested at particular testing times;
and
(iii) via the tracing concessions, allowing the continuity of ownership tests to be
satisfied by reference to identified deemed owners of rights to voting,
dividends and capital distributions;
(b) in relation to other continuity of ownership rules contained in Division 165:
(i) modifying the circumstances in which a company is required to calculate its
taxable income and losses by reference to parts of the income year
(Subdivision 166-B);
(ii) modifying the continuity of ownership testing for the carry forward of bad
debt deductions (Subdivision 166-C);
(iii) modifying the 'trigger points' for the application of Division 165-CD in
respect of realised losses (for which the trigger point is an 'alteration time')
and Division 165-CC in respect of unrealised losses (for which the trigger
point is a 'changeover time').
This paper focuses on (a).
2. The companies to whom Division 166 applies
In broad terms Division 166 applies to:
(a) a 'widely held company', which is defined to be:
(i) a company the shares in which are listed on an Approved Stock Exchange,
but ignoring shares that carry a right to a fixed rate of dividends;
(ii) a company with more than 50 members, unless there are 20 or fewer
persons holding shares representing 75% or more of value, voting power
or dividend rights;
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(b) an 'eligible Division 166 company', which is defined to be a company:
(i) which is not a widely held company under (a);
(ii) in respect of which shares carrying more than 50% of the rights to voting,
dividends or capital distributions are beneficially owned (directly or
indirectly) by a widely held company, complying superannuation fund,
regulated managed investment scheme, approved deposit fund and/or
certain non profit entities.
It is relevant to note that the first limb of the definition of 'widely held company' requires that
all shares in the company be listed on an Approved Stock Exchange other than shares
which carry a right to a fixed rate of dividends. As such, an ASX company will not satisfy
the first limb of the definition if it has on issue shares which are not listed on the ASX and
which do not pay fixed dividends. This may arise, for example, where the ASX listed
company has on issue unlisted floating rate preference shares, some other unlisted hybrid
shares (not carrying a right to fixed dividends) or unlisted 'founding member' shares (which
can be a feature of foreign listed companies). Of course, the ASX listed company may
nevertheless satisfy the second limb of the definition.
Where a company ceases to be eligible to apply Division 166 (for example if an ASX listed
company issues unlisted floating rate preference shares and is otherwise unable to satisfy
the second limb of the definition) it will need to revert to the provisions of Division 165 in
order to recoup prior year tax losses. This will create particular difficulties for the company,
as it will generally not be maintaining the type of information that would be necessary for it
prove continuity of ownership under Division 165.
The question of whether a company is entitled to apply Division 166 is to be determined in
the year in which a company seeks to recoup a tax loss. As such, in the above example, it
seems that the company could still recoup prior year losses under the provisions of
Division 166 provided it had bought back and cancelled the unlisted floating rate
preference shares prior to the start of the income year in which the prior year losses are to
be recouped.
Joint Venture Companies
The fact that Division 166 is also available to be applied by an 'eligible Division 166
company' is an important development. It means that the benefits of Division 166 will often
be available to joint venture companies in respect of which a majority of the shareholders
are widely held companies (including ASX listed companies) or the other entities listed in
the definition.
Interposition of a new Head Company
In ATOID 2007/106 the ATO concludes that the insertion of a new holding company above
the head company of a consolidated group does not have the effect of causing the new
holding company to be excluded from access to the benefits of Division 166.
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3. How Division 166 modifies the basic continuity of ownership test
The basic continuity of ownership test in section 165-12 requires:
(a) that there be persons who had more than 50% of the rights to voting, dividends
and capital distributions at all times in the period:
(i) from the start of the loss year;
(ii) to the end of the income year in which the prior year loss is recouped;
(b) if (a) is not satisfied, that the company carry on the same business for the income
year in which loss is to be recouped as was carried on:
(i) when the company failed (a), if it is practicable to demonstrate this; or
(ii) the start of the loss year.
The three key ways in which Division 166 modifies this basic continuity of ownership test
are as follows.
(c) First, the basic continuity of ownership test in section 165-12 is deemed to be
satisfied if there is substantial continuity of ownership as between the nominated
testing times, being:
(i) the start of the loss year;
(ii) the end of each income year; and
(iii) the end of each 'corporate change'.
(d) Second, in determining whether there has been substantial continuity of ownership,
the company applies the tracing concessions, under which the company is relieved
of the need to trace through to underlying beneficial ownership and is, instead, able
to rely on certain deemed owners of rights to voting, dividends and capital
distributions.
(e) Third, if (c) cannot be satisfied, the company must carry on the same business for
the income year in which the loss is to be recouped as was carried on at the earlier
of:
(i) the end of the income year in which the continuity of ownership test was
failed;
(ii) the end of the corporate change which caused the continuity of ownership
test to be failed.
Testing times
It is important to note that, as compared to Division 165, Division 166 modifies the testing
times for both the continuity of ownership test and the same business test. This can be
shown in the following table.
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How Div. 166 modifies testing times
Div. 165 Div. 166
must prove continuity of ownership at all times in the period:
• start of loss year
• end of recoupment year
must prove continuity of ownership as between:
• start of loss year
• end of each income year
• end of each corporate change
having failed COT, loss co must carry on the same business in the recoupment year as it carried on:
• when fail COT, if practicable to show; or
• start of loss year
having failed COT, loss co must carry on the same business in the year of recoupment as it carried on:
• end of income year in which COT failed;
or
• end of corporate change which caused
COT to be failed
whichever is earlier
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Division 166 is elective
As the application of Division 166 is elective, the fact that the testing times for the same
business test under Division 166 are different from those under Division 165 can be
significant.
The business of a company can change gradually over time or it can change as a result of
one-off events such as the sale of substantial assets. As the application of Division 166 is
elective, where a loss company has experienced a change in its business and is seeking to
recoup prior year losses on the basis of the same business test, the loss company will
analyse whether its ability to satisfy the same business test is better under the testing times
required by Division 165 or Division 166.
