Tax losses – carry-backs and carry-forwards, issues and ... · PDF filecarry-forwards, issues and challenges . June 2013 . ... 4.6.7 Calculation of the loss carry-back tax offset

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Tax losses – carry-backs and carry-forwards, issues and challenges June 2013

Tax Losses – Carry-backs and carry-forwards, issues and challenges June 2013

Copyright © The Institute of Chartered Accountants in Australia 2013 2

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Table of Contents 1. Introduction ....................................................................................................................... 7

2. Overview ............................................................................................................................ 9

2.1 Methodology for deducting prior year tax losses .......................................................... 9

2.2 How to calculate a tax loss for an income year ............................................................ 9

2.3 How to deduct tax losses ........................................................................................... 10

2.3.1 Entities other than corporate tax entities ................................................................. 10

2.3.1.1 No net exempt income ........................................................................................ 10

2.3.1.2 Net exempt income ............................................................................................. 11

2.3.2 General rules for entities that are not corporate tax entities in deducting tax loss ... 11

2.3.3 Corporate tax entities ............................................................................................. 13

2.3.3.1 No net exempt income ........................................................................................ 13

2.3.3.2 Net exempt income ............................................................................................. 14

2.3.3.3 Limits on choosing the amount of tax losses to deduct – “excess franking offsets” 14

2.3.3.4 Converting excess franking offsets into tax losses .............................................. 19

2.3.3.5 General rules for corporate tax entities in deducting tax loss .............................. 21

2.3.3.6 Adjustments required if subsequent amendment to tax position .......................... 21

2.4 Net exempt income .................................................................................................... 22

2.4.1 Net exempt income of Australian resident .............................................................. 22

2.4.2 Net exempt income of a foreign resident ................................................................ 23

2.5 Special rules about tax losses .................................................................................... 23

3. Individuals ....................................................................................................................... 27

3.1 Losses from hobbies .................................................................................................. 27

3.2 General deductions .................................................................................................... 27

3.3 Carrying on a business .............................................................................................. 28

3.4 Non-commercial business losses ............................................................................... 33

3.5 Deferral of non-commercial business losses .............................................................. 33

3.5.1 Non-commercial business losses ........................................................................... 33

3.5.2 Exempt income ...................................................................................................... 34

3.5.3 Blackhole expenditure ............................................................................................ 35

3.5.4 Non-commercial business activities ........................................................................ 36

3.5.5 Grouped non-commercial business activities .......................................................... 36

3.5.6 Exception ............................................................................................................... 37

3.5.6.1 Profits test ........................................................................................................... 39

3.5.6.2 Real property test ............................................................................................... 40



3.5.6.3 Other assets test ................................................................................................. 40

3.5.7 Commissioner’s discretion ...................................................................................... 41

3.5.8 Modifications for bankruptcy ................................................................................... 41

3.5.9 Application to certain partnerships .......................................................................... 42

4. Companies ....................................................................................................................... 43

4.1 Rules for Use of Prior Year Tax Losses by Companies .............................................. 43

4.2 Continuity of ownership test ....................................................................................... 44

4.2.1 General continuity of ownership test rules............................................................... 44

4.2.1.1 Proposed modifications clarifying aspects of the COT ......................................... 46

4.2.1.2 Special continuity of ownership test rules ............................................................ 47

4.2.1.3 Saving provision .................................................................................................. 49

4.3 Same business test .................................................................................................... 52

4.3.1 Same business test period ...................................................................................... 52

4.3.2 The same business test requirements .................................................................... 54

4.3.2.1 Positive requirement ........................................................................................... 54

4.3.2.2 Cases where positive requirement satisfied ........................................................ 56

4.3.2.3 Cases where positive requirement failed ............................................................. 57

4.3.2.4 Negative requirements ........................................................................................ 59

4.3.2.5 Anti-avoidance test .............................................................................................. 60

4.4 Applying net capital losses of earlier income year ...................................................... 61

4.5 Division 166 concessional tracing rules ...................................................................... 62

4.5.1 Which entities are able to rely on Division 166? ...................................................... 63

4.5.2 Point-in-time testing ................................................................................................ 64

4.5.3 Concessionary tracing rules .................................................................................... 65

4.5.4 Other special rules in Division 166 .......................................................................... 66

4.5.5 Final points on Division 166 .................................................................................... 69

4.5.5.1 Change in control of voting power ....................................................................... 69

4.5.5.2 Application is optional.......................................................................................... 69

4.6 Loss carry-back regime .............................................................................................. 70

4.6.1 Overview of the loss carry back regime .................................................................. 71

4.6.2 Entities eligible for loss carry-back .......................................................................... 72

4.6.3 Choice to apply the loss carry-back regime............................................................. 72

4.6.4 Relationship between loss carry-back and loss carry-forward ................................. 73

4.6.5 Losses which are subject to the loss carry-back regime.......................................... 73

4.6.6 Franking credit cap ................................................................................................. 74

4.6.7 Calculation of the loss carry-back tax offset ............................................................ 75



4.6.8 Examples ............................................................................................................... 76

4.6.9 Overview of the loss carry-back integrity measure.................................................. 79

4.6.10 Key elements of the loss carry-back integrity measure ........................................... 80

4.6.11 Relevant Circumstances......................................................................................... 81

4.6.12 Examples ............................................................................................................... 82

4.7 Proposed improvements to the company loss recoupment rules ............................... 85

4.7.1 Modifications to the continuity of ownership test ..................................................... 85

4.7.2 Extension of the concessional tracing rules under the modified continuity of ownership test ...................................................................................................................... 85

4.7.3 Holding company interposed between a direct stakeholder and the tested company 86

4.7.4 Demerger by a top interposed entity ....................................................................... 86

4.7.5 Entity interposed between a superannuation fund and the tested company ........... 87

4.7.6 Bearer depository receipts ...................................................................................... 88

4.7.7 Applying the modified COT following an issue of new shares ................................. 89

4.7.8 Loss integrity rules – low value asset exclusion ...................................................... 89

4.8 Proposed tax loss incentive for designated infrastructure projects ............................. 90

4.9 Common errors when utilising tax losses ................................................................... 90

4.9.1 Common errors ...................................................................................................... 90

4.9.2 ATO target areas .................................................................................................... 91

4.10 Record keeping .......................................................................................................... 91

5. Modifications ................................................................................................................... 93

5.1 Tax losses and consolidated groups .......................................................................... 93

5.1.1 Overview ................................................................................................................ 93

5.1.2 Transfer of carried forward tax losses..................................................................... 93

5.1.3 Utilisation of tax losses by head company of consolidated group ........................... 94

6. Foreign Losses ............................................................................................................... 97

7. Trusts ............................................................................................................................... 99

7.1 A summary of the trust loss rules ............................................................................... 99

7.2 Important definitions .................................................................................................101

7.3 Fixed trust .................................................................................................................101

7.4 Non-fixed trust ..........................................................................................................102

7.5 Closely held trust ......................................................................................................102

7.6 Widely held trust .......................................................................................................103

7.6.1 Unlisted and listed widely held trusts .....................................................................103

7.6.2 Unlisted very widely held trust ...............................................................................103



7.6.3 Wholesale widely held trust .................................................................................. 104

7.6.4 Family trust ........................................................................................................... 104

7.6.5 Excepted trust ....................................................................................................... 105

7.7 Fixed trusts, not widely held unit trusts or excepted trusts ........................................ 105

7.7.1 50% stake test ...................................................................................................... 106

7.7.2 Non-fixed trust stake test ...................................................................................... 106

7.8 Non-fixed trusts ........................................................................................................ 107

7.8.1 50% stake test ...................................................................................................... 107

7.8.2 Pattern of distributions test ................................................................................... 107

7.8.3 Control .................................................................................................................. 109

7.8.4 Income injection test ............................................................................................. 110

7.8.4.1 Introduction ....................................................................................................... 110

7.8.4.2 Elements of the test .......................................................................................... 110

7.8.4.3 The trust must have an allowable deduction ...................................................... 111

7.8.4.4 There must be a scheme ................................................................................... 111

7.8.4.5 There must be a connection between the deduction and one or more of the things that happen under the scheme ........................................................................................... 112

7.8.4.6 Examples .......................................................................................................... 112

8. Restricting tax deductions for related party debt ....................................................... 115

8.1 Current Law ............................................................................................................. 115

8.1.1 Debts which are outside of the TOFA regime ........................................................ 116

8.1.2 Debts which fall within the TOFA regime .............................................................. 117

8.2 Impact of the proposed amendments ....................................................................... 118

8.2.1 What is a related party? ........................................................................................ 119

8.2.2 Application date .................................................................................................... 120



1. Introduction

This paper, aimed at an intermediate to advanced audience, discusses the recoupment of tax

losses by individuals, trusts and companies pursuant to the Income Tax Assessment Act 1997

(ITAA 1997) and Income Tax Assessment Act 1936 (ITAA 1936). It also discusses the

proposed loss carry-back rules for companies which are expected to apply from 1 July 2013.

This paper is presented as part of The Institute of Chartered Accountants in Australia (Institute)

special topics program.

References to sections in this paper are references to the ITAA 1997, unless otherwise

indicated.





2. Overview

2.1 Methodology for deducting prior year tax losses

Subdivision 36-A contains the key provisions dealing with deductions for tax losses of earlier

years. It contains the rules for calculating the amount of the tax losses1 and the method for

deducting them2. It also provides signposts to the special rules which apply to particular types of

loss or taxpayer3

2.2 How to calculate a tax loss for an income year

.

If a taxpayer’s assessable income4 for a particular income year exceeds the allowable

deductions5, the taxpayer will be taken to have taxable income equal to the excess.6

Conversely, where the allowable deductions exceed the assessable income, the taxpayer will,

in general terms, incur a “tax loss” for that year.

7

• Adding the allowable deductions for the income year (excluding tax losses of earlier

income years);

Specifically, section 36-10 provides that a tax

loss for a particular income year is calculated by:

• Subtracting the total assessable income; and

• Subtracting any amount of “net exempt income”8 2.3.1.2 (refer to Section below),

any amount remaining is the tax loss for the income year (the loss year).

1 Section 36-10 2 Sections 36-15 and 36-17 3 Section 36-25 4 See Division 6 5 See Division 8 6 Section 4-15 7 Subsection 36-10(4) 8 Section 36-20



A tax loss does not entitle a taxpayer to any kind of tax “refund” for that year; instead, the loss

remains available (subject to the satisfaction of any relevant general recoupment tests or until

cancellation) to be deducted from taxable income derived in subsequent income years. This

process is called “carrying forward” the loss.

Note that the meaning of tax loss and loss year is modified by section 36-55 which applies to

corporate tax entities which have an amount of excess franking offsets.

In addition, section 26-55 specifies that certain allowable deductions cannot create or add to a

tax loss. These allowable deductions include gifts, certain superannuation contributions and

gratuities.

2.3 How to deduct tax losses

2.3.1 Entities other than corporate tax entities

Section 36-15 sets out how tax losses are carried forward for deduction in later income years by

an entity other than a “corporate tax entity”. “Corporate tax entity” is defined to mean a

company, corporate limited partnership, corporate unit trust or a public trading trust.9

The application of the carried forward tax losses against income depends upon whether the

entity has net exempt income.

2.3.1.1 No net exempt income

Generally, if the total assessable income for a later income year exceeds the total deductions

for that year (ignoring the tax loss), the tax loss is deducted from that excess.10 Where the tax

loss is greater than the excess, the undeducted part of the tax loss is carried forward to the next

income year.11

9 Section 960-115

There is no limit on this carry forward period (however, a 7 year limit applied to

non-primary production losses incurred before the 1990 income year).

10 Subsection 36-15(2) 11 Subsection 36-15(7)



If the total assessable income does not exceed the total deductions, then the tax loss cannot be

deducted in that year, and is carried forward to later years.12

2.3.1.2 Net exempt income

In circumstances where the taxpayer has net exempt income in the income year in which the

taxpayer seeks to apply the tax loss, the tax loss is deducted first from the net exempt income,

and secondly from the part of the total assessable income that exceeds the total deductions.13

However, if the deductions exceed the total assessable income, then that excess is subtracted

from the net exempt income, and the tax loss is deducted from any net exempt income which

remains.

