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Focus: New rules proposed on utilisation of losses

7 September 2009

In brief: Treasury has released exposure draft legislation that is designed to resolve long-standing difficulties with the continuity of ownership test rules for the utilisation of company losses. The proposed legislation will have significant implications for companies with multiple classes of shares on issue that are seeking to utilise prior year losses for tax purposes. Partner Martin Fry (view CV) reports.

How does it affect you?

  • Companies with prior year tax losses may be able to utilise the losses to shelter income from tax in circumstances where utilisation of the losses was previously denied.
  • The proposed new rules are particularly relevant to companies with multiple classes of shares on issue, eg companies with preference shares on issue.

Background

In order for a company to utilise revenue or capital losses from a prior income year, it must be able to establish that there has been more than a 50 per cent continuity in the ownership of the rights to dividends and capital distributions, and in the rights to vote, in the company. If a company fails to establish this continuity in the ownership of such rights, it may nevertheless be able to utilise the prior year losses on the basis of having satisfied the Same Business Test (SBT).

The exposure draft legislation aims to resolve three areas of uncertainty in the application of these 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 SBT when a company joins a tax consolidated group or MEC group.

Shares with variable dividend and 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. 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.

The exposure draft seeks to resolve this difficulty. 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 (COT) 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; or
  • 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:
    • 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;
    • 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:
    • 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
    • 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.

Proposed commencement date

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.

Shares with variable voting power

The COT rules require 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.
Proposed commencement date

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.

SBT and entering consolidated groups or MEC groups

The exposure draft also proposes to introduce a provision which, for the purposes of applying the SBT, will turn off the 'entry history rule' when an entity is joining a tax consolidated group or MEC group. This new rule is to apply from 1 July 2002.

Submissions

The closing date for submissions on the exposure draft is Friday 2 October 2009. If you have any queries about this or any other tax matter please contact one of those listed below.

For further information, please contact:

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