Division 166 does not modify all aspects of Division 165
Division 166 does not modify all aspects of the continuity of ownership tests in Division
165. For instance:
(f) Division 166 will not apply (and the provisions of Division 165 will apply) to the
extent that the taxpayer elects to not apply Division 166;
(g) many of the interpretation rules contained in Division 165 (for example, the
interpretation rules dealing with shares held by government entities: section 165-
202; dealing with shares held by companies in liquidation: section 165-208; the
carve out for DLC voting shares: section 165-209) will continue to apply. Strictly
speaking, the 'same share rule' contained in section 165-165 does not apply where
a company is applying the provisions of Division 166, however a variation of the
same share rule applies for the purposes of certain of the tracing concessions;
(h) whilst Division 166 modifies the basic continuity of ownership test in section 165-
12, it does not modify the continuity of control test in section 165-15. As such, as
pointed out in ATOID 2005/8, a company can satisfy the continuity of ownership
test under Division 166 but can still be denied the ability to recoup a prior year tax
loss by reason of having failed the continuity of control test in section 165-15.
When do the testing times "end"?
As noted, Division 166 modifies the basic continuity of ownership test in section 165-12
such that it is deemed to be satisfied if there is 'substantial continuity of ownership' as
between:
(i) the start of the loss year;
(j) the end of each income year; and
(k) the end of each 'corporate change'.
As such, for a company with a year ending 30 June, it would seem that it is necessary to
test at the start of the loss year (ie 1 July), at the end of each income year (ie each 30
June) and at the end of each corporate change.
However, 'substantial continuity of ownership' is defined in section 166-145 such that it is
satisfied if there is more than 50% continuity in the rights to voting, dividends and capital
distributions as between the start of the loss year and immediately after the other testing
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times. For a company with a 30 June year end, 'immediately after' the end of each income
year must presumably mean immediately after the end of each 30 June, ie it must
presumably mean 1 July. If that is correct, then for a company with a year ending 30 June,
it would seem that it is necessary to test at the start of the loss year (ie 1 July), and at the
start of each subsequent income year (ie each 1 July) and immediately after the end of
each corporate change.
4. Corporate change
Division 166 modifies the basic continuity of ownership test in section 165-12 such that it is
deemed to be satisfied if there is substantial continuity of ownership as between:
(a) the start of the loss year;
(b) the end of each income year; and
(c) the end of each 'corporate change'.
The concept of a 'corporate change' is defined in section 166-175 to be:
(d) a takeover bid under Chapter 6 of the Corporations Act or under a foreign law
relating to takeover regulation. Note, for these purposes:
(i) a takeover bid is taken to 'end' at the latest time when the bid period ends.
This means that where the bid period is extended by the bidder, the
relevant testing time is the end of the extended bid period;
(ii) a takeover bid creates a need to test for continuity of ownership even
though the bid may have been unsuccessful;
(e) an arrangement involving more than 50% of the company's shares which is:
(i) a court approved Scheme of Arrangement; or
(ii) an other arrangement for the acquisition of shares which is regulated by
the Corporations Act or a foreign equivalent law;
(f) the issuance of shares in the company that results in an increase of 20% or more
in:
(i) share capital; or
(ii) shares on issue;
(g) a 'corporate change' under (d), (e) or (f) in another company which owns directly or
indirectly more than 50% of the rights to voting, dividends or capital distributions.
Impact of equity raisings
Over the last two years Australian companies have raised an extremely large amount of
new equity by way of rights issues and share placements.
The majority of the rights issues have occurred by way of a non-tradeable
non-renounceable rights issue, ie. an arrangement under which shareholders are offered
rights to acquire additional shares in the company where those rights cannot be traded on
the ASX and where the rights lapse if not exercised by the shareholder. However there
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have also been significant renounceable rights issues, both tradeable renounceable rights
issues (refer Rio Tinto's 21 for 40 rights issues in July 2009) and non-tradeable
renounceable rights issues (refer Alumina's 5 for 19 rights issue in September 2008 and
the Wesfarmers 1 for 18 rights issue in April 2008).
Set out below is a table showing a sample (only) of rights issues undertaken in the nine
months from January to September 2009 where the capital raising was at least
A$150million.
In this context it is relevant to ask whether the companies undertaking rights issues, private
placements and other equity capital raisings, have experienced a 'corporate change' for the
purposes of testing for continuity of ownership under Division 166. More particularly,
whether the equity capital raising was an event which resulted in an increase of 20% or
more in:
• the share capital of the company; or
• the shares on issue.
If the answer is yes then the company has experienced a 'corporate change' as defined
and the company must therefore test for continuity of ownership under Division 166 of the
Tax Act 1997.
Date announced Issuer Size ($m)
7 Sep 09 Sigma 297
24 Aug 09 ConnectEast 421
18 Aug 09 Amcor 1,611
17 Aug 09 Boart Longyear 406
10 Aug 09 Bendigo & Adelaide Bank 300
6 Aug 09 Goodman Group 1,300
27 Jul 09 Australand Property Group 475
27 Jul 09 Virgin Blue 210
15 Jul 09 Transpacific Industries 737
1 Jul 09 Hastings Diversified Utilities Fund 192
25 Jun 09 FKP Property Group 324
15 Jun 09 Asciano 769
10 Jun 09 Kagara 150
5 Jun 09 Rio Tinto 15,200
18 May 09 Billabong 290
13 May 09 Stockland 1,780
12 May 09 SP AusNet 413
11 May 09 Santos 3,000
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Date announced Issuer Size ($m)
11 May 09 Pacific Brands 226
7 May 09 GPT 1,400
5 May 09 Bluescope Steel 1,413
30 Apr 09 Alumina 1,020
21 Apr 09 DEXUS Property Group 749
16 Apr 09 OneSteel 549
31 mar 09 DUET Group 264
27 Feb 09 Fairfax Media 625
5 Feb 09 Suncorp-Metway 656
22 Jan 09 Wesfarmers 3,700
20 Jan 09 Abacus Property Group 187
5. The tracing concessions
The tracing concession provide a series of deeming rules which are used for the purposes
of determining whether the test of substantial continuity of ownership has been satisfied.
That is, the tracing concessions provide five scenarios in which the rights to voting,
dividends and capital are attributed to an identified deemed owner for the purposes of
determining whether there has been substantial continuity of ownership.
The five scenarios can be summarised in the following table.