14

Accordingly, the effect under either subsection is that any prior year tax losses (or current year

losses) of the taxpayer will be automatically offset against the net exempt income of the

taxpayer for the income year.

2.3.2 General rules for entities that are not corporate tax entities in deducting tax loss

The tax losses that are deducted in accordance with section 36-15 will also be subject to the

following general rules:

• Tax losses are deducted in the order in which they are incurred;15

• Tax losses are deductible only to the extent that they have not already been deducted;

16

• The undeducted amount of a tax loss can be carried forward for deduction in later income

years.

and

17

12 Subsection 36-15(7)

13 Subsection 36-15(3) 14 Subsection 36-15(4) 15 Subsection 36-15(5) 16 Subsection 36-15(6) 17 Subsection 36-15(7)



Example 1

Xene incurs a loss of $25,000 in the 2011 income year. In the 2012 income year, Xene’s total

assessable income is $20,000 and deductions (other than for the tax loss) are $3,000, thus

resulting in an excess of $17,000. Assuming that there is no net exempt income, the $25,000 is

carried forward so as to reduce the $17,000 to nil. The balance of $8,000 is available to be

carried forward to the 2013 and later income years.

Example 2

Assume that in the 2013 income year, Xene’s total assessable income is $50,000 and

deductions (other than for the tax loss) are $10,000, resulting in an excess of $40,000. The

unrecouped tax loss of $8,000 is carried forward so as to reduce the excess to $32,000. The tax

loss is now fully recouped.

Example 3

Assume the same facts as in Example 1, except that in the 2012 income year, Xene also has a

net exempt income of $6,000. The $25,000 tax loss is deducted first against this $6,000. The

balance $19,000 is then deducted from the $17,000 excess of total assessable income over

deductions, so as to reduce the $17,000 to nil. The balance of the tax loss $2,000 is available to

be carried forward to the 2013 income year and later income years.

Example 4

Assume that in the 2013 income year, Xene’s total assessable income is $50,000, and the

deductions (ignoring the tax loss) are $10,000, resulting in an excess of $40,000. Assume also

that Xene has net exempt income of $5,000. The balance of the tax loss $2,000 is deducted first

against the $5,000, reducing it to $3,000. The tax loss is now exhausted and no part of it is

available to be deducted against the excess of $40,000.

Example 5

Assume instead that in the 2013 income year, Xene’s total assessable income is $50,000, the

deductions (ignoring the tax loss) are $65,000, and the net exempt income is $25,000. As the

deductions exceed the total assessable income, the excess $15,000 is subtracted from the net

exempt income, resulting in a balance of $10,000. The tax loss $2,000 is deducted from that

balance, reducing it to $8,000. The tax loss is now exhausted.



2.3.3 Corporate tax entities

Section 36-17 sets out how tax losses of corporate tax entities are carried forward for deduction

in later income years. Section 36-17 applies where the relevant entity is a corporate tax entity at

any time during the later income year.

The purpose of introducing section 36-17 was to enable a corporate tax entity to choose the

amount of prior year losses it wished to deduct in a later income year. This enables a corporate

tax entity with carried forward tax losses:

• To ensure it does not “waste” the benefit of tax offsets for franking credits received in an

income year where the corporate tax entity had current year or carried forward tax losses;

and

• To pay sufficient tax to enable it to make franked distributions to its members.

As with taxpayers that are not corporate tax entities, the application of the carried forward tax

losses against income depends upon whether the corporate tax entity has net exempt income.

2.3.3.1 No net exempt income

Subject to the limits prescribed in subsection 36-17(5) (see below), if the total assessable

income for the later income year exceeds the total deductions for that year (ignoring the tax

loss), the corporate tax entity may choose the amount of the tax loss that is deducted from the

excess.18

The corporate tax entity is able to effectively choose not to deduct any part of the tax losses by

choosing to deduct a nil amount. The balance of any tax losses remaining after the chosen

losses are deducted is carried forward to a later income year.

This is in contrast to section 36-15, which does not allow the taxpayer a choice in

deducting tax losses.

19


There is no limit on this carry

forward period but the utilisation of tax losses in later income years is subject to the satisfaction

of the general recoupment tests or cancellation.




If the total assessable income does not exceed the total deductions, then the tax loss cannot be

deducted in that year and is carried forward into the next year.20

2.3.3.2 Net exempt income

Where, in a later income year, the corporate tax entity has net exempt income and the entity’s

total assessable income for the later income year exceeds the total deductions for that year

(ignoring the tax loss), the calculation involves two separate steps.

The first step requires that the tax loss be deducted from the net exempt income.21

The second step requires the entity to deduct such amount of the tax loss as the entity chooses

from the part of the total assessable income that exceeds the total deduction.

There is no

ability for the entity to choose not to deduct the tax losses against the net exempt income, even

if the entity does not propose to deduct losses against the net assessable income.

22

If the deductions exceed the total assessable income, then that excess is subtracted from the

net exempt income and the tax loss is deducted from any net exempt income that remains.

The entity can

effectively choose not to deduct any part of its losses against the assessable income by

choosing to deduct a nil amount.

23

2.3.3.3 Limits on choosing the amount of tax losses to deduct – “excess franking offsets”

There is no ability for the corporate tax entity to choose not to deduct the excess against any

net exempt income.

In making the choice of the amount of tax loss to be deducted, the corporate tax entity cannot

choose an amount that would result in:

• The entity generating any “excess franking offsets” (see below) which would not

otherwise have arisen if the entity had not chosen to deduct the tax loss; or

20 Subsection 36-17(9) 21 Paragraph 36-17(3)(a) 22 Paragraph 36-17(3)(b) 23 Subsection 36-17(4)



• The entity increasing any excess franking offsets that would otherwise have arisen if the

entity had not chosen to deduct the tax loss.

The meaning of excess franking offsets is set out in section 36-55. Generally, an entity will have

excess franking offsets for an income year to the extent that:

• The total non-refundable tax offsets of the entity under Division 207 (offsets for franking

credits) and Subdivision 210-H (offsets for superannuation funds receiving distributions

franked with a venture capital credit) exceed the amount of income tax that would be

payable by the entity in respect of the income year, assuming:

- The entity did not have those tax offsets;

- The entity did not have any tax offsets that are subject to the tax offset carry forward

rules in Division 65 or the refundable tax offset rules in Division 67;

- The entity did not have any tax offsets in relation to franking deficit tax under section

205-70; and

- The entity had all its other tax offsets.

The amount of the excess will be the entity’s excess franking offsets for the income year.

Broadly, this amount reflects the franking offsets received by a corporate tax entity during the

income year that would otherwise be wasted on account of the entity’s current year losses.

Example 1

During the 2012 income year, Company A derives assessable income of $250 (consisting of a

fully franked dividend of $140, franking credit of $60 and other income of $50) and incurs

allowable income tax deductions amounting to $100. As at 1 July 2011, Company A had carried

forward revenue losses of $500.

As the tax offset of $60 attributable to Company A’s franking credit is not stated to be subject to

the refundable tax offset rules in Division 67, Company A has excess franking offsets of $15 for

the 2012 income year, calculated as follows:



Step 1: Determine income tax payable (disregarding offsets)

Assessable income $250

Less: deductions ($100)

Taxable income $150

Tax payable $45

Step 2: Determine non-refundable tax offsets under Division 207 or Division 210

Franking credit (Division 207) $60

Step 3: Determine excess franking offsets


Less: Income tax payable ($45)

Excess franking offsets $15

As Company A has excess franking offsets for the 2012 income year (ignoring Company A’s tax

losses), Company A will not be able to utilise any amount of its carried forward tax losses during

the 2012 income year.24

However, Company A may be able to convert its excess franking offsets into additional tax

losses that can be carried forward by Company A, subject to satisfaction of the relevant loss

integrity rules (or cancellation).

25

Further information about the conversion of excess franking offsets is provided at Section

2.3.3.4 below.

24 Paragraph 36-17(5)(a) 25 Subsection 36-55(2)



Example 2

During the 2012 income year, Company B derives assessable income of $200 (consisting of a

franked dividend of $70, franking credit of $30 and other income of $100) and incurs allowable

income tax deductions of $70. As at 1 July 2011, Company B had carried forward tax losses of

$200.

Company B does not have any excess franking offsets for the 2012 income year, as shown by

the following calculation:

Step 1: Determine income tax payable (disregarding offsets)

Assessable income $200

Less: deductions ($70)

Taxable income $130

Tax payable $39



Step 2: Determine non-refundable tax offsets under Division 207 or Division 210


Step 3: Determine excess franking offsets


Less: Income tax payable ($39)

Amount remaining / excess franking offsets ($9) / Nil

As Company B does not have any excess franking offsets for the 2012 income year (ignoring

Company B’s tax losses), Company B will be able to utilise its carried forward tax losses to

reduce its taxable income during the period, subject to satisfaction of the relevant loss integrity

rules (or cancellation).

However, Company B will only be entitled to utilise an amount of tax losses that would not result

in Company B generating excess franking offsets for the 2012 income year.26

$30 = (($200 - $70 - $X)*30%)

On this basis,

Company B will only be entitled to utilise a maximum of $30 of its carried forward tax losses for

the 2012 income year, calculated using the following formula:

Where:

• $30 is the value of Company B’s non-refundable tax offsets for the 2012 income year;

• $200 is Company B’s assessable income for the 2012 income year;

• $70 is Company B’s allowable deductions for the 2012 income year;

• $X is the maximum value of carried forward losses which can be applied by Company B for

the 2012 income year; and

• 30% is the corporate income tax rate for the 2012 income year.

26 Paragraph 36-17(5)(b)



2.3.3.4 Converting excess franking offsets into tax losses

In certain circumstances, a corporate tax entity may “convert” its excess franking offsets for an

income year into additional tax losses in accordance with the method statement prescribed by

subsection 36-55(2). Broadly, that method statement is designed to prevent a corporate tax

entity’s franking offsets for an income year being wasted on account of the entity’s current year

losses. The method statement is premised on the fact that corporate tax entities (unlike

individuals) are generally not able to receive a refund in respect of franking credit offsets.27

Pursuant to the method statement in subsection 36-55(2), where a corporate tax entity has an

amount of excess franking offsets for an income year, its tax loss for the period will be

determined as follows:

Step 1: Work out the amount that would have been the entity’s tax loss for the income year

under section 36-10 (or, if applicable, sections 165-70, 175-35 or 701-30) assuming

the entity had no net exempt income;

Step 2: Divide the amount of the entity’s excess franking offsets for the income year by the

corporate tax rate;

Step 3: Add the results of Step 1 and Step 2;

Step 4: Reduce the result of Step 3 by the entity’s net exempt income for the income year.

Any positive amount remaining after Step 4 will be the entity’s tax loss for the income year.

However, if the result obtained under Step 4 is nil or negative, the entity will not have any tax

loss for the income year.

To the extent that a positive amount remains after Step 4, the income year will be taken to be a

“loss year” for the corporate tax entity.28

27 Subsections 67-25(1C), 67-25(1D) and 67-25(1E) 28 Paragraph 36-55(2)(d)



Example

Continuing Example 1 above (see Section 2.3.3.3), Company A would be taken to have

incurred a tax loss of $50 for the 2012 income year, calculated as follows:

Step 1: Determine tax loss otherwise incurred by Company A under section 36-10

Deductions (ignoring carried forward tax losses) $100

Less: assessable income $250

Less: net exempt income Nil

Amount remaining / tax loss ($150) / Nil

Step 2: Add excess franking offsets divided by corporate tax rate

Excess franking offsets $15

Corporate income tax rate 30%

Excess franking offsets divided by tax rate $50

Step 3: Reduce the result of Step 2 by net exempt income

Net exempt income Nil

Step 4: Determine amount remaining after Step 3

Step 1 result Nil

Add: Step 2 result $50

Less: Step 3 result Nil

Amount remaining (Step 4) $50

The result remaining after applying Step 4 of the method statement in subsection 36-55(2) is

$50. As this is a positive amount, Company A will be deemed to have incurred a tax loss for the

2012 income year of $50 under paragraph 36-55(2)(c). In addition, the 2012 income year will be

treated as a “loss year” for Company A under paragraph 36-55(2)(d). This will have

ramifications for application of the continuity of ownership test (COT) and the same business

test (SBT) (see Section 4 below).



