Focus: Long-awaited reform to company loss rules
21 September 2015
In brief: The company loss recoupment rules have been amended to give effect to long-awaited reforms to the continuity of ownership tests. This will assist companies that have multiple classes of shares with unequal rights to dividends, capital distributions and voting power. Partner Martin Fry (view CV) and Associate Jay Prasad review the changes.
- Unequal share structures: Division 167
- Dividend and capital rights
- Voting rights
- Other reforms – tracing concessions
- Other reforms – single entity rule
How does it affect you?
- The new rules will improve the ability of companies to pass the continuity of ownership test where they have different classes of shares. Companies having an 'unequal share structure' will be able to 'reconsider' whether there has been continuity of dividend rights, capital rights and voting rights for the purposes of recouping prior-year losses for the period from 1 July 2002.
- The new rules also introduce concessional tracing rules for non-widely held companies applying the continuity of ownership test, and clarify the interaction of the entry history rule with the same business test for consolidated groups.
The company loss recoupment rules allow a company to claim deductions for prior-year losses, provided the continuity of ownership test (the COT) or the same business test (the SBT) is satisfied.
The COT is an integrity measure that prevents entities from acquiring ownership or control of a company for the purpose of claiming the company's accrued losses as a tax deduction. Broadly, the COT requires that the shares that carry more than 50 per cent of all voting, dividend and capital rights of the company are beneficially owned by the same persons from the start of the loss year to the end of the income year in which the loss is recouped. The continuity of ownership must be separately assessed for each of the voting rights, dividend rights and capital rights of the company. Concessional tracing rules apply to widely held entities and certain prescribed entities. If a company fails the COT, in order for the company to deduct prior-year losses the company must demonstrate that it carried on the 'same business' in the income year/s in which the loss is recouped, as it carried on immediately before it failed the COT (ie the company must satisfy the SBT).
The key change the new legislation introduces relates to the application of the COT for companies that have an 'unequal share structure'.
A company will have an unequal share structure where the company has different classes of shares with unequal rights to dividends, capital distributions or voting power, or where there is some discretionary right attached to the share. It is not uncommon for a company to have an unequal share structure. For instance, companies that have issued preference shares with priority rights to income and capital distributions, or discretionary dividend shares that allow the board to distribute income and capital to shareholders subject to the exercise of board discretion.
When applying the COT, a company with an unequal share structure may not be able to properly assess whether 50 per cent of all voting, dividend and capital distribution rights in the shares of the company have been held by the same persons. The modified COT rules operate to effectively align the application of the COT for companies with unequal share structures with those companies whose shares are all of a single class, with the same rights, by allowing the company to 'reconsider' the conditions for applying the COT in a number of different ways. The modified rules provide different methods for a company to reconsider the continuity of the rights to dividends and capital distributions, on the one hand, and voting rights, on the other. These rules are considered separately below.
The changes have retrospective effect from 1 July 2002.
A company that has an unequal share structure is allowed to reconsider the conditions for applying the COT to determine whether there is continuity of dividend and capital rights in the company, in the following sequential order:
- The first way that the modified COT rules will apply is by disregarding any interest issued by a company that is characterised as a debt interest by reference to the debt/equity rules in Division 974.
- After having disregarded any debt interests of the company, if the company is still unable to establish continuity of ownership of its dividend and capital rights, it may also disregard a class of shares other than the ordinary shares representing the majority of the company's value (a secondary share class), provided the market value of the secondary share class does not exceed 10 per cent of the total market value of all the company's shares, and together the total market value of all the secondary share classes on issue does not exceed 25 per cent of the total market value of all the company's shares (debt interests should be disregarded when calculating these market values).
- The Explanatory Memorandum notes that any secondary class of share on issue during the test period that is not on issue at the end of the test period (eg if that class were redeemed during the test period), cannot be disregarded under the second test. Taxpayers may need to rely on the third test for establishing continuity of ownership in these circumstances.
- If the company is still unable to establish continuity of ownership of its dividend and capital rights, it may choose to treat the remaining shares (ie the shares that are not included in (1) and (2) above) as having fixed rights to dividend and capital distributions, based on the market value of the remaining shares or, where it is impractical to calculate the market value, on a 'reasonable' basis, having regard to the company's constitution, company policies and agreements, historical distributions, rights attaching to different share classes, and the principle that losses should only be carried forward if the majority of persons entitled to the dividend and capital distributions is maintained. The Explanatory Memorandum does not provide any guidance on how these factors may apply, and the weight that should be given to each. If market values are unable to be ascertained, taxpayers should consider whether to document the approach adopted in establishing how the dividend and capital distribution rights were fixed.
- The test times under this method will be the beginning of the test period – just before and just after certain share issues, variations, redemptions or cancellations – and the end of the test period. This is in contrast to the continuous testing that is otherwise required when applying the COT for non-widely held entities.
The tests must be applied in order, so that a company must first apply (1), then (2), then (3). The company's tax return will be sufficient to demonstrate which of the above tests the company is relying on to reconsider the application of the COT.
It is not uncommon for the voting power in a company to be separated from the rights attaching to shares. For instance, a shareholder (or a class of shareholders) may hold particular rights relating to the appointment of directors, or a shareholders' agreement may regulate certain decision making of the company, or certain shares may have limited voting rights (eg preference shares are typically structured to have limited or no voting rights).
If the shares in the company do not carry all the voting rights, the COT may be worked out by reference to the maximum number of votes that could be cast on a poll:
- for an election of the company's directors; or
- an amendment to the company's constitution (other than an amendment to the rights attaching to shares or amendments to voting power).
The modified approach must be applied to all the shares of the company (other than dual listed company voting shares), without any regard to the interests that may have been disregarded under the modified tests for dividend and capital rights considered above.
When applying the COT, a company will prima facie be required to trace through interposed entities to the ultimate beneficial owners of its shares. This is problematic for companies whose shares are held indirectly by a number of different entities. The modified COT rules will allow a company to treat shares held by certain shareholder entities as though those shares were held by a single person. Similar concessional tracing rules currently exist for widely held companies. The entities that may be treated as a single shareholder include a complying superannuation fund, a foreign superannuation fund, a complying approved deposit fund, a special company or a managed investment scheme. These changes will have effect from the 2011-12 income year.
There is also an amendment to the application of the SBT for consolidated groups. The amendment provides that the head company of a consolidated group or a MEC group will not need to take into account the history of a subsidiary member before the time that the subsidiary member joined the group for the purposes of applying the SBT. This change is addressing historical concerns as to the interaction of the entry history rule with the SBT, and will have retrospective effect from 1 July 2002.
The amendments to the company loss recoupment rules have been a long time coming and are welcome. This is particularly the case for those companies with 'unequal share structures'.
Taxpayers should now consider how the modified COT rules may impact on their historical treatment of prior-year losses, and whether any amendments to prior-year income tax returns are required.
- Martin FryPartner, Practice Leader, Tax,
Ph: +61 3 9613 8610
- Charles ArmitagePartner,
Ph: +61 2 9230 4756
- Larry MagidConsultant,
Ph: +61 2 9230 4918
- Toby KnightPartner,
Ph: +61 3 9613 8590
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