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COT Tracing Concessions scenario rights to vote etc are attributed to special rules
1. an entity is the direct holder of shares in the loss company which carry less than 10% of rights to vote, etc
a single notional shareholder nominees
2. an entity holds an indirect interest in shares in the loss company which carry less than 10% of rights to vote, etc
the entity in which the direct interest is held which creates the less than 10% indirect interest in the loss company
nominees & top hat
3. a widely held entity holds direct or indirect interests in shares in the loss company which carry between 10% and 50% of rights
the widely held entity top hat
4. an interest in shares in the loss company is held by a complying super fund, regulated MIS, ADF, FHSA trust, special co., Regs
the entity if it has more than 10 members or an indirect interest of less than 10%, otherwise attributed to members
subject to 1,2,3
5. an interest in shares in the loss company is held by a foreign listed company for which more than 50% of shares are bearer shares or are held by depository, and the identity of the owners of those shares is not revealed
a single notional shareholder (but different from the single notional shareholder under 1.)
subject to 1,2,3
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6. The stakeholder thresholds of the concessional tracing rules
The tracing rules in Division 166 seek to simplify the tests under Division 165 for certain
companies, and to reduce the compliance costs that these companies would otherwise
face from its application.1 As such, the tracing rules in Division 166 are intended to be
concessional.
In practice, however, Division 166 can give rise to technical difficulties and compliance
costs of its own. The circumstances under which this may occur are explained below.
Some of the concessional tracing rules seek to solve the tracing problems of Division 165
by attributing ownership of the loss company to a single notional shareholder or another
entity higher up the ownership chain. For example, the ownership of all shareholdings that
are a less than 10% direct shareholding in the loss company is attributed to a single
notional shareholder. Further, direct or indirect shareholdings of between 10% and 50% in
the loss company held by a widely held company are attributed to the widely held
company.
Difficulties may arise where there are small movements around the stakeholder thresholds
relevant to these concessionary tracing rules. This is problematic because, first, it may
mean that the loss company then has to apply a different continuity of ownership test to the
shareholding interests. Monitoring small changes of shareholding and changing continuity
of ownership tests accordingly creates an administrative and compliance burden. Second,
it may have the result that the loss company then fails the continuity of ownership test
because of a change in ownership, even though the change was relatively minor.
The following examples illustrate these issues.
Example 1.1
X Co is a widely held company.
X Co has a direct shareholding in Loss Co amounting to 9.9% of the shares in Loss
Co. As such the ownership of X Co's shareholding is attributed to the Single
National Shareholder.
During the ownership test period, X Co acquires further shares such that it then
has a direct shareholding in Loss Co amounting to 10% of the shares in Loss Co.
The Single Notional Shareholder test is no longer applied to X Co's shareholding in
Loss Co. Instead, X Co's shareholding in Loss Co must now be traced to a different
deemed owner. In this case, as X Co is a widely held company, ownership of the
10% shareholding would thereafter be attributed to X Co under section 166-240.
As such, for the period that X Co held its 9.9% direct shareholding in Loss Co the
ownership of this shareholding is attributed to the Single Notional Shareholder,
whereas for the period that X Co holds its 10% shareholding this shareholding is
attributed to X Co.
1 The Explanatory Memorandum to the Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Act 2005
(Cth).
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The example demonstrates that the rules can create a compliance burden due to
companies having to monitor even small changes in their shareholding in order to apply the
appropriate tracing rules.
The example also demonstrates that the rules effectively treat the acquisition of a 0.1%
stake by X Co. as a change in the ownership of 9.9% of the shares in Loss Co., even
though this is not the case. In some circumstances, this can cause an inappropriate
application of COT. This is demonstrated by the example below.
Example 1.2
X has a direct shareholding in Loss Co amounting to 9% of the shares in Loss Co.
The total interests of all stakeholders in Loss Co. with direct shareholdings of less
than 10% (including X) is 51%. As such, under section 166-225 the ownership of
this 51% shareholding is attributed to the Single Notional Shareholder.
B Co. holds 49% of the shares in Loss Co.
During the ownership test period:
B Co. disposes of its entire stake to a widely held company; and
X acquires an additional 1% stake.
After these transactions, the stakeholders who collectively hold a 42% direct stake
in Loss Co (i.e. the stakeholders, other than X, with a less than 10% direct
shareholding in Loss Co) are unchanged.
As a result of the shareholding changes, Loss Co will fail the continuity of
ownership test. This is because the continuity of ownership of the direct
shareholdings of less than 10% will be attributed to the single notional shareholder
and will amount to 42%. However, X's 10% direct shareholding will not be
attributed to the single notional shareholder – it will be separately traced to a
different deemed owner under the Division 166 tracing rules.
The outcome in Example 1.2 is an inappropriate COT outcome, given that, in substance,
51% of the stakes in Loss Co have not changed hands (as would generally be expected in
order for a failure of COT to occur).
The legislation attempts to address the problems caused by changes in shareholdings
around the relevant thresholds of the tracing concessions through the 'no detriment' rule in
s 166-275. Under this rule, a company must hold a reasonable belief that it would not fail
the COT if concessional tracing rules did not apply to the stake. However, in practice this
provision is of uncertain application (see further below).
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7. The no detriment rule: section 166-275
As noted in some circumstances a particular concessional tracing rule may make it more
difficult for a company to satisfy the continuity of ownership test. The legislation seeks to
address this problem through the 'no detriment' rule in s 166-275. As such, the provision
has an important role to play. However, there are a number of difficulties in its practical
application.
The difficulties primarily arise in satisfying the requirement that the loss company believes
"on reasonable grounds" that if the tracing rule did not modify how the tests applied to the
loss company, it would satisfy the continuity of ownership test.2
One issue is that it may be difficult for a company to demonstrate that it would satisfy COT
without the concessional tracing rules. For example, if a loss company would need to have
recourse to the standard Division 165 rules in order to demonstrate that it would satisfy
continuity of ownership test, this may result in the very same difficulties which the tracing
rules were designed to overcome.
The Explanatory Memorandum to the provisions notes these issues and makes the
following comments:
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.3
The indication from the above is that the no detriment rule is intended to uphold the
concessional nature of the Div 166 rules, and should not prevent a taxpayer from failing
continuity of ownership test where it would not otherwise have done so. This suggests that
a broad, principle based interpretation of the no detriment rule should be favoured,
especially if such an interpretation would assist achieving the policy objectives of the rules
as a whole.