2.3.3.5 General rules for corporate tax entities in deducting tax loss

The tax losses that a corporate tax entity chooses to deduct will be subject to the following

general rules:

• Where the entity chooses to deduct a tax loss in accordance with section 36-17, the entity

must state its choice under the relevant subsection in its income tax return.29

• Tax losses are deducted in the order in which they are incurred.

30

• Tax losses are deductible only to the extent that they have not already been deducted.

31

• The undeducted amount of a tax loss can be carried forward for deduction in subsequent

income years.

32

2.3.3.6 Adjustments required if subsequent amendment to tax position

In certain circumstances, a corporate tax entity may, after it has lodged its tax return for an

income year:

• Choose to change the amount of the tax loss that it chose to deduct in a previous income

year; or

• Choose an amount of tax loss to be deducted where a choice previously had not been

made.

This will arise where there has been a recalculation of any of the following amounts of the entity

after it has lodged its tax return for an income year:

• The tax loss the entity can deduct in that year;

• The amount of the difference between the entity’s total assessable income and total

deduction (other than tax losses) for that year; or

• The entity’s net exempt income for that year.33


30 Subsection 36-17(7) 31 Subsection 36-17(8) 32 Subsection 36-17(9)



The adjustments may be made whether or not:

• The amount is recalculated in an amendment of the entity’s assessment for that year;

• The amount was a nil amount before the recalculation; or

• The amount has become a nil amount for that year.34

If the entity had chosen to deduct an amount of tax loss for the income year and, as a result of

the recalculation, the entity wishes to change that choice, the entity can change the choice by

lodging a written notice with the Commissioner.

35

For example, the entity may wish to increase the previous choice of tax loss deducted where

the entity’s assessable income was increased and tax would have been payable otherwise as a

result of the recalculation.

If, before the recalculation, the entity was not able to choose an amount of tax loss to deduct

but, as a result of a recalculation, the choice had become available, the entity may choose the

amount of tax loss to be deducted by written notice given to the Commissioner.36

2.4 Net exempt income

The net exempt income is calculated differently for residents and non-residents. The difference

in treatment reflects the fact that, in general, residents are assessable on income from all

sources, whereas non-residents are assessable only on income from sources in Australia.

2.4.1 Net exempt income of Australian resident

For Australian residents, net exempt income is calculated in accordance with subsection 36-

20(1), as follows:

• Calculate the total exempt income (as defined in section 6-20) from all sources, whether in

or out of Australia; and

33 Subsection 36-17(10) 34 Subsection 36-17(10) 35 Subsection 36-17(12) 36 Subsection 36-17(11)



• Subtract any (non-capital) losses or outgoings incurred in deriving that exempt income,

and any taxes payable outside Australia on that exempt income.

Example

For the income year, a resident taxpayer’s only exempt income is overseas employment income

(exempt under section 23AG of the ITAA 1936) of $50,000. Non-capital expenses incurred in

deriving that income are $10,000 and the foreign tax payable on the income is $15,000. The

taxpayer’s net exempt income is $50,000 − $10,000 − $15,000 = $25,000

2.4.2 Net exempt income of a foreign resident

For foreign residents, the net exempt income is calculated in accordance with subsection 36-

20(2), as follows:

• Calculate the exempt income from sources in Australia;

• Add the amount of exempt section 26AG of the ITAA 1936 film income from all sources;

and

• Subtract any (non-capital) losses or outgoings incurred in deriving the exempt income,

and any taxes payable outside Australia on the exempt section 26AG of the ITAA 1936

film income.

The balance remaining is the foreign resident’s net exempt income.

2.5 Special rules about tax losses

Section 36-25 contains no substantive law, but guides the reader to various rules which apply in

determining the deductibility of tax losses of particular types of taxpayers.



Amongst other things, section 36-25 alerts the reader to rules affecting tax losses in the

following situations:

• An individual goes bankrupt (Subdivision 36-B);

• A company has a change of ownership or control during an income year (Subdivision 165-

A and 165-B);

Note

Readers should be mindful of the current year loss rules contained in Subdivision 165-B which

may require a company’s tax loss (and, if applicable, taxable income) for an income year to be

determined in a special way where there is a change of ownership or control in the company

during the income year. However, a detailed exposition of these rules goes beyond the scope of

this paper.

• An arrangement is entered that is designed to exploit available losses through the

injection of income and related schemes (Division 175);

• A trust has a change of ownership or control during an income year (Division 266, 267

and 268 of Schedule 2F of the ITAA 1936); and

• A trust is involved in a scheme to take advantage of deductions (Division 270 of Schedule

2F of the ITAA 1936).

Although not mentioned in section 36-25, readers should also be mindful of Subdivisions 165-

CC and 165-CD when considering the treatment of tax losses. Broadly, these Subdivisions have

the following effect:

• Subdivision 165-CC applies where, broadly, there is a change in the ownership or control of

a company (referred to as a “changeover time”) and the company has an unrealised net loss

at that time. If the Subdivision applies, unless the company satisfies the SBT, it will not be

able to take advantage of deductions or capital losses arising from the subsequent disposal

of assets held by it at the changeover time, up to the extent of the unrealised net loss; and



• Subdivision 165-CD applies to decrease the reduced cost base of relevant equity or debt

interests held by non-individual taxpayers in a loss company (a company with any realised

or unrealised losses) where there has been a change in majority ownership or control of the

loss company (referred to as an “alteration time”). If Subdivision 165-CD applies, the

reduced cost base of these interests is generally decreased such that any duplication of

realised or unrealised losses in the loss company is avoided on disposal of the interests.

As with the current year loss rules in Subdivision 165-B, a detailed exposition of these

Subdivisions goes beyond the scope of this paper. Readers should be aware, however, that

given the compliance burden imposed by these Subdivisions, the rules outlined above do not

apply to entities with less than $6 million net asset value (as calculated under section 152-15).

Note

Subdivisions 165-CC and 165-CD provide certain carve outs when determining losses in

respect of assets acquired for less than $10,000.

Based on a Treasury consultation paper released in July 2011, new amendments to these

Subdivisions will clarify that all membership interests (as defined under section 995-1) in an

entity which are owned by the tested company will be treated as a single asset for the purpose

of applying these carve-outs.

The consultation paper is available via the following link:

http://archive.treasury.gov.au/contentitem.asp?ContentID=2087





3. Individuals

3.1 Losses from hobbies

Broadly, where an activity of an individual is properly characterised as a hobby or recreation,

then:

• Any money derived by the individual from the activity is generally not assessable income;

• Any losses or outgoings of the individual attributable to the activity is not deductible;

• If the activity results in a loss, the individual is not entitled to offset this loss against other

income or carry the loss forward.

Whether an activity constitutes a hobby or recreation is a question of fact.

3.2 General deductions

Broadly, a general deduction is available for a loss or outgoing under section 8-1.37

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

Specifically,

section 8-1 states that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or

producing your assessable income.

8-1 (2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-

assessable non-exempt income; or




(d) a provision of this Act prevents you from deducting it.

In the context of deductions for losses and outgoings relating to “hobbies”, the question often

asked is whether the hobby amounted to carrying on a business such that the loss or outgoing

had the sufficient nexus to qualify for a deduction under section 8-1. In this regard, the Court

stated in Ferguson v. FC of T (1979) 37 FLR 310 that:

“... if what he is doing is more properly described as the pursuit of a hobby or recreation or

an addiction to a sport, he will not be held to be carrying on a business, even though his

operations are fairly substantial.”

3.3 Carrying on a business

The question of whether an individual is carrying on a business (as opposed to a hobby or

recreation) can only be determined by considering all the relevant facts and circumstances.

A business is defined as including any profession, trade, employment, vocation or calling, but

does not include occupation as an employee.38 This definition is further interpreted as limiting

the term “business” to “a commercial enterprise as a going concern.39

In most cases it is obvious whether a business is being carried on. Where it is not obvious, in

particular, is where the relevant activity is subsidiary to a person’s main income-producing

activity, for example, where the person vigorously pursues a hobby. The main indicators of

carrying on a business are as follows:

40

38 Section 995-1 39 Hope v Bathurst City Council (1980) 144 CLR 1 40 Paragraph 18 of Taxation Ruling TR 97/11



Positive factors More likely to be a business if…

Negative factors Less likely to be a business if…

Large scale operations Small scale operations

Involves employees One person operation

Frequent acts/transactions Infrequent acts/transactions

Conducted with a view to profit Conducted as mere hobby

Profitable Non-profitable

Conducted over long period Short-term

Conducted continuously and systematically Spasmodic

In commercial premises At home

Involves items typically dealt with

commercially

Involves items not ordinarily dealt with

commercially

Involves exercise of specialised knowledge Involves little knowledge or skills

Significant capital investment Little or no capital investment

Business records kept Records not kept, or inadequate

Full-time Part-time

Market research done No market research

Associated with other commercial activities

of taxpayer

No other commercial activities

Existence of business organisation,

business name

Conducted personally/privately



Advertising No advertising

Active Inactive or preliminary

There is often significant overlap between these indicators and no individual indicator should be

regarded as decisive. In addition, the weighting to be given to each indicator will vary from case

to case.

Note

A taxpayer can obtain a Private Ruling under Division 359 of Schedule 1 to the Taxation

Administration Act 1953 on whether he/she is carrying on a business (see Taxation Ruling TR

2006/11).

In Taxation Ruling TR 97/11, the Commissioner considers that an activity will constitute a hobby

where the following indicia are present:41

• It is evident that the taxpayer does not intend to make a profit from the activity;

• Losses are incurred because the activity is motivated by personal pleasure and not to

make a profit and there is no plan in place to show how a profit can be made;

• The transaction is isolated and there is no repetition or regularity of sales;

• Any activity is not carried on in the same manner as a normal, ordinary business activity;

• There is no system to allow a profit to be produced in the conduct of the activity;

• The activity is conducted on a small scale;

41 Paragraph 87 of TR 97/11



• There is an intention by the taxpayer to carry on a hobby, a recreation or a sport rather

than a business;

• Any produce is sold to friends and relatives and not to the public at large.



Example 1

Richard was a musician and singer in a rock band. He was also interested in dressage. Richard

owned a substantial land holding on which he bred horses to obtain better mounts for his

dressage competitions. He trained his own horses. He belonged to the local dressage club and

usually sold any unwanted and untrained offspring through his club and the local newspaper.

The sale prices were well below the expenses associated with maintaining the horses. He

conducted research into breeding and training techniques and tried to keep up to date with the

latest information. He kept detailed records of breeding and all expenses associated with the

horses. When the horses became too old to compete he put them out to pasture, as he could

not bear to part with his old companions. Was Richard carrying on a business of horse

breeding?

In Taxation Ruling 97/11, the Commissioner answers this question in the negative. He notes

that despite the keeping of records, the organisation, the repetition and regularity of activity and

the research conducted, the activity was a hobby given that:

• The activity was primarily motivated by his desire to compete and any returns were merely

incidental to this purpose;

• No profit was made from the activity;

• There was no intention to carry on a business or to make a profit; the keeping of records,

the research and the sales were all associated with Richard's dressage activities; and

• There was no significant commercial purpose or character to the activity.

Example 2

In Case 4/2005, it was held that the taxpayer’s activities which included attempts to bring his

work to the market, hiring of space in a gallery, holding an exhibition and use of a public

relations consultant went beyond a mere hobby or recreational activity and constituted a

carrying on of a business.



3.4 Non-commercial business losses

Division 35 prevents losses of individuals from non-commercial business activities being offset

against other assessable income in the year that the loss is incurred.

