This initiative is one of the few tangible outcomes arising from the 2011 Tax Forum and is also one of the recommendations of the Henry Review (Australia’s Future Tax System). The IPA has long advocated for this initiative in its pre-budget submissions, and we are very supportive of such a measure as part of our tax loss rules.
Adoption of the loss carry back measure will at last bring Australia into line with other overseas tax jurisdictions. The US, Canada, Singapore, UK, Ireland, Germany and France are a few of the OECD countries that have already adopted loss carry back rules.
Current treatment drawbacks
Two major drawbacks with the current treatment of losses relate to timing and utilisation. When a company is experiencing tax losses, this can place financial stress on cash flow. The problem with our current rules is that the company needs to return to profit before it can utilise some value for its past losses. No future profit equates to zero tax benefits for carried forward losses. Even if future profits materialise, there is the risk that the company may fall foul of the integrity rules, which may disqualify it from using the loss in the future when it returns to profit.
Earlier access to losses reduces the risk of companies failing the loss integrity rules and thereby obtaining no tax benefit from past losses. The integrity rules are the continuity of ownership test and the same business test. Under existing rules, a company’s ability to utilise carry forward losses depends on whether it satisfies the continuity of ownership test or, failing that, the same business test. In general, the continuity of ownership test is satisfied if the same persons have more than 50 per cent of the company’s voting power, rights to dividends and rights to capital distributions at all times during the ownership test period. The ownership test period is generally the period from the start of the income year in which the loss was incurred (the loss year) to the end of the year in which the loss is sought to be recouped (the utilisation year).
The same business test is generally satisfied if the company is carrying on the same business in the loss utilisation year that it carried on immediately before the time it failed the continuity of ownership test.
A simple scenario
Company A had taxable income for the 2012 income tax year of $2 million, on which it paid tax of $600,000. Company A has not paid a dividend to its shareholders and accordingly has a franking credit of $600,000. For the year ended 30 June 2013, Company A suffered a taxable loss of $1 million from its business activities.
Under the previous law, based on the above facts and subject to Company A meeting the continuity of ownership test or the same business test, the loss of $1 million could have been offset against any future income that Company A generated.
With the new proposals, Company A would be entitled to a cash refund of $300,000 in respect of the loss incurred in the 2013 year (based on a corporate tax rate of 30 per cent) and the franking account would be reduced by the tax refund.
Details of the proposal
The Assistant Treasurer has released an exposure draft on the application of the proposed loss carry back, with draft legislation expected later this year. The design features are described below.
Limited carry back period
A one-year carry back period will be allowed for the 2012/13 income year, followed by a two-year carry back period from the 2013/14 income year onwards. If companies have carried forward losses prior to this date, they will need to satisfy existing integrity rules and generate future taxable profits in order to extract value from those losses.
A quantitative cap
A cap of $1 million will apply in each claim year to the amount of losses that any company can carry back against taxes paid in previous income years. The maximum potential refund in any year will be the tax value of the cap. With a $1 million cap and a 30 per cent tax rate, this will be $300,000.
Only available to companies
Loss carry back will be available only for companies and other corporate tax entities (which are taxed as companies). Section 960-115 of the Income Tax Assessment Act 1997 defines a corporate tax entity as a company, a corporate limited partnership, a corporate unit trust or a public trading trust.
The proposed loss carry back changes are mainly intended to give small businesses that have limited capacity to weather challenging conditions better access to more timely tax loss relief than would be the case under present rules.
Refunds cannot exceed franking account balance
The maximum amount of the tax value of loss carry back (currently $300,000) cannot exceed the surplus balance of the company’s franking account at the end of the income year for which the loss carry back is claimed. In effect, the amount of carry back will be the lower of $300,000 or the franking account balance.
Revenue losses only
Because taxpayers can time the realisation of capital losses, loss carry back will be restricted to revenue losses only.
Integrity rules
What hoops do companies have to jump through to access loss carry back? The Government’s concern is that taxpayers expecting losses for a new venture might seek to gain a tax advantage by conducting the venture through a defunct company or other company with both franking credit balances and prior year tax payments.
The two integrity options explored in the exposure draft are:
- to enact rules in Part IVA which propose that, if new owners acquire a company for a purpose (other than a merely incidental purpose) of obtaining a loss carry back tax offset, the Commissioner of Taxation can deny the offset (the provision would not apply where there was a genuine acquisition of a profitable business)
- to have a modified or simplified continuity of ownership test for loss carry back similar to the current test used for deducting carry forward losses.
The IPA’s policy position
Given that the policy intent is to help struggling companies deal with challenging economic conditions, it may be argued that no integrity rules other than limiting the refund to the available franking account balance are required for companies to be eligible for loss carry back.
Limiting any refund to past taxes paid ensures that access to the refundable tax offset is available only where franking credits have not been distributed to shareholders. Unlike carry forward losses, carry back losses are subject to maximum upper limits (being the lesser of the franking account balance or $300,000).
Part IVA could also be strengthened by extending it to include tax offsets that arise from a carry back of losses to capture instances where the dominant purpose is manipulation of the loss carry back rules to obtain a tax benefit.
If there are concerns that the proposed loss carry back will be subject to abuse (eg through trafficking of defunct companies with both franking credit balances and prior year tax payments) and further integrity rules are deemed warranted, then for the sake of simplicity and consistency, the rules governing carry forward losses should be replicated for carry back losses.
Standalone integrity rules for loss carry back would introduce more compliance and administration cost. A modified version of the existing rules would appear more appropriate if existing rules are deemed necessary.
Under existing rules, a company’s ability to utilise carry forward losses depends on whether it satisfies the continuity of ownership test or, failing that, the same business test. These tests would need to be modified so the test period runs from the profit year to the claim year to enable existing tests that apply to carry forward losses to be replicated for carry back losses.
These tests are, however, governed by complex sections of income tax laws. Both the Henry Review and Business Tax Working Group have highlighted the need to simplify and provide more certainty to these rules. If these integrity measures were later reviewed to give greater weight to simplicity and certainty, then any such amendments to simplify these rules will apply equally to carry back losses and carry forward losses.
Delivery mechanism
The policy intent behind the changes is to assist viable companies continue operations. While amending a previous year’s return would have been the most expedient way to return previously paid taxes, we acknowledge the administrative difficulties of this approach and accordingly support the proposal to use a refundable tax offset in the claim year.
As companies are not the preferred entity for small business operators, the option of extending the principles of loss carry back to other entity types was not considered. While not without its problems, this option is also worthy of future consideration. The IPA is very supportive of measures that bring relief to struggling small companies, and we look forward to having loss carry back as a feature of our tax system.