In the NTLG Losses and CGT Subcommittee meeting of 11 June 2008, the ATO was
asked for guidance on the establishment of 'reasonable grounds'.4 The response from the
ATO was that whether a company has formed reasonable grounds is a question of fact and
degree, requiring an examination of all reasonably available evidence in each case.
The ATO was asked to consider the following hypothetical scenario:
2 Section 166-275(c).
3 At 1.136.
4 The issue was raised in response to ATO ID 2008/14. In ATO ID 2008/14, the question was whether a loss company could
rely on the tracing concessions in former subdivs 166-F and 166-G as reasonable grounds for forming the belief that, but for
the COT modification rule in section 166-230, it would pass the COT. The ATO took the view that former subdivs 166 – F
and 166 – G could not be relied on as reasonable ground because they were 'statutory creations relevant only for the
particular legislative scheme of which they formed a part'.
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Example 2.1
Company A incurs a tax loss.
Company A is a 100% subsidiary of listed Company B at the start of the test
period.
Company A becomes a 100% subsidiary of widely held Company C at a later point
in the test period and remains a 100% subsidiary of Company C until the end of the
test period.
The shareholders of company B and C are superannuation funds.
The shareholders of Company B and C each have indirect shareholdings in
Company A amounting to less than 10% indirect stakes in Company A.
Just after Company A becomes a subsidiary of Company C, the shareholders of
Company B are the same as the shareholders of Company C.
The tracing concession which attributes the ownership of indirect stakes of less than 10%
to the first interposed entity at which the less than 10% indirect stake is created (being
section 166-230) would attribute the ownership of the less than 10% indirect stake to B
while A is owned by B and then to C when A becomes owned by C. As such, company A
would fail the continuity of ownership test by reason of the fact that before the transfer of A
the ownership of the indirect shareholding is attributed to B whereas after the transfer of A
the ownership of the same indirect shareholding is attributed to C under section 166-230.
The ATO was asked whether the no detriment rule would apply such that Company A
could nevertheless establish reasonable grounds for passing the continuity of ownership
test on the basis of the tracing concession contained in section 166-245. Under this tracing
concession (for these purposes called the investment entity rule), ownership of the
shareholding in A would be attributed to the superannuation funds.
The ATO responded that the investment entity rule could not be used as a means for
establishing reasonable grounds. The ATO's view was that as the application of the
investment entity rule is subject always to there being ownership of the shareholding
attributed to an entity under the 10% indirect stake tracing concession (ie under section
166-230) the investment entity rule was precluded from applying. The same comment
mafm A0114068904v2 150130 27.2.2010 Page 18
would apply in relation to the fact that the investment entity rule is also subject to there
being ownership of the shareholding attributed to an entity under the single notional
shareholder tracing rule (s 166-225), or the widely held company tracing rule (s 166-240).
The investment entity rule is subject to these other tracing rules by virtue of subsection
166-245(1)(b).
This appears to be an unduly strict application of the no detriment rule. First, given that the
no detriment rule is being evoked to disregard the application of the indirect stakes tracing
rule, it is then a somewhat circular argument to say that the investment entity rule cannot
be relied on as its application is precluded when the indirect stakes tracing rule applies.
Secondly, such an interpretation does not appear to be consistent with the stated policy
objective of preventing inappropriate failures of continuity of ownership test due to rigidity
around the concessional tracing rules.
8. Interposition of a new entity between notional shareholders
When a new entity is interposed between indirect stakeholders in a loss company and the
loss company, an additional tracing concession seeks to ensure that the interposition does
not trigger a change of ownership, provided that the ultimate stakeholders are left
unchanged (new interposed entity concession). 5
Some practical applications of the new interposed entity concession are problematic and
appear to result in outcomes that are not clearly explicable from a policy perspective.
For example, the interposition of a holding company appears to result in a de-recognition of
the notional shareholder under the single notional shareholder concession.6 This is
demonstrated by the following example, adapted from the example used in the NTLG
Losses and CGT Sub-committee meeting of 15 November 2006:
5 Section 160-230(3)
6 Section 166–225.
mafm A0114068904v2 150130 27.2.2010 Page 19
Example 3.1
Company A has 100 shares on issue.
A non profit organisation, NPO, holds 51% of the shares in Company A.
Various individuals hold the remaining 49% of shares in Company A. The individual
shareholders are treated as one ’notional’ shareholder under s 166–225.
A new company, HoldCo, is interposed between Company A and its shareholders.
Ignoring the tax consolidation implications of the interposition of Holdco for present
purposes, Company A is still an eligible Division 166 company as the NPO still
owns 51% of the shares indirectly.7 However, there has been a 49% change in the
shareholders from the notional shareholder to HoldCo.
If NPO was to sell 1% to another non-profit organisation, COT would be breached,
even though there has only been a 1% change in the beneficial ownership of the
company.
The ATO agreed with the analysis of the interaction between the new interposed entity
concession and the notional shareholder test when it was presented at the NTLG meeting.
However, the ATO noted that the no detriment rule may be of assistance to address the
problem. While this is theoretically possible, the no detriment rule would be practically
difficult to apply as there would need to be sufficient evidence to provide reasonable
grounds for concluding that there had been no substantial change in underlying ownership.
7 See section 995-1 definition of eligible Division 166 company.
mafm A0114068904v2 150130 27.2.2010 Page 20
PART B: SAME BUSINESS TEST
9. Same business test - cases
Over the past three years a series of decisions have been handed down dealing
with the application of the same business test. These decisions are discussed
below – being the decisions in Lilyvale, Coal Developments and R+D Holdings.
Background
The same business test is found in subdivision 165-E of the Tax Act 1997.
When first introduced in 1965, the same business test was designed to play a
'relieving' role. That is, it was recognised that the operation of the continuity of
ownership test would result in a disallowance of prior year losses where there had
been a change in majority ownership of a loss company even though the change of
ownership had occurred for entirely commercial reasons. This was viewed as
inappropriate in view of the fact that the continuity of ownership test was first
introduced to target changes of ownership which were occur as part of a strategy
of loss-trafficking and not changes of ownership which occur for commercial
reasons.
The 'relieving' role of the same business test continues today, ie the effect of
section 165-13 and Subdivision 165-E of the Tax Act 1997 is that prior year losses
which cannot satisfy the continuity of ownership test will still be available for
utilisation if the loss company can satisfy the same business test.