Losses that cannot be offset against other income in the year in which they arise (that is,

deferred losses) may be carried forward to be offset in a future year when there is a profit from

the non-commercial activity or, in certain circumstances, against other income.42

Division 35 applies to individuals (either alone or as a partner in a partnership) only.

43

3.5 Deferral of non-commercial business losses

3.5.1 Non-commercial business losses

Subject to the exception below, where deductions in relation to a non-commercial business

activity for that year exceed the assessable income (if any) from the business activity for that

year, the excess cannot be deducted in the income year in which it is incurred.44

Rather, the excess is treated as being deductible from the assessable income from the

business activity in the next income year in which the business activity is carried on.

45

In most cases, the loss will be deferred and offset against the assessable income from the non-

commercial business activity in the next income year. However, if the individual makes losses in

the next income year, the amount of the losses from the first and second year are added

together and deferred to a future income year in which the business activity makes profits.

Where the business activity ceases for a year or number of years, the loss will be carried

forward and become deductible in the income year when the activity is next carried on.

The

deductions relating to that activity must be deductible under ITAA 1936 or ITAA 1997 before

Division 35 applies.

42 Section 35-1 43 Sections 35-5 and 35-10 44 Subsection 35-10(2) 45 Paragraph 35-10(2)(b)



Example

Michael is a student but is also carrying on a business activity of online photo sales. Under the

tests, his business activity is treated as non-commercial. He starts his business on 1 July 2000

and for the 2001 income year he obtains online sales of $3,000; however, deductions incurred

in operating the business total $3,500. In 2002, his business obtains sales income of $4,000

and generates deductions of $4,100. In 2003, Michael’s business derives sales of $6,000 and

deductions of only $2,000. The losses for 2001 ($500) and 2002 ($100) are not allowed in those

years but are carried forward to the 2003 income year, where they reduce his profit in that year

($4,000) to $3,400.

3.5.2 Exempt income

Section 35-15 modifies the general rule which defers certain losses from a non-commercial

business activity.46 The amount of the loss that is deferred to future years is reduced by net

exempt income derived by the individual in the current or future years that has not already been

offset against carry forward tax losses under section 36-10 or section 36-15.47

Example

Bayfield incurs a loss from his non-commercial business activity in 2002 of $17,000 and derives

exempt income of $3,000. Bayfield did not have any Division 36 tax losses carried forward from

earlier income years. The Division 35 amount that is deductible in a later year is $14,000 after

reducing the deferred loss by the amount of exempt income.

However, where there is a deferred loss from a prior year and profit arising in the current

income year from a non-commercial business activity, any exempt income would reduce the

deferred loss before that loss can be used to reduce the current year profit from that business

activity.48


47 Subsection 35-15(1) 48 Subsection 35-15(2)



3.5.3 Blackhole expenditure

Subject to the exception below, the non-commercial loss rules also apply to pre-business or

post-business expenditure that is deductible under section 40-880 (business related costs).49

A taxpayer cannot deduct an amount under section 40-880 for pre-business expenditure in

relation to a business activity that the taxpayer proposes to carry on (either alone or in

partnership) in an income year before the one in which the business activity starts to be carried

on. In the income year a business activity starts to be carried on, a taxpayer can only offset a

loss from the business activity carried on against other income if one of the exceptions applies.

If the loss cannot be offset against other income in the income year in which it arises, it is

deferred and offset in a future year when there is a profit from the same activity, or a like

activity, or against other income when the taxpayer satisfies one of the tests for that activity.

Example

Lee, a salary earner, incurs $1,000 which is otherwise deductible under section 40-880, during

the 2006 income year, for the purpose of establishing a supermarket business in the 2007

income year. She intends to carry on the business activity as a sole trader. Apart from Division

35, section 40-880 would provide deductions in equal proportions for the $1,000 expenditure for

the 2006 to 2010 income years.

An individual taxpayer is also prevented from deducting an amount that is otherwise deductible

under subsection 40-880(4) for expenditure in relation to a business activity that another entity,

other than an individual (either alone or in partnership), proposes to carry on until the income

year in which the activity starts to be carried on.

If the business activity ceases, amounts otherwise deductible after this event under section 40-

880 are not deductible if one of the exceptions does not apply to the business activity before the

business ceased.

49 Subsection 35-10(2A)



3.5.4 Non-commercial business activities

A non-commercial business activity is any business activity. As noted above, a business is

defined as including any profession, trade, employment, vocation or calling, but does not

include occupation as an employee.50 This definition is further interpreted as limiting the term

“business” to “a commercial enterprise as a going concern.51

This definition would exclude domestic transactions involving jointly owned family homes from

being a business. Further, passive investments such as the derivation of interest, dividends

and royalties are not businesses.

52

Although business activities are not defined, context suggests that they are activities connected

with, or necessary for, the conduct of a business.

This is confirmed by the guide in section 35-5.

3.5.5 Grouped non-commercial business activities

Subsection 35-10(3) permits an individual to group similar business activities together for the

purpose of the rules.

In effect, this allows losses from a non-commercial business activity to be offset against the

assessable income arising from another closely related business activity. In determining

whether an activity is part of a particular business activity, or a separate business activity, the

facts and circumstances surrounding each activity should be closely considered.

If the activity is not a part of another business activity it should be viewed in isolation and

treated as a separate business activity, and losses from one non-commercial business activity

should not be offset against income from another business activity.

50 Section 995-1 51 Hope v Bathurst City Council (1980) 144 CLR 1 52 Commissioner of Inland Revenue v Marine Turbo Co [1920] 1 KB 193



Example

Ann conducts a business activity as an olive farmer producing olive oil. She has had great

success manufacturing high-grade oil and selling it both locally and to exporters. Recently, Ann

started producing bottled olives in an attempt to expand her business. This new activity is

sustained independently from the olive oil market activity. Division 35 will treat Ann’s bottling

activity as a part of her primary business activity of producing olive oil. Both her olive oil activity

and her bottling activity are similar, and may therefore be looked at in aggregate against the

four tests to determine whether her losses, if any, from those activities can be deducted from

her other income.

Ann is also a keen amateur scientist. In her home laboratory, Ann has developed a new

chemical insecticide for olives. She has patented its composition and is now receiving royalties

from a chemical manufacturer. Ann has also written a research paper on insecticides, which is

available for purchase. Ann’s research activities are not of an inherently similar nature to her

olive oil production and bottling activity and will be considered as a separate business activity

under Division 35.

3.5.6 Exception

Non-commercial business losses will not be subject to the non-commercial loss rules if the

following conditions are satisfied for an income year in relation to each business activity:

• The sum of the following is less than $250,000:

- The individual’s taxable income for that year;

- The individual’s reportable fringe benefits total for that year;

- The individual’s reportable superannuation contributions for that year; and

- The individual’s “total net investment losses” for that year,53

and one of the following is satisfied:

54

53 Subsection 35-10(2E)



- The assessable income test: the amount of assessable income from the business

activity is at least $20,000;55

- The profits test;

56

- The real property test;

57

- The other assets test;

58

• The Commissioner has exercised the discretion set out in section 35-55 for the business

activity for that year;

or

59

• The business is a primary production business or a professional arts business (for

example, an author or a performing artist) for that year and the individual’s assessable

income for that year (other than any net capital gain) from other sources is less than

$40,000.

or

60

Non-commercial business blackhole expenditure will also not be subject to the non-commercial

loss rules if the above conditions are satisfied for the income year in which the business activity

ceased or in an earlier income year.

61

54 Subsection 35-10(1) 55 Section 35-30 56 Section 35-35 57 Section 35-40 58 Section 35-45 59 Paragraph 35-10(1)(b) 60 Paragraph 35-10(1)(c) and subsection 35-10(4) 61 Subsection 35-10(2A)



Example

Amanda earned a salary of $175,000 in 2011. Also in that year, her reportable superannuation

contributions were $45,000, her reportable fringe benefits were $32,000 and she had net

investment losses of $13,000.

Amanda also operated a natural therapies business which had assessable income of $22,000 in

2011 and deductions totalling $34,000.

Assuming that there were no other amounts of assessable income or allowable deductions in

2011, Amanda does not pass the income threshold test and cannot offset the net loss of

$12,000 from the natural therapies business against other income.

Amanda’s adjusted taxable income is $252,000, calculated as her salary income ($175,000),

less the net investment losses ($13,000) plus the reportable superannuation contributions

($45,000), the reportable fringe benefits ($32,000) and the net investment losses ($13,000).

That amount is more than the threshold of $250,000.

Unless the Commissioner exercised the discretion in section 35-55 not to apply the non-

commercial losses rules in respect of the business for the 2011 income year, the $12,000 loss

from the natural therapies business will be quarantined, and may only be applied against

assessable income from the alternative therapies business in later income years.

3.5.6.1 Profits test

The profits test is satisfied if, for each of at least three of the past five income years (including

the current year), the sum of the deductions (disregarding any deferred losses, but including

any share of deductions from a partnership) is less than the assessable income (including any

share of income from a partnership) from the activity.62

62 Section 35-35



3.5.6.2 Real property test

The real property test is satisfied if the total of the greater of the market value or reduced cost

bases of real property or interests in real property used on a continuing basis in carrying on the

activity is at least $500,000.63

A dwelling, and any adjacent land used in association with the dwelling, that is used mainly for

private purposes and any fixtures owned by a tenant are not counted for this test.

64

3.5.6.3 Other assets test

The other assets test is satisfied if the total values of assets listed below that are used on a

continuing basis in carrying on the activity is at least $100,000:65

Item Value

1 An asset whose decline in value you can

deduct under Division 40

The asset’s written down value

2 An item of trading stock Its value under subsection 70-45(1)

3 An asset that you lease from another

entity

The sum of the amounts of the future

lease payments for the asset to which you

are irrevocably committed, less an

appropriate amount to reflect any interest

component for those lease payments

4 Trademarks, patents, copyrights and

similar rights

Their reduced cost base

63 Section 35-40 64 Section 35-40 65 Section 35-45



Real property or interests in real property that are taken into account for the real property test

and cars, motorcycles and similar vehicles are not counted for this test.66

Apportionment of an asset may be necessary where it is used during an income year partly in

carrying on the relevant non-commercial loss business activity and partly for other purposes.

67

3.5.7 Commissioner’s discretion

The Commissioner can decide that the non-commercial loss rules do not apply to non-

commercial business activity for one or more income years if the Commissioner is satisfied that

it would be unreasonable to apply that rule because of one or more of the reasons described in

section 35-55. The taxpayer must apply to the Commissioner for a determination and the

application must be made in the approved form.

3.5.8 Modifications for bankruptcy

A loss from a non-commercial business activity and blackhole expenditure incurred prior to

bankruptcy (or being released from a debt) cannot be deducted after the date of bankruptcy.68

Where an individual’s bankruptcy is annulled due to a composition or scheme of arrangement

under which the individual’s debts are released, no losses from non-commercial business

activities can be deducted in the year of annulment or in later income years.

69

66 Subsection 35-45(4) 67 Section 35-50 68 Subsection 35-20(1) 69 Subsection 35-20(3)



3.5.9 Application to certain partnerships

Division 35 applies to businesses carried on by individuals, either alone or in partnership.

Therefore, a partnership that carries on a business activity and consists of at least one

individual as partner will fall within the non-commercial business loss rules.

Readers are directed to section 35-25 which contains certain modifications to the assessable

income test, real property test and other assets test.



4. Companies

4.1 Rules for Use of Prior Year Tax Losses by Companies

As noted above, the deductibility of tax losses by certain taxpayers may be affected by various

rules in the Tax Act.

Section 165-10 sets out the basic conditions which a company must satisfy in order to deduct

losses of earlier years.

In effect, the section provides that the company cannot deduct a tax loss unless it satisfies the

COT under section 165-12, or alternatively, if the company fails to meet that test, the SBT under

section 165-13.

Section 165-15 provides that even if the company satisfies the COT or the SBT, it still will not be

able to deduct the loss if there is a specified change in the control of the voting power in the

company enabling some person to obtain a tax advantage under the Tax Act.