Justices Edmonds and Graham in Lilyvale Hotel Pty Ltd v FCT provided the
following useful snapshot of the history to the same business test at paragraphs 6
and 7 of their judgement:
The precursor to s 165-210 of the 1997 Act was s 80E of the Income Tax
Assessment Act 1936 (Cth) ("the 1936 Act"), introduced into that Act by Act No. 103
of 1965. Section 80E of the 1936 Act was introduced as a "safety net" to overcome
the harsh consequences of the application of s 80A (which had been introduced the
previous year to deny the deductibility of carry forward losses unless there was a
requisite continuity of beneficial ownership of shares in the loss company) where
there was a takeover of a company for reasons unassociated with its carry forward
tax losses. This policy is acknowledged in the Treasurer's Second Reading Speech
to Income Tax Assessment Bill 1965 which became Act No. 103 of 1965:
"The final matter covered by the Bill is income tax deductions for company losses.
Honourable Members will recall that in October last year, the income tax law was
amended to provide a counter to the buying-up of shares in companies with
accumulated losses deductible for income tax purposes so that the purchasing
company could divert its income to the loss company. The diversion of the income
in this way resulted in the purchasing company escaping tax on income up to an
amount equal to the unrecouped losses incurred by the loss company in the seven
years prior to the year of income.
mafm A0114068904v2 150130 27.2.2010 Page 21
Under the legislation introduced last October, losses of a previous year are not, for
1965-66 and subsequent years, allowable as deductions against the income of a
year of income of any company unless there is found to be, during both years, a
beneficial ownership by the same shareholders of shares in the company that carry
at least 40 per cent of the voting and dividend rights and 40 per cent of entitlements
to distributions of capital in the event of the company being wound up.
It is proposed to retain this basic principle but to modify its application in a number
of ways.
One amendment proposed will ensure that a major, or even a total, change in the
shareholdings of a company will not operate to disturb a deduction for a prior year
loss incurred by the company if, at all times in the year of income in which the
deduction may be claimed, the company is carrying on the same business as it
carried on immediately prior to the change in its shareholdings. For this purpose, a
company is not to be treated as qualifying for the deduction if, after the change in
its shareholdings occurred, it begins to carry on a business, or enters into
transactions, of a kind that it did not carry on or enter into before the change
occurred.
The Government considers that this amendment will satisfactorily meet cases of
mergers and takeovers of companies that are carried out for sound economic
purposes and with which there is not associated any transfer of profitable business
from one company to another so that income which would otherwise be taxed is
derived free of tax." (Emphasis added)
7. It is also acknowledged in the reasons for judgment of Gibbs J in
Avondale Motors (Parts) Pty Ltd v Federal Commissioner of Taxation 71 ATC 4101; (1971)
124 CLR 97 at 105 where his Honour said:
"The relevant sections of the Act show an intention on the part of the legislature to
impose, in the case of companies, a special restriction on the ordinary right of a
taxpayer to treat losses incurred in previous years as a deduction from income. The
company cannot take the losses into account if there has been a change in the
beneficial ownership, of its shares or of the shares in the company of which it is a
subsidiary, of the kind mentioned in s. 80A or s. 80C. This restriction is imposed to
prevent persons from profiting by the acquisition of control of a company for the
sole purpose of claiming its accrued losses as a tax deduction. However the
restriction if imposed absolutely would lead to injustice in cases where a company,
notwithstanding substantial changes in the ownership of its shares, continued to
carry on the same business." (Emphasis added)
9.1 Lilyvale Hotel Pty Ltd v Commissioner of Taxation [2009] FCAFC 21 (6 March 2009)
In a decision handed down on 6 March 2009, the Full Federal Court allowed in full
deductions for losses carried forward by the Lilyvale Hotels Australia Pty Ltd (Lilyvale),
following the sale of all of the shares in Lilyvale, ie. following an event which caused
Lilyvale to fail the continuity of ownership test. The critical issue for determination was
whether Lilyvale satisfied the 'same business test' in Division 165-E of the Tax Act 1997
throughout the relevant period. In finding that Lilyvale did satisfy the same business test,
the Full Court set aside the earlier orders of a single judge of the Federal Court in favour of
the Commissioner of Taxation, which had previously disallowed deductions of $10,579,458
claimed by the Lilyvale (in respect of the 2003 income year).
mafm A0114068904v2 150130 27.2.2010 Page 22
Lilyvale owned the leasehold estate on land on which it constructed a hotel. The hotel was
operated by ANA Enterprises Australia Pty Ltd (ANA Enterprises), as agent for the
Lilyvale, in return for which ANA Enterprises received a management fee. In August 2002,
following the completion of a sale of the shares in Lilyvale to Reco Harbour Grande Pte Ltd
(Reco), the management agreement between Lilyvale and ANA Enterprises was
terminated and, until re-branding of the hotel after 1 July 2003, management of the hotel
was assumed by Lilyvale.
Single Judge
The primary judge was satisfied that a seamless transition was achieved during the change
in ownership, with no material difference being apparent between the way the hotel was
operated and managed during the relevant period. The primary judge nonetheless
concluded that the business carried on by Lilyvale before the share sale was not the same
business it conducted after the share sale. In doing so, the judge appeared to accept the
Commissioner's characterisation of Lilyvale's activities as limited to the provision of the
physical asset (the hotel) and the procurement of management arrangements. On this
basis, the primary judge reasoned that prior to the sale of the Lilyvale shares, Lilyvale's
involvement in the business of the hotel was so distant from the day to day activities of the
hotel that it could not be attributed to the appellant
[70] The same business test requires, however, not merely that the same business be
carried on, but that it be carried on by the taxpayer, in this case Lilyvale. I accept that after
the share sale Lilyvale carried on the business of managing the hotel. The critical question
remaining is whether the business that Lilyvale carried on before the share sale is properly
characterised as the business of managing the hotel in the same way that the business it
carried on after the share sale can be characterised.
The primary judge was unwilling to attribute the activities of Enterprises Australia to the
Lilyvale under the law of agency.
Full Court
The Full Court concluded that the execution of the management of the business
(conducted variously with and without with the assistance of a hotel management group)
had no bearing on the identification of the business that Lilyvale carried on. The Full Court
found that Lilyvale's business could correctly be described as 'owning and operating' a
hotel to derive revenue and profits. Consequently, changes in the way the business was
carried on did not render it a different business for the purposes of the 'same business
test.' On the application of the law of agency to the facts, Perram J remarked (in a
separate judgment) that:
a person does not cease to carry out an activity because he or she carries out the activity through an agent. The whole point of the law of agency involves the attribution of the activities in fact carried out by one person to the legal account of another.
Decision Impact Statement
The ATO view of the decision, set forth in a Decision Impact Statement, is that the decision
in Lilyvale will not have any significant implications for the operation of the same business
test:
mafm A0114068904v2 150130 27.2.2010 Page 23
The Commissioner considers the case has been decided on its facts in accordance with established principles governing the operation of the same business test. The joint judgment acknowledges the authority of Avondale Motors and the general principle that the same business test requires a continuing identity (as opposed to similarity) of the taxpayer's business which is to be determined by an evaluation of all relevant facts.. It does not follow that changes to the manner in which a taxpayer's business is carried on, will necessarily manifest a change in the actual business carried on by a taxpayer.
Comment
The relevant point to emerge from the decision in Lilyvale is that the same business test is
directed at identifying the nature and characteristics of the business activity, and is not
concerned with the identity of who conducts that business activity. The fact that the same
business activity was conducted by ANA Enterprises as agent for Lilyvale in one period
and then by Lilyvale in its personal capacity did not result in there being a change of
business.
However the decision does not mean that taxpayers can be indifferent to the
circumstances in which other parties carry out activities which from part of the overall
business. In Lilyvale it was critical that there was agency at law, ie ANA Enterprises
carried out its activities as agent of Lilyvale. It is suggested that the position would be
different in the absence of agency. For example, a large construction company may
engage a labour-hire firm to provide construction workers to build the construction project.
The construction workers would be employees of the labour hire firm and there would be a
contract between the construction company and the labour-hire firm for the provision of
labour services. If the construction company were to terminate the contract with the labour
hire firm and then directly employ the same employees to complete the construction project
then it is doubted that the principles in Lilyvale would be applied.
9.2 Coal Developments (German Creek) Pty Ltd ACN 009 974 896 v Commissioner of
Taxation [2008] FCAFC 27 (11 March 2008)
This was an appeal from orders of a single judge of the Federal Court dismissing an appeal
by the appellant taxpayer against an objection decision of the respondent Commissioner
disallowing deductions for carried forward losses.
Coal Developments (German Creek) Pty Ltd (CDGC) was member of a coal development
joint venture. In order to facilitate operations, the participants in the joint venture entered
into various contractual arrangements with 3rd parties, including for the transport and
loading of coal. On 25 March 1998, RAG Australia Coal Pty Ltd (RAGAC) acquired all of
the ordinary A class shares in CDGC. From that time until 25 June 2001, CDGC was a
wholly owned subsidiary of RAGAC. It was decided that CDGC should cease to be
involved in the joint venture, and computation and finalisation of the purchase price relating
to the sale of CDGC's interest and the novation of CDGC's obligations in respect of
contractual arrangements with 3rd parties was not finalised until after December 2001.
CDGC sought to carry forward losses in the amount of $13,372,739 for the income year
ending 31 December 2001. The deduction was disallowed by the Commissioner on the
basis that the taxpayer did not satisfy the 'same business test'. It was not disputed that
mafm A0114068904v2 150130 27.2.2010 Page 24
CDGC was entitled to claim the deduction provided it satisfied 'same business test'. The
applicable 'test time' commenced on 25 March 1998, which was when the last relevant
change in ownership and control of CDGC had occurred.
The primary judge dismissed CDGC's appeal against the Commissioner's decision,
commenting that:
Managing or disposing of remaining assets after active business operations have ceased will not necessarily constitute the continued conduct of the original business. Assets are often sold in the course of conducting a business, and such conduct does not necessarily imply that the former business has ceased. However, where those assets are essential to the conduct of the business and are not replaced, it is difficult to infer that the same business continues to be conducted.
The decision of the primary judge was subsequently appealed to the Full Court of the
Federal Court. Before the Full Court, counsel for the taxpayer argued that it was carrying
on the same business because it was carrying on winding down activities (associated with
the cessation of CDGC's involvement in the business). The Full Court was not persuaded
by this argument despite accepting "that a business does not lose its identity or cease to be
the same business merely because it is being wound down." The Full Court distinguished
between activities which arose as a product of the 'winding down' of a business and those
which were necessitated by the disposal by sale of a business, as in this case:
19 The fact that a former owner, after the sale of a business, retains liabilities in respect of some incidents of the business, such as a lease of real estate or machinery, does not require the conclusion that the former owner continues to carry on the same business after control of it has passed to the purchaser. The activities undertaken by CDGC in the present case, such as the assignment of mining leases and novation of rights under port user agreements and other contracts as well as the preparation of tax returns and the claiming of concessions for research and development, are more explicable, as a matter of fact, as having been engaged in as a consequence of the sale of the business rather than of its being "wound down"
The Full Court determined that activities cannot be characterised as the 'carrying on of a
business' where the assets of the business are sold to a single purchaser with a view to its
assuming the control and conduct of the business (as opposed to the winding down of a
business). The Full Court considered, therefore, that the analysis undertaken by the
primary judge was correct and CDGC's appeal was dismissed.
Comment
There are circumstances in which an amount incurred is allowable as a deduction even
though it is incurred after the relevant business activity ceased. A key factor in establishing
the deduction will be to show that the liability to make the payment arose in the course of
the (now ceased) business activity. See for example Brown v FCT 99 ATC 4600 and TR
2000/17.
The decision in Coal Developments shows that the activities which comprised the business
do not 'carry over' to a period after the owners have agreed to sell the business even
though those activities were entered into prior to the sale.
mafm A0114068904v2 150130 27.2.2010 Page 25
9.3 Commissioner of Taxation v R & D Holdings Pty Limited [2007] FCAFC 107 (13 July
2007)
This case is an appeal from a single judge of the Federal Court regarding the taxpayer's
entitlement to claim deductions from losses incurred by its wholly owned subsidiary.