A further test for deductibility is provided by section 165-215 which makes available to

companies one of the concessional tracing rules available to trusts under the trust loss

measures contained in Schedule 2F of the ITAA 1936 where the company is predominantly held

by non-fixed trusts.

Division 166 modifies the COT rules that apply to “widely held companies” and “eligible Division

166 companies”.

Warning

Subdivision 175-A enables the Commissioner, in certain circumstances, to prevent the

utilisation of a tax loss by a company where an amount of income is injected into the company

for the purpose of taking advantage of the tax loss, or a person obtains a tax advantage under a

scheme which was carried out in order to access the tax loss. Subdivision 175-A can operate

even where the company otherwise satisfies the COT requirements in section 165-12 and the

control test in section 165-15. Readers are advised to refer to ATO Interpretive Decision

2002/836, ATO Interpretive Decision 2002/845 and ATO Interpretive Decision 2010/48 for

further details in respect of the application of Subdivision 175-A.



4.2 Continuity of ownership test

4.2.1 General continuity of ownership test rules

Section 165-12 sets out the conditions which must be satisfied under the COT. If a company

fails this test, it will not be able to claim a deduction in respect of carried forward tax losses

unless it satisfies the SBT under section 165-13.

Subsection 165-12(1) defines the period during which ownership and control of a company must

remain constant (the “ownership test period”). For the purposes of Subdivision 165-A, the

ownership test period:

• Starts at the beginning of the year in which the loss is incurred (the “loss year”), and

• Finishes at the end of the year in which the loss is utilised (the “income year”).

The term “loss year” for these purposes is defined in section 36-10, being a year in which a

company has a “tax loss” under section 36-10, or if relevant, section 36-55 (see note 2 to

section 36-10).

Section 165-255 contains the rules in relation to incomplete test periods. In this regard, section

165-255 contains rules for establishing the COT of a company that comes into existence during

the loss year (for example, on incorporation) or that ceases to exist during the income year (for

example, where the company is deregistered).

Subsections 165-12(2), 165-12(3) and 165-12(4) set out the conditions that must be satisfied

during the ownership test period before the COT is passed by a company. They provide that

there must be persons who had more than 50% of the:

• Voting power;

• Rights to dividends; and

• Rights to capital distributions,

in the company at all times during the ownership test period.

The tests for determining whether persons have more than 50% of the voting power, rights to

dividends and rights to capital distributions during a particular period are set out in sections 165-



150, 165-155 and 165-160 (as incorporated by subsections 165-12(5) and 165-12(6).

Specifically:

• The primary test applies if no other companies beneficially own shares or interests in

shares in the loss company at any time during the ownership test period. This is expressly

stated at subsection 165-12(5). This test provides that if there are persons who, at all

times during the ownership test period, beneficially own (between them) shares that carry

(between them) the right to exercise more than 50% of the voting power, the right to

receive more than 50% of the dividends or the right to receive more than 50% of the

capital distributions in the company, then those persons are treated as having more than

50% of the voting power, dividends and capital distributions in the company at all times

during the ownership test period.70 In the case of public companies, the test will be

satisfied if it is “reasonable” to assume that it is satisfied.71

• The alternative test applies where at any time during the ownership test period, any

shares or interests in shares in the loss company are beneficially held by one or more

other companies. This is expressly stated at subsection 165-12(6). This test provides that

if there are persons (none of them companies or trustees) who between them have at all

times during the ownership test period beneficial interests in shares in the company that

carry between them more than 50% of the voting power, the right to receive more than

50% of the dividends or the right to receive more than 50% of the capital distributions in

the company, those persons are treated as having more than 50% of the voting power,

dividends and capital distributions in the company at all times during the ownership test

period. This applies whether the beneficial interests are held directly or indirectly through

one or more interposed entities and also where is it “reasonable to assume” that the

provisions of the test have been met.

72

Practically, application of the alternative test

generally requires that a tracing process be undertaken in order to determine the ultimate

individual (natural person) owners of the tested company.

70 Subsections 165-150(1), 165-155(1) and 165-160(1) 71 Subsection 165-165(7) 72 Subsections 165-150(2), 165-155(2) and 165-160(2)



If a company is a non-profit company, a mutual affiliate company or a mutual insurance

company during the entire ownership period, it is taken to have satisfied the conditions in

subsection 165-12(3) relating to rights to dividends and subsection 165-12(4) relating to rights

to capital distributions.73

4.2.1.1 Proposed modifications clarifying aspects of the COT

As a result, these companies satisfy the COT if they satisfy the voting

power condition under either the primary or alternative test (as applicable).

Under the current law, a company which has more than one class of shares with different

owners could technically fail the COT, even if majority beneficial ownership of the company’s

shares remains the same. This may occur, for example, where the various classes of shares in

the company have unequal rights to dividends and capital distributions, or unequal voting

power. In such circumstances, it may not be possible to identify which particular group of

owners is entitled to more than 50% of the relevant rights.

In recognition of this issue, the Federal Government released draft legislation (proposed

Division 167) on 4 September 2009 which is designed to ameliorate problems encountered by

companies with multiple share classes in satisfying the COT.74

Broadly, the draft legislation would allow a company which would otherwise fail the COT to

reconsider the test, disregarding the following:

• Debt interests held in the company (such as redeemable preference shares with

characteristics that cause them to be classified as debt under Division 974); and

• Secondary share classes issued by the company (for example, special shares issued to

employees under an ESAS arrangement), provided that the value of each such class does

not exceed 10% of the total value of the company’s shares, and the combined value of all

secondary share classes does not exceed 25% of the total value of the company.

If the company continues to fail the COT after disregarding these interests, the draft legislation

allows a further mechanism, whereby any remaining shares in the company may be taken to

have fixed dividend and capital rights for the purpose of applying the test.

73 Subsection 165-12(7A) 74 The draft legislation and accompanying explanatory materials can be found on the Treasury website at: http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1601

http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1601�



The draft legislation also clarifies that, if the shares of a company have distinct voting rights, the

voting power of those shares is to be tested solely by reference to the maximum number of

votes that could be cast on a poll for the election of the company’s directors, or on the adoption

/ amendment of the corporate constitution.

The draft legislation is generally proposed to apply from 1 July 2002. However, modifications to

the test for voting power are proposed to apply only from 1 July 2007. Consequential

amendments will be made to section 170 of the ITAA 1936 to ensure that taxpayers will be able

to retrospectively rely on the proposed modifications.

Note

A revised exposure draft of the proposed legislation was released for limited consultation in July

2011. Treasury’s Forward Work Program indicates that the revised exposure draft should be

released for public comment in mid to late 2012.

4.2.1.2 Special continuity of ownership test rules

A number of special rules expand upon particular aspects of the primary and alternative tests.

Some of the more significant rules are summarised below:

• Unbroken continuity is necessary. In respect of income years ending after 21 September

1999, the tests are required to be satisfied during the whole of the loss year, the whole of

the income year and the whole of the intervening period (referred to in total as the

“ownership test period”);

• The identity of shares is essential. In this regard, for income years ending after 21

September 1999, rights attaching to shares generally cannot be taken into account under

either the primary or alternative tests unless, at all times during the relevant period, they

are the same shares and are beneficially held by exactly the same shareholders (this is



known as the “same share rule”).75 However, this requirement is relaxed in the case of

share / unit splits76 and share / unit consolidations;77

Warning

The same share rule may be problematic where new shares are issued by a company, or

existing shares are subject to a rollover (for example, under Subdivision 124-G, which deals

with the interposition of holding companies). There are no statutory carve outs applying in these

circumstances and accordingly it may be necessary to rely on the saving provision to ensure

COT is satisfied (refer to Section 4.2.1.3 below).78

• Tests may be satisfied by one person. Each of the tests refer to persons (in the plural).

However, to avoid doubt, section 165-175 specifically provides that any of the tests may

be satisfied by one person;

• A public company is taken to have satisfied any of the primary tests if it is reasonable to

assume that the tests are satisfied.79

• Shares held by certain concessionally taxed entities (for example, a government or a

charitable institution) are deemed to be held by a notional shareholder when applying the

tests;

The reason for such a provision is that the numerous

sales of shares in large companies could make it impracticable to accurately determine

details of beneficial ownership. Note, however, that the effect of this provision is limited,

as “widely held companies” and “eligible Division 166 companies” would normally be

tested under the modified rules in Division 166;

80

• Shares held by the trustee or beneficiary of a deceased person’s estate will be deemed to

continue to be held by the deceased person when applying the tests;

81

75 Section 165-165

76 Subsections 165-165(2) and 165-165(3) 77 Subsections 165-165(4) and 165-165(5) 78 Subsection 165-12(7) 79 Subsection 165-165(7) 80 Section 165-202 81 Section 165-205



• Shares held by a discretionary trust that has made a family trust election will be deemed

to be held by a separate notional shareholder when applying the tests.82

• A company will not be prevented from satisfying the tests merely because a liquidator or

administrator has been appointed in respect of the company, or an interposed holding

company.

This overcomes

issues which may otherwise be encountered in tracing beneficial ownership through non-

fixed trusts (without reliance on Subdivision 165-F);

83 This overcomes the decision in FC of T v Linter Textiles Ltd (in liq),84

• The tests are subject to anti-avoidance rules contained in section 165-180 and 165-185

which broadly empower the Commissioner to treat shares as not being beneficially owned

by certain shareholders (or as not carrying certain rights) where the Commissioner is

satisfied that arrangements have been entered into to exploit the COT. These rules may

be enlivened where, for example, an arrangement is entered between existing

shareholders and prospective shareholders, under which the existing shareholders agree

to retain their shares in a company until such time as any carried forward tax losses have

been absorbed, and thereafter formally dispose of the shares to the prospective

shareholders.

which

confirmed that upon appointment of a liquidator to a company, the incumbent

shareholders in that company cede control of their voting power to the liquidator; and

85

4.2.1.3 Saving provision

If the continuity of majority ownership test in section 165-12 is not satisfied, subsection 165-

12(7) may deem the test to be satisfied where:

• The test is only failed because the group of persons who have maintained majority

ownership of the company have not retained exactly the same shares during the relevant

period (that is, the same share rule in section 165-165 has been breached); and

• Based on the information available to the company, it is reasonable for the company to

conclude that less than 50% of its tax loss has been reflected in deductions, capital losses

82 Section 165-207 83 Section 165-208 84 [2005] HCA 20 85 K Porter & Co Pty Ltd v FCT 77 ATC 4472



or reduced gains that arose (or could arise in the future) because of the happening of a

CGT event (for example, disposals) in relation to any direct or indirect equity interests in

the company during the ownership test period.

A company will, therefore, not be treated as having failed the COT where the company can

demonstrate, for example, that the only equity interests in the company that were sold during

the relevant test period have been subject to the anti-loss duplication measures in Subdivision

165-CD.86

Note

This is because no deduction associated with the tax loss is reflected in a loss or

reduced gain on the disposal of an ownership interest that is subject to Subdivision 165-CD (as

a result of the adjustments made under those provisions).

In ATO Interpretive Decision 2012/64, the Commissioner considered the application of the

saving provision contained under the modified COT in Division 166, which employs substantially

the same wording as subsection 165-12(7). In that ATO ID, the Commissioner stated that the

application of the saving provision cannot be anticipated before the end of the relevant test

period, as it is only at this point that a company may ascertain if the requirements of the

provision have been met. The Commissioner also stated that references to losses which could

occur in the future, generally meant those losses which had been subject to the stop-loss rule in

Subdivision 170-D.

Subsection 165-12(8) specifically provides that the disposal of a direct or indirect interest in a

company that triggers the application of Subdivision 165-A is taken, for the purposes of the

saving provision to have occurred during the relevant ownership test period.

86 Paragraph 165-12(7)(b)



Example

At the start of an ownership test period, Alex holds 90% of shares in a loss company. Brian

owns the remaining 10%. At this time, the company has issued 100 ordinary shares (that is,

Alex owns 90 shares and Brian owns 10 shares).

A hundred more new shares are then issued at some time during the test period. Of these, Alex

owns 90 and Brian owns 10. The total shares on issue are now 200. The original shares held by

Alex now only carry 45% of the power and rights in the company (90/200 = 45%). The original

shares held by Brian now carry 5% of the power and rights in the company (10/200 = 5%).