In 1987, Chapel Road Pty Ltd (Chapel Road) acquired land on which it constructed a
commercial office block. Construction was initially financed by a loan of $12.3 million from
Burns Philp Trustee Company Ltd, later extended to $14 million and secured by mortgage
over the property to Mercantile Mutual Life Insurance Company Ltd (Mercantile).
Ultimately, the rent received on the property was not sufficient to cover interest payments
and outgoings. In March and April 1990, Chapel Road was unable to make interest
payments due under the mortgage. In May 1990, Mercantile exercised its right to receive
rents of the property and ultimately effected the sale of the property in November 2000 for
$11.75 million. By this point in time, Chapel Road's debt to Mercantile exceeded $100
million. In the intervening 10 years between defaulting on the loan and the sale of the
property, Chapel Road did not have possession of the land and was not involved in the
operation or management of the building. Chapel Road continued to be liable for the
capital and interest accruing on the loan notwithstanding that the mortgagee had exercised
its rights to receive rents.
At all times, Chapel Road was a wholly owned subsidiary of R & D Holdings Pty Limited (R
& D). However, in July 1997, there was a change in the ownership of 50% of the shares of
R & D. R & D sought to carry forward and utilise losses transferred by Chapel Road for the
1997, 1998 and 1999 income years. Following the change of ownership in 1997, it was not
in contention that R & D was unable to satisfy the 'continuity of ownership test' in s 165-12
of the Tax Act 1997 and needed to satisfy the 'same business test' in order to succeed in
its claim. The critical issue, therefore, was whether Chapel Road carried on the same
business in the 1998 and 1999 years as it did immediately before R & D's change of
ownership in 1997.
Single Judge
The primary judge held that Chapel Road had incurred losses in all three years. R & D's
claim was upheld in respect of losses transferred to it by Chapel Road in respect of the
1997 financial year. However, due to the change in ownership its claims for the 1998 and
1999 year failed. The primary judge reasoned that at the relevant times Chapel Road did
not carry on a business at the property; but rather, that this was done by Mercantile Mutual.
Full Federal Court
An appeal to the Full Federal Court was lodged by the Commissioner in respect of the
1997 year and by R & D in respect of the 1998 and 1999 years. Ultimately, both parties'
appeals were dismissed. The Full Court held Chapel Road was not carrying on the same
business for the 1997 and 1998 years and thus losses in the later two years of tax were
not allowable deductions for R & D. A significant factor in the Full Court's decision was the
cessation of Chapel Road's involvement in the conduct of the business once Mercantile
assumed possession:
63. Carrying on a business, as His Honour pointed out, was not a matter of owning an asset, but of engaging in a course of conduct. In July 1997, and indeed from
mafm A0114068904v2 150130 27.2.2010 Page 26
1990, Chapel Road was the legal owner of the mortgaged land, but was not in possession of it and carried on no business. It could make no decisions about such matters as engaging tenants or carrying out repairs and maintenance.
In a separate yet concurring judgment, Stone J concluded:
from the time Mercantile Mutual went into possession Chapel Road did not carry on any business and for that reason it was incapable of meeting the same business test. The fact that Chapel Road was the legal owner of the land on which the business of leasing the Bankstown property was carried on does not alter the fact that from the time Mercantile Mutual went into possession, it, rather than Chapel Road, was carrying out the business.
Special leave was denied both parties to appeal to the High Court.
Comment
The decision in R&D Holdings provides a useful contrast to the decision in Lilyvale.
In R&D Holdings, although the taxpayer continued to be the legal owner of the property the
fact that the taxpayer ceased to have possession and control of the property (upon
Mercantile exercising security) meant that there had been a change in the business of the
taxpayer. By contrast, in Lilyvale there was no change in the business of the taxpayer
notwithstanding the termination of the management agreement with ANA Enterprises given
that the manager was acting as mere agent of the taxpayer.
mafm A0114068904v2 150130 27.2.2010 Page 27
PART C: EXPOSURE DRAFT LEGISLATION
10. Proposals for change
10.1 Company losses – Exposure draft legislation
Exposure draft legislation designed to improve the income tax company losses regime was
released in September 2009. The exposure draft legislation aims to resolve three areas of
uncertainty in the application of the company loss recoupment rules. They are:
the treatment of shares with variable rights to dividends and capital distributions;
the treatment of shares with variable voting power; and
the application of the same business test when a company joins a tax consolidated group or MEC group.
10.2 Shares with variable dividend or capital rights
It has long been recognised that a company's ability to demonstrate continuity in the
ownership of rights to dividends and capital distributions may be highly uncertain in
circumstances where the company has classes of shares with differing rights to dividends
and capital distributions.
Preference Shares
One example is where a company has preference shares on issue which give the
preference shareholders priority over ordinary shareholders in the payment of dividends.
Recall that the combined effect of sections 165-12 and 165-155 requires us to identify the
persons who have 'the right to receive for their own benefit (whether directly or indirectly)
more than 50% of any dividends that the company may pay'.
If the terms of the preference shares state that a dividend will be paid on the shares if the
issuing company achieves certain financial benchmarks then two scenarios become
relevant.
First, there will be years in which the company does achieve the benchmarks and pays
dividends on both the preference shares and the ordinary shares. In these years, what are
the dividend rights of the ordinary shareholders? In identifying rights to the dividends that
the company 'may pay', are the rights of the ordinary shareholders affected by the priority
created in favour of the preference shareholders? Is it that the ordinary shareholders have
no rights to dividends until the dividend entitlements of the preference shareholders have
been satisfied (whether by the payment of dividends in accordance with the terms of the
shares, or by the non-payment of dividends because the company has failed to achieve the
requisite financial benchmarks).
Second, there may be years in the loss recoupment period in which the benchmarks are
not achieved and there are no dividends paid on the preference shares. What are the
implications of this when compared to the years in which preference share dividends were
paid? Will there be a dramatic shift in the continuity of rights to dividends on the basis that
mafm A0114068904v2 150130 27.2.2010 Page 28
the group of preference shareholders had rights to dividends in the good year and then had
no rights to dividends in the bad year?
A further complication arises when it is recognised that our thinking on these issues is,
based on the premise that a shareholder's rights are established by the cash dividends
received in the year. That is, the issues identified above arise when one takes the view
that the 'rights to dividends' of the shareholders are identified by reference to the dividends
in fact received by the shareholders over the course of the income year.
This can be described as an historical view of the 'rights to dividends' test. That is, one
must first wait for the income year to elapse and then determine the rights to dividends for
the income year by looking back over the year and identifying the amount of dividends paid
to the shareholders.
This historical view does not sit well with the modifications to the continuity of ownership
test under Division 166. Under these modifications, it is necessary to identify the rights to
dividends at the particular testing times, basically at the start of the year, at the end of the
year and at each 'corporate change' event. This is a 'point in time' test, ie at these testing
times one must take a 'snapshot' of the rights to dividends for the purposes of satisfying the
continuity of ownership test. This will obviously be very difficult in circumstances where
one is relying on an historical view in which to determine the rights to dividends of the
shareholders.
This, in turn, begs the question of what the 'rights to dividends' test really means. As
noted, we must identify the rights to the dividends that the company 'may pay'. We know
that no shareholder has a right (in the sense of a legal right or entitlement) to a dividend
until the directors have declared the dividend. Is it the case that for the purposes of the
'rights to dividends' test there are no rights to dividends in existence other than the period
between the declaration of dividends by the directors and the payment of dividends
pursuant to such declarations? It would rarely be the case that there is a declared but
unpaid dividend at the particular testing times identified by Division 166.
Exposure Draft
The exposure draft seeks to resolve some of these difficulties.
The proposed new provisions are directed at companies that have shares on issue with
differing rights to dividends or capital and which are unable to satisfy the continuity tests for
dividends or capital distributions for the purposes of utilising prior year losses, utilising past
bad debt deductions, applying certain integrity rules to losses, or eligibility for access to the
continuity of ownership test tracing concessions. Where a company is in this situation:
the company may reapply the continuity tests after disregarding shares that are
treated as debt for tax purposes;
if still unable to satisfy the continuity tests, the company may reapply the continuity
tests by taking into account only its 'principal' class of shares. Note:
o the principal class of shares is the ordinary or common shares which
represent the majority of the voting power and market value of the
company;
mafm A0114068904v2 150130 27.2.2010 Page 29
o each secondary class of shares must not account for more than 10 per
cent of the total market value of the company, and all secondary classes
must not account for more than 25 per cent of the market value of the
company;
if still unable to satisfy the continuity tests, the company may reapply the continuity
tests on the basis that each of its remaining shares had the rights to dividends and
capital determined as follows:
o the rights to dividends and capital distributions that equate to the market
value of each share as a proportion of the total market value of the
remaining shares, if it is reasonably practicable for the company to
determine the relative market value of each such share; or
o otherwise, the rights to dividends and capital distributions that is
reasonable having regard to the purpose of the relevant continuity test, the
company's constitution and dividend policy, and other matters.
Note, this methodology can be applied by a company for the shares that it has on issue,
and also for companies owning shares in that company. Also, there is an integrity rule that
is directed at preventing companies from using this methodology to effectively refresh tax
losses.
The new provisions are to apply to losses incurred in a year commencing on or after 1 July
2002. Also, the provisions are to apply to pre-1 July 2002 losses if such losses could have
been utilised in the first income year after 30 June 2002 on the basis of the COT rules as at
30 June 2002.
10.3 Shares with variable voting power
The continuity of ownership test requires a company to demonstrate more than a 50 per
cent continuity in the ownership of the rights to vote in the company. A long-standing
difficulty with this requirement has been that in many cases particular shares will have
different voting power for the purposes of casting votes on different matters put to
shareholders. For example, the rights attaching to certain classes of shares may specify
that the shares have a blocking vote in relation to proposed changes to the constitution of
the company but otherwise vote as ordinary shares.
In such circumstances, it has been very difficult for companies to establish continuity in the
ownership of the rights to vote in the company. The exposure draft seeks to resolve this
difficulty by providing that a shareholder's voting power in a company is to be determined
by reference to the votes that can be cast in a poll for:
the election of directors, where the election is determined by casting votes
attached to shares; or
otherwise, the adoption or amendment to the company's constitution.
The changes to the voting power test are to apply to losses incurred in a year commencing
on or after 1 July 2007. Also, the new provisions are to apply to pre-1 July 2007 losses if
such losses could have been utilised in the first income year after 30 June 2007 on the
basis of the COT rules as at 30 June 2007.
mafm A0114068904v2 150130 27.2.2010 Page 30
10.4 Same business test
The exposure draft legislation purports to modify the operation of the same business test
for consolidated groups and MEC groups. Pursuant to a substituted s 165-212E, the entry
history rule will not apply for the purposes of section 165-210 when an entity joins a
consolidated group or MEC group. According to the associated Explanatory Material this
will make it easier for the head company of a consolidated group or MEC group to satisfy
the same business test, thereby giving companies greater access to deductions for prior
year losses. In reality, the change to the existing provision is more technical in nature.
The section currently provides that if an entity becomes a member of a consolidated group
or MEC group the entry history rule is "switched off", meaning that the business of the
joining entity before it was a member of the group is not taken into account for the purpose
of determining the same business test. The objective of the section is to ensure that only
the 'post-joining' activities of the new member are attributed to the head company of the
consolidated group or MEC group. It had been suggested that the wording of the section
did not prevent the application of the entry history rule as it referred only to the "business"
of the joining entity. As such, there is a question as to whether the section did not apply for
the purpose of applying the "new business test" or "new transactions test".
The ATO considered that this interpretation was not consistent with the purpose of the s
165-212E and in TR 2007/2 signalled its intention to apply the less restrictive view of the
section:
93. The Commissioner does not agree with these alternative arguments. Firstly, when section 165-212E makes it necessary to disregard the business of the joining entity before it became a subsidiary member, this naturally refers to the transactions and activities constituting that business. Secondly, the Commissioner's view is that the reference to 'same business test' in section 165-212E incorporates both the positive condition and the negative conditions of section 165-210 and thereby 'turns off' the entry history rule for the purposes of the same business test, the new business test, and the new transactions test [TR 2007/2].
The amended section makes it abundantly clear that the head company of the consolidated
group or MEC group need not take the joining member's history into account for the
purpose of determining whether it can satisfy the same business test. It does this by re-
drafting the section with reference to the same business test described in s 165-210.
The commencement date of the proposed amendment is 1 July 2002.