Due to the operation of the same share rule in section 165-165, only the original shares may be

counted for the purposes of determining whether there has been continuity of ownership

throughout the period. In the absence of a saving provision, the company would fail the COT

because only 50% of the power and rights in the company have been maintained throughout

the test period. To satisfy the test, more than 50% continuity must be maintained.

Under the saving provision, the company will be treated as though it satisfies the COT if it is

able to prove that:

• But for the same share rule the company would satisfy the COT (that is, there has been

no substantial change in proportionate shareholding between Alex and Brian) —

throughout the period Alex has maintained a 90% interest and Brian has maintained a

10% interest; and

• Less than 50% of the loss has been duplicated during the period — neither Alex nor Brian

have sold any of their original shares during the ownership test period, and accordingly,

neither have crystallised deductions, capital losses or reduced gains.



4.3 Same business test

4.3.1 Same business test period

Section 165-13 contains the SBT. A company must satisfy the SBT to deduct a tax loss if the

company either:

• Fails, or is treated as failing, to meet any of the conditions of the COT; or

• It is not practicable to show that it meets all of the conditions of the COT.

The SBT requires a comparison between the activities of the company during the income year

(SBT period) with its activities immediately before the “test time”. The test time is determined in

accordance with subsection 165-13(2) as follows:

Situation Test Time

1 Where it is practicable to show that there

is a period commencing at the start of the

ownership test period (or if the company

came into being during the loss year, at

the time the company came into being)

during which the company would satisfy

The last time in the period that the COT

was satisfied by the company.

2 Where Item 1 does not apply and the

company was in being throughout the loss

year

The start of the loss year

3 Where Item 1 does not apply and the

company came into being during the loss

year

The end of the loss year



Example 1: Test time

Closer Pty Ltd (Closer) is an Australian company that was incorporated on 19 December 1999.

Closer is owned as to 65% by Law Limited, which was incorporated in a foreign country. The

shareholders of Law Limited are not known by Closer and cannot be obtained under the law of

that foreign country.

Closer made a tax loss in the 2000 income year (that is, the year of incorporation). As it is not

practicable to show that Closer has satisfied the COT in section 165-12 since incorporation,

Closer will only be able to claim the losses where it satisfies the SBT since the test time. As

Closer was incorporated during the 2000 income year, the test time will be 30 June 2000, being

the end of the loss year.

Example 2: Test time and SBT period

A company incurs a tax loss in the income year ended 30 June 2006 and wishes to deduct the

tax loss in the income year ended 30 June 2008.

The company fails the COT during the income year ended 30 June 2007.

Based on these facts, the test time for the company will be just before the COT is failed (that is,

some point during the income year ended 30 June 2007) and the SBT period will be 1 July 2007

to 30 June 2008.



4.3.2 The same business test requirements

To satisfy the SBT, the company must satisfy all of the following requirements:87

• A positive requirement that, throughout the SBT period, the company carries on the same

business as it did immediately before the test time;

• A negative requirement that the company must not, at any time during the SBT period,

have derived assessable income from a business of a kind which it did not carry on before

the test time;

• A further negative requirement that the company must not, at any time during the SBT

period, have derived assessable income from a transaction of a kind that it had not

entered into in the course of its business operations before the test time; and

• An anti-avoidance requirement which applies where a company commences certain

business activities before the test time for the purpose of satisfying the same business

requirement.

The Commissioner sets out his views on the application of the SBT in Taxation Ruling TR

1999/9 (TR 1999/9). In that ruling, the Commissioner emphasises that whether or not a

company has complied with the requirements of the SBT is a matter of fact and degree.

4.3.2.1 Positive requirement

For the purpose of the positive requirement outlined above, a company is treated as carrying on

one overall business at the test time and during the SBT period. This is because the reference

to “business” under the positive requirement is a reference to all of the activities carried on by

the company at those times, regardless of whether the company treats the activities as

constituting separate and distinct activities or enterprises. In addition, as indicated in TR 1999/9,

it is inappropriate to consider certain business activities only, to identify the business by

reference to industry standards or to have regard to activities which the company intended or

had power to carry on if it did not in fact carry on such activities.

87 Section 165-210



In determining whether the positive requirement has been satisfied, the word “same” in the

phrase “same business as” is read as referring to the same business, in the sense of an

identical business. However, this does not mean identical in all respects. It requires the

continuation of the actual business carried on immediately before the test time. In this regard,

the Commissioner acknowledges that some changes may be permissible in the way in which

the business is carried on, provided that the identity of the business carried on immediately

before the test time is unchanged – for example, a change in one of the company’s many

suppliers.

Similarly, the ruling states that a company will not always fail to satisfy the positive requirement

where its activities expand or contract. In this regard, so long as the business carried on by the

company retains its identity, the organic growth of the business through the adoption of new

compatible operations or the discarding of old operations will not in themselves result in the

company failing the SBT. However, if the business changes its essential character, or there is a

sudden and dramatic change in the business due to the acquisition or loss of activities on a

considerable scale, it may be difficult to pass the SBT.

In determining whether the positive requirement has been satisfied, the Commissioner sets out

a non-exhaustive list of indicia which may generally be considered.88

• Business or trade name;

These indicia can broadly

be summarised as follows:

• Business location;

• Directors, management and employees;

• Customers and suppliers;

• Goodwill;

• Products and stock;

• Methods of manufacturing;

88 Paragraph 61 of TR 1999/9



• Methods of selling (for example, outright sale versus leasing);

• Capital and financing; and

• Intellectual property.

4.3.2.2 Cases where positive requirement satisfied

In DFCT v Australasian Feed Pty Ltd89

In Lilyvale Hotel Pty Ltd v FCT

(a case concerning former section 80E of the ITAA

1936), the Federal Court confirmed the AAT’s decision that the company continued to carry on

the same business following a change of ownership, despite going into receivership and

entering into an arrangement to sell its product (sheep feed) almost exclusively to an entity with

which it had previously had only one major dealing. This was because the taxpayer continued to

produce the same product from the same mill, obtained its supplies from the same sources,

continued to trade under the same name and retained most of its employees. Indeed, according

to the Court the only significant change that arose to the taxpayer’s business subsequent to the

change of ownership concerned the entry of the near-exclusive sales arrangement. However,

as was indicated in the case, the market into which the taxpayer made its sales remained

generically the same, even if the customer base had shifted.

90

The taxpayer’s owners sold the taxpayer to Reco Harbour Grand Pte Ltd (a company owned by

the Government of Singapore Investment Corporation Pte Ltd) with the sale completing on 30

August 2002. From 30 August 2002 until 30 June 2003 the hotel was operated and managed by

the taxpayer under the pre-sale name ANA Harbour Grand. The taxpayer claimed a deduction

for past losses amounting to $10,579,458 in its tax return for the period 1 January 2002 to 31

March 2003.

, the Full Federal Court found that the taxpayer was carrying on

the same business. The taxpayer owned and operated the ANA Hotel Sydney (later known as

the ANA Harbour Grand Hotel and then the Shangri-La Hotel). The hotel was operated and

managed by ANA Enterprises Australia Pty Ltd pursuant to an operating and management

agreement.

89 2000 ATC 4632 90 [2009] FCAFC 21



The Full Federal Court found that the primary judge fell into error in concluding that in

answering the “same business test” one had to have regard to the management of the

business. In the court’s opinion, the fact that at one stage the taxpayer conducted its hotel

business without the intervention of a hotel management group and at another did so with the

assistance of such a hotel management group is a distinction without a difference.

The Court found that the taxpayer had correctly described the business which it carried on as

that of:

“owning and operating ... [a] hotel to derive revenue from its guests and profits from its

operation”. The execution of the management of the hotel at different times in different ways

had no bearing upon the identification of the business carried on by the taxpayer.”

4.3.2.3 Cases where positive requirement failed

In Avondale Motors (Parts) Pty Ltd v FCT91

In these circumstances, Gibbs J held that even if the company had not effectively discontinued

its business (thereby disqualifying it from relying on the SBT), the company would still have

failed to satisfy the SBT under former section 80E of the ITAA 1936. To this end, Gibbs J

emphasised that the SBT requires an identical (not merely similar) business to be carried on at

all relevant times. Accordingly, notwithstanding that the company carried on a similar kind of

business following the change of ownership, the differences outlined above meant that the

business could not satisfy the SBT (as it was not materially identical to that previously carried

on by the taxpayer).

, a company that originally sold spare motor parts

and accessories effectively discontinued its business prior to a change in majority ownership.

Following the change in ownership, the company’s business was resumed, but under a different

name and management, through different premises and using different plant and stock.

In TelePacific Pty Ltd v FCT92

91 71 ATC 4101

, which also considered former section 80E of the ITAA 1936, the

Federal Court held that the taxpayer did not satisfy the SBT because the company acquired the

relevant business after the date of the disqualifying change in ownership. The disqualifying

92 2005 ATC 4107



ownership took place on the date the takeover of the company became unconditional, not the

later date of payment of the consideration for the takeover. However, the business was only

acquired on the later of the date the contract was entered into or the satisfaction of the

conditions precedent. Before this date, the company did not carry on the business because it

did not own it. Further, the acquisition of the new business could not be considered to be the

same business as was previously carried on because its customer base was different, its

product was different, it was a retailer by contrast with the previous business of a wholesaler, its

area of operations was much wider and it had many more staff.

A company that derived income from a rental property ceased to carry on business, and

therefore could not satisfy the SBT, when the mortgagee of the property entered into

possession, following a default on the mortgage.93

Similarly, in Coal Developments (German Creek) Pty Ltd v FCT

94

, the Full Federal Court held

that a taxpayer’s winding up activities in relation to a business did not constitute the carrying on

of the business and therefore the taxpayer could not satisfy the SBT. From 3 December 1990

until 25 June 2001, the taxpayer and its parent company held interests in a coal mining joint

venture. On 25 June 2001, the taxpayer and its parent sold their joint venture interests to

another company. The taxpayer claimed that, after the sale, it continued to carry out activities

arising out of its participation in the joint venture. However, the court held that there was a

disposal of the business as a whole once and for all on 25 June 2001. Consequently, after that

date, the taxpayer could no longer be said to be carrying on the same business. The activities

engaged in by the taxpayer were incidents of the management or disposal of assets following

the discontinuance of business, rather than incidents of the continued conduct of the business.

93 FCT v R & D Holdings Pty Ltd 2007 ATC 4731 94 [2007] FCA 1324



4.3.2.4 Negative requirements

As discussed above, the SBT also comprises two negative limbs (referred to as the new

business test and the new transaction test). Both of these tests are embodied in subsection

165-210(2).

The new business test provides that the SBT will be failed where a company, during the SBT

period, derives assessable income from a business of a kind that it did not carry on before the

test time. TR 1999/9 indicates that the new business test is concerned with separate enterprises

or business lines (rather than an overall business). According to the Commissioner, the new

business test puts a limit on the type of expansion a company may undertake if it is to retain the

benefit of accumulated losses. The test is intended to prevent the injection of income into a loss

company through the addition of distinct operations, whilst permitting, within similar fields of

endeavour, the development and expansion of the overall business carried on immediately

before the test time.

The new business test will be particularly relevant in takeover or merger situations, where

additional business operations may be commenced or transferred to an existing company with

tax losses. Unless these operations are of a similar kind to those already carried on by the

company, there would generally be a failure of the SBT.

Similarly, the new transaction test provides that the SBT will be failed where a company, during

the SBT period, derives assessable income from a transaction of a kind that it had not entered

into in the course of its business operations before the test time. Although the Commissioner

adopts a broad view of the meaning of “transaction” in the new transaction test (being any

operation or dealing from which income may arise), TR 1999/9 indicates that the new

transaction test will generally not be failed where a company undertakes transactions that could

have been entered into ordinarily and naturally in the course of the company’s business

operations before the test time (even if such transactions had not actually been entered by the

company).



Tip

According to the Commissioner, the new business test and new transaction test are subject to a

de minimis requirement. In this regard, where an amount of income derived through a new

business line or transaction is so trifling as to be negligible (particularly when compared with the

value of the accumulated losses), the SBT should not be failed.95

Warning

For the purposes of the new business and new transaction tests, the Commissioner interprets

the phrase “before the test time” very broadly. According to the Commissioner, it is relevant to

examine the period from immediately before the test time to the point in the past where the

business can no longer be described as the business carried on immediately before the test

time.96

4.3.2.5 Anti-avoidance test

Even where the company otherwise satisfies the positive and negative requirements outlined

above, the company will fail the SBT to the extent that:97

• Before the test time, the company started to carry on a business it had not previously

carried on, or entered into a transaction of a kind it had not previously entered; and

• The company did so for the purpose, or for purposes including the purpose, of satisfying

the SBT.

95 Paragraphs 89 and 90 of TR 1999/9 96 Paragraph 88 of TR 1999/9 97 Subsection 165-210(3)



These requirements together are referred to as the anti-avoidance test. TR 1999/9 indicates

that the reference to business in the anti-avoidance test is to a separate undertaking or

enterprise (rather than an overall business). The ruling also emphasises that where a company

changes its activities prior to the test time for the purpose of satisfying the SBT, the anti-

avoidance test will be enlivened, even if the relevant purpose is not the dominant purpose of the

taxpayer in bringing about the change.

4.4 Applying net capital losses of earlier income year

Subsection 165-96(1) sets out when a company cannot take a carried forward net capital loss

into account in calculating its net capital gain for an income year.

“Net capital gain” is explained in sections 102-5 and 165-111 and “net capital loss” is explained

in sections 102-10 and 165-114. Note that subsection 102-10(2) provides that a taxpayer

cannot deduct a net capital loss from its assessable income for any income year.

The company cannot take the earlier capital loss into account if, assuming the loss were a tax

loss rather than a capital loss and section 165-20 (when a company can deduct part of a loss)

were disregarded, the COT or SBT is not satisfied. The loss will also be unavailable where the

control test in section 165-15 is failed by the company.

Therefore, if a company does not satisfy either the COT or the SBT, in addition to the control

test, it cannot deduct a net capital loss from an earlier year in calculating its current year net

capital gain. However, a company may be able to apply the loss if it satisfies the alternative test

provided for in Subdivision 165-F (special provisions relating to ownership by non-fixed trusts).

If a company is prevented from applying a net capital loss under subsection 165-96(1), it can

apply part of a loss in accordance with subsection 165-96(2). A company can apply part of the

loss that it made during part of that earlier income year if, assuming that part of the year were

the whole income year, the company would have been entitled to apply the net capital loss.

Warning

A company may not be able to take advantage of prior year net capital losses where, broadly, a

capital gain is injected into the company or a scheme exists to provide the benefit of the capital

loss to another person (for more information, readers are advised to refer to Subdivisions 175-

CA and 175-CB).



4.5 Division 166 concessional tracing rules

Division 166 provides an alternative, simpler test for establishing that the COT has been

satisfied in relation to a “widely held” or “eligible Division 166 company” by modifying the

application of Division 165.

Ordinarily, determining whether a company satisfies the COT involves continuous testing of

beneficial ownership throughout the loss year, income year and any intervening period.

However, considerable issues may be encountered in continuously testing the beneficial

ownership of public companies due to the multiplicity of share transactions undertaken in

respect of these companies, and the difficulty of tracing through upstream holding structures

(often involving nominee vehicles or significant chains of interposed entities). In recognition of

this, the Commissioner has in the past exercised the discretion to disregard normal stock

exchange transactions in determining whether a public company had complied with the test.

With the introduction of Division 166 (initially in 1997 and revised in 2005), public companies

and certain other eligible entities are now able to rely on the modified COT in utilising tax

losses. Broadly, the modified COT is aimed at providing statutory (as opposed to administrative)

relief for companies with accumulated losses where the application of the usual rules in Division

165 would be inappropriate or constitute an excessive compliance burden.

Note

The modified COT (as revised) may be relied upon for losses incurred in an income year

commencing on or after 1 July 2002. Tax losses incurred before 1 July 2002 may also be

tested under the modified COT, provided that those losses could have been deducted, in

accordance with former Divisions 165 and 166, in the first income year commencing after 30

June 2002.



4.5.1 Which entities are able to rely on Division 166?

Companies that are either “widely held companies” or “eligible Division 166 companies”

throughout an income year can apply the modified COT in Division 166. A company that is

widely held for part of the income year and is an eligible Division 166 company for the rest of

the income year can also apply the modified COT.98

“Widely held companies” are defined in section 995-1 to be companies:

• Listed on an approved stock exchange; or

• Companies with more than 50 members, unless:

– At any time in the income year, 20 or fewer people hold or have the right to acquire

or become the holder of shares representing 75% or more of the value of shares in

the company, other than shares entitled to a fixed rate of dividend only;

– At any time during the income year, 20 or fewer people are capable of exercising

75% or more of the voting power in the company;

– In that income year, 20 or fewer people receive 75% or more of any dividend paid by

the company; or

– If no dividend was paid by the Company during the income year, the Commissioner

is of the opinion that if a dividend had been paid by the company at any time during

the income year, 20 or fewer people would have received 75% or more of that

dividend.

“Eligible Division 166 companies” are defined in section 995-1 to be companies where more

than 50% of the voting power, rights to dividends or rights to capital distributions are held by

one or more widely held companies, superannuation funds, approved deposit funds, special

companies, managed investment schemes, prescribed entities, non-profit companies, charitable

institutions, charitable funds or any other kind of charitable bodies.

98 See, for example, subsection 166-5(1)



4.5.2 Point-in-time testing

Pursuant to the modified COT requirements set out in Division 166, ownership in an eligible

company is only required to be tested at particular points in time, rather than continuously over

periods. Specifically:

• In the case of tax losses, net capital losses, foreign losses and film losses, Subdivision

166-A modifies the application of the COT. In this regard, the COT is satisfied if there is

“substantial continuity of ownership” between the beginning of the loss year and each test

time in the ownership test period.99

– A company will demonstrate substantial continuity of ownership if it satisfies the

alternative test in relation to its voting, dividend and capital rights. This test will be

satisfied where, at each relevant test time, the same persons (other than companies

and trustees) directly or indirectly hold more than 50% of the voting power, rights to

dividends and rights to any distributions of capital in respect of the company.

For these purposes:

100

– Relevant test times include the end of each income year and the end of a “corporate

change” in the company. A typical example of a corporate change is a takeover bid

for shares in the company.

A

company may rely on the concessionary tracing rules contained in Subdivision 166-

E in order to demonstrate substantial continuity of ownership (refer to Section 4.5.3

below); and

101

• In the case of current year losses, Subdivision 166-B modifies the application of the COT.

Substantial continuity of ownership is tested by comparing ownership at the beginning of

the income year with ownership at the end of each corporate change event during the

year;

102

• In the case of unrealised losses, in determining whether a “changeover time” has

occurred, Subdivision 166-CA modifies the application of Subdivision 165-CC. There is no

changeover time in a particular income year if there is substantial continuity of ownership

between the reference time, the end of that income year and any other test times in that

99 Section 166-5 100 Section 166-145 101 Subsection 166-175(1) 102 Section 166-20



year.103

• In the case of multiplication of losses within a group of companies, in determining whether

an “alteration time” has occurred, Subdivision 166-CA modifies the application of

Subdivision 165-CD. There is no alteration time in a particular income year if there is

substantial continuity of ownership between the reference time, the end of that income

year and any other test times in that year.

The reference time is the date of the last changeover time for the company for the

purposes of Subdivision 165-CC. If no changeover time has previously occurred, the

reference time is the later of 11 November 1999 and the date the company came into

existence; and

104

4.5.3 Concessionary tracing rules

The reference time is the date of the last

alteration time for the company for the purposes of Subdivision 165-CD. If no alteration

time has previously occurred, the reference time is the later of 11 November 1999 and the

date the company came into existence.

In addition to point-in-time testing, Division 166 also contains several concessions that simplify

the tracing of beneficial owners. These concessions may be summarised as follows:

• A direct stake of less than 10% is attributed to a single notional entity.105

• An indirect stake of less than 10% is attributed to the top interposed entity as an ultimate

owner;

Note, however,

that such attribution is subject to the minimum interest rule contained in section 166-270.

Under this rule, the notional entity can never be taken, at a test time, to control more

voting power, rights to dividends or rights to capital distributions in respect of a company

than it did at the beginning of the loss year;

106

• A stake of between 10% and 50% held by a widely held company is attributed to the

widely held company as an ultimate owner;

107

103 Section 166-80

104 Section 166-80 105 Section 166-225 106 Section 166-230 107 Section 166-240



• A stake held by an entity deemed to be a beneficial owner (certain superannuation funds,

approved deposit funds, FHSA Trusts, special companies or managed investment

schemes) is generally attributed to that entity as an ultimate owner.108 However, where the

entity has 10 or fewer members, the stake will be attributed in equal proportions to those

members.109 Note that section 166-245 cannot apply where sections 166-225, 166-230 or

166-240 have already applied.110

• An indirect stake held by way of bearer shares in a foreign listed company is attributed to

a single notional entity in certain circumstances.

111 This is subject to the minimum interest

rule explained above;112

• An indirect stake held by a depository entity through shares in a foreign listed company is

attributed to a single notional entity in certain circumstances.

and

113

Tip

If any of the tracing concessions outlined above apply, the actual beneficial owners of shares in

the tested company are effectively deemed not to be beneficial owners for the purpose of

applying the modified COT.114

4.5.4 Other special rules in Division 166

The modified COT in Division 166 is also subject to the following general rules, which readers

should be mindful of:

• Subsection 166-235(7) states that if a company holds a stake in the tested company as a

nominee for one or more other entities, that stake can be attributed to the respective

entities directly for the purposes of determining substantial continuity of ownership.

108 Section 166-245 109 Subsection 166-245(4) 110 Paragraph 166-245(1)(b) 111 Section 166-255 112 Paragraph 166-270(1)(b) 113 Section 166-270 114 Section 166-265



Consequently, if the nominee company holds stakes of less than 10% on behalf of other

entities, then each of these different stakes may be attributed to the single notional

shareholder pursuant to section 166-225;

Example

Assume Nominee Co holds 30% of the shares in Loss Co, but holds those shares on behalf of 5

different entities, each with a respective interest of 6% in Loss Co.

Under subsection 166-235(7), the 6% interests may be attributed directly to the respective

entities. This will have the effect that each of those entities will be deemed to directly hold 6% of

the shares in Loss Co for the purposes of applying the modified COT. Since each direct interest

is less than 10%, section 166-225 will then operate to attribute all of the interests to a notional

beneficial owner.

It is acknowledged that it may not always be practical to ascertain the interests held in Nominee

companies such as Nominee Co.

• Section 166-165 incorporates the provisions in Subdivision 165-D (specifically, the

concessionary tracing rules and the various anti-avoidance tests under Division 165) for

the purposes of applying the modified COT;

• Section 166-272 contains a same share rule which is similar in effect to that prescribed

under Division 165. However, this rule only applies to stakes held directly or indirectly by

the following entities:

– A top interposed entity (for indirect stakes of less than 10%);

– A widely held company;

– An entity deemed to be a beneficial owner under section 166-245; or

– A depository entity subject to section 166-260.

The rule is subject to a saving provision in subsection 166-272(8) which substantially

mirrors that contained under subsection 165-12(7).



Note

The same share rule in section 166-272 does not apply to stakes held by the notional entity

created under section 166-225. Accordingly, it is not necessary that the same shareholders hold

direct stakes of less than 10% in applying the modified COT. However, the minimum interest

rule may still need to be considered in these circumstances.

• The concessionary tracing rules in Subdivision 166-E are subject to the controlled test

companies rule under section 166-280. This rule effectively prevents the concessionary

tracing rules from hiding significant interests in a tested company. In this regard, a tested

company will generally not be entitled to apply a tracing rule when determining substantial

continuity of ownership if:

– The tested company is sufficiently influenced by a controlling entity which directly or

indirectly holds a stake in the company; or

– The tested company is a widely held company and its voting power is controlled by:

An individual (together with associates) directly or indirectly controlling more

than 25% of the voting power; or

A company or trustee (together with associates) directly or indirectly

controlling more than 50% of the voting power.

Example

Assume Controller Co indirectly holds more than 50% of the voting power in Loss Co but does

so through a number of stakes in entities which directly hold less than 10% of the shares in

Loss Co.

In the absence of the controlled test companies rule, the tracing rule about direct stakes of less

than 10% would attribute these interests to a single notional entity under section 166-225.

However, where the controlled test companies rule applies, the tracing concession in section

166-225 will be inapplicable and it will be necessary to trace through those less than 10% direct

stakes to the ultimate stakeholders (thereby uncovering Controller Co’s real interest in Loss

Co).



• Division 166 is intended to be a concessional regime applying to eligible companies.

Accordingly, to the extent that application of a tracing rule in Subdivision 166-E produces

a less favourable result than would have been achieved by the tested company under the

ordinary regimes, the effect of that rule may be disregarded.115

4.5.5 Final points on Division 166

4.5.5.1 Change in control of voting power

Under Division 165, continuity of voting control is an additional precondition which a company

must satisfy in order to deduct losses.116

4.5.5.2 Application is optional

This requirement is not modified by Division 166.

Widely held companies and eligible Division 166 companies must, therefore, continue to comply

with this requirement.

The rules in Division 166 provide an alternative to the COT rules, and will apply unless the

company chooses to have the COT rules apply.117

The company may elect to have the COT rules under Division 165 apply for any income year. A

company may also make separate elections in relation to carried forward tax losses and

current-year tax losses.

115 Section 166-275 116 Sections 165-15, 165-40, 165-115D, 165-115M and 165-129 117 Sections 165-15, 165-35, 165-50 and 165-90



4.6 Loss carry-back regime

On 13 February 2013, the Tax and Superannuation Laws Amendment (2013 Measures No. 1)

Bill 2013 and accompanying explanatory memorandum were tabled in Parliament and received

Royal Assent (Act No. 88 of 2013) on 28 June 2013.118

“…companies should be allowed to carry back a revenue loss to offset it against the prior

year’s taxable income, with the amount of any refund limited to the company’s franking

account balance”.

These measures were originally

proposed as part of Recommendation 31 of the 2010 Australia’s Future Tax System Review,

which stated:

Subsequently, in October 2011, the Federal Government established an independent Business

Tax Working Group (BTWG) to consider the loss carry back proposal. In its Final Report on the

Tax Treatment of Losses, the BTWG endorsed the proposal, specifically recommending an

approach to loss carry back that:

• Is limited to companies;

• Provides a two-year loss carry-back period on an ongoing basis; and

• Limits the amount of losses that can be carried back by applying a quantitative cap of at

least $1 million.

The bill seeks to give effect to the above approach, subject to compliance with appropriate

integrity measures. The explanatory memorandum accompanying the bill notes that such an

approach will enable companies to utilise their losses sooner and reduce the extent to which

they risk never being able to use those losses. This will in turn encourage companies to adapt

to changing economic conditions and take advantage of new opportunities through investment.

The explanatory memorandum also notes that the loss carry back approach will correct the

current asymmetric treatment between profits and losses under Australia’s taxation system. In

this regard, it was noted that, whilst the Federal Government collects, in terms of tax, a share of

any profits a company makes in an income year, it does not directly share in a company’s loss.

Rather, Australia’s current taxation regime allows future tax to be reduced by deducting that

loss from future profits derived by the company. This means that there is an asymmetric

118 http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r4964

http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r4964�



treatment of profits compared with losses. As a consequence, a company making a profit in one

year followed by a loss in the next year will pay a higher effective tax rate over the two year

period than another company that makes the same overall profit in a more consistent fashion.

4.6.1 Overview of the loss carry back regime

The loss carry-back regime provides a corporate tax entity the choice of carrying back all or part

of a tax loss incurred in the current or preceding income year to offset an unutilised income tax

liability for either of the income years occurring before the current year. The regime generally

applies to assessments for the income year ending 30 June 2013 (2013 Tax Year) and later

income years. However, for the 2013 Tax Year, a transitional measure will apply which limits the

applicable loss-carry back period to one year. The loss carry-back regime will be contained in

newly inserted Division 160.

Under the loss carry-back regime, a corporate tax entity (broadly, an entity that is taxed like a

company) will be able to obtain a refundable tax offset for the losses that it chooses to carry

back against an unutilised income tax liability. The tax offset will be calculated as the lowest of

the following amounts:

• The tax value of the amount of the loss the entity chooses to carry back;

• The entity’s franking account balance at the end of the current income year;

• A quantitative cap of $300,000 (being $1 million multiplied by the applicable corporate tax

rate); and

• The entity’s unutilised income tax liability for the income year(s) to which it carries back a

loss.

In order to ensure consistency with the current treatment of net exempt income, a corporate tax

entity that carries back a loss to an income year with unutilised net exempt income must first

reduce the loss by the amount of that income before working out its offset for the remaining

loss.

The availability of the loss carry-back regime to corporate tax entities will be subject to

satisfaction of a specific anti-avoidance rule, which may apply where there is a scheme for the

disposition of membership interests in a corporate tax entity that changes the control of that

entity. In this regard, to the extent that such a scheme can be considered objectively to have

been entered into with a non-incidental purpose of enabling an entity to obtain a financial benefit



calculated by reference to a loss-carry back offset, the loss carry-back tax offset will be denied

to the corporate tax entity.

The key features of the loss carry-back regime are discussed in further detail in the following

sections of this paper.

4.6.2 Entities eligible for loss carry-back

The loss carry-back regime is only available to corporate tax entities. Broadly speaking, a

corporate tax entity is an entity that is taxed like a company (it need not necessarily be a

company in legal form). In this regard, section 960-115 defines a corporate tax entity to be any

of the following:

• A company;

• A corporate limited partnership under Division 5A of Part III of the ITAA 1936;

• A corporate unit trust under Division 6B of Part III of the ITAA 1936; and

• A public trading trust under Division 6C of Part III of the ITAA 1936.

It should be noted that some of the above entities may be corporate tax entities for only part of

an income year (for example, a public unit trust which only carries on a trading business within

the meaning of section 102M of the ITAA 1936 for part of the income year). However, an entity

will only be entitled to claim a loss carry-back tax offset where it is a corporate tax entity

throughout the current income year. It must also have been a corporate tax entity throughout

the income year in which the loss is carried back to (and any intervening income years).

4.6.3 Choice to apply the loss carry-back regime

Application of the loss carry-back regime is optional for eligible corporate tax entities, which

mirrors the existing choice corporate tax entities have about whether to deduct their tax losses

under subsection 36-17(2) and subsection 36-17(3). A corporate tax entity will be able to

choose to carry back certain losses under the regime if all of the following requirements are

satisfied:

• It has an unutilised tax loss for the current income year or the preceding income year

(termed the “middle year”);



• It has an unutilised income tax liability for the middle year or for the income year which

preceded the middle year (termed the “earliest year”). Note that any unutilised income tax

liability is determined after making allowance for tax offsets obtained by the corporate tax

entity in the relevant income year; and

• For the current income year and each of the previous 5 income years, it has lodged an

income tax return, was not required to lodge an income tax return or has been assessed

for income tax purposes by the Commissioner.

A corporate tax entity may choose to carry back a tax loss as it sees fit. In this regard, a

corporate tax entity can decide the quantum of tax losses to be carried back (subject to

available caps) and the allocation of those tax losses between the middle and/or earliest year.

If a corporate tax entity is able to choose to carry back its tax losses, any resulting tax offset will

be refundable to the corporate tax entity in the current income year.

4.6.4 Relationship between loss carry-back and loss carry-forward

When seeking to apply prior year tax losses in subsequent income years, corporate tax entities

must deduct such losses in the order in which they were incurred pursuant to subsection 36-

17(7). There is no comparable ordering rule under the loss carry-back regime. That is, a tax loss

need not be carried back to the earliest year, before it can be carried back to the middle year.

However, it will be a requirement under the loss carry-back regime that prior year tax losses be

deducted in the current income year prior to determining the loss-carry back tax offset. Of

course, a corporate tax entity may choose not to apply any carried forward tax losses in the

current income year, in which case, the ordering rule will have no application.

4.6.5 Losses which are subject to the loss carry-back regime

The loss carry-back regime will only be available in relation to “tax losses” incurred by a

corporate tax entity. Generally, a tax loss arises for an income year where the entity’s

deductions exceed its assessable income for that year (refer to Division 36 and section 0 of this

paper).

The regime will not be available in relation to capital losses incurred by corporate tax entities.

The rationale for excluding capital losses from the regime focuses on the fact that Australia’s



capital gains tax rules operate on a realisation basis. Accordingly, allowing capital losses to be

carried back to produce a tax offset would mean that corporate tax entities could choose to

realise their capital losses in order to obtain a refundable tax offset, whilst continuing to defer

realisation of their capital gains.

Certain types of tax losses will be precluded from being carried back under the regime. In this

regard, a corporate tax entity will not be entitled to carry back losses that have been transferred

under Division 170 (which regulates the transfer of losses between companies in the same

foreign banking group) or under Division 707 (which regulates the transfer of losses to the head

company of a tax consolidated group by an entity that becomes a subsidiary member of that

group). Furthermore, any tax loss that is deemed to exist by virtue of section 36-55 on

conversion of a corporate tax entity’s excess franking offsets (refer to section 2.3.3.4 of this

paper) will also be ineligible for loss-carry back under the regime.

4.6.6 Franking credit cap

As discussed previously, there are a number of limitations which restrict the quantum of any

refundable tax offset under the loss-carry back regime. Most importantly, the loss carry-back tax

offset will not be able to exceed the balance of an entity’s franking account at the end of the

current income year.

Limiting the loss carry-back tax offset to the amount in the corporate tax entity’s franking

account at the end of the current income year precludes a double tax benefit arising from the

past payment of tax. Such a double benefit could otherwise arise where the shareholders in a

corporate tax entity receive franking credits attached to distributions paid by the entity, and the

entity is subsequently able to claim a tax offset with respect to any underlying tax paid. That is,

an imputation benefit could otherwise arise to the shareholders in relation to company tax that,

because of the loss carry-back regime, had effectively no longer been paid by the corporate tax

entity.

Limiting the loss-carry back tax offset in this manner also reduces the possibility that a

corporate tax entity’s franking account will be put into deficit as a result of the payment of the

loss-carry back tax offset. This minimises administrative churn in the tax system from

companies that receive a refund from the loss-carry back tax offset only to later have to return

part or all of the refund in the form of franking deficit tax.



It should be noted that the franking account limitation will not apply to a foreign corporate tax

entity with a permanent establishment in Australia. Consequently, such an entity will be able to

obtain an offset under the regime, notwithstanding it is likely to have a nil balance in its franking

account (due to the fact that it is not tax resident in Australia and hence is not subject to

Australia’s imputation system). However, the franking account limitation will apply to loss carry-

back tax offsets claimed by New Zealand franking companies. Broadly, these are companies

that are resident in New Zealand for tax purposes but have chosen to be within the Australian

imputation system.

4.6.7 Calculation of the loss carry-back tax offset

Mechanically, the loss carry-back tax offset available to a corporate tax entity is generally

determined by applying the following method statement:

Step Description

1 Work out the amount of the loss to be

carried back

This step involves determining the amount of

the tax loss that a corporate tax entity is

carrying back to each of the middle year and

earliest year

2 Reduce the step 1 amount by net

exempt income

This step involves reducing the amount

worked out under step 1 by any net exempt

income derived by the corporate tax entity in

the middle and/or earliest year

3 Convert the step 2 amount to a tax

equivalent amount

This step involves converting the reduced

amount determined under step 2 to a tax

equivalent by multiplying that amount by the

corporate income tax rate (currently 30%)

4 Reduce the step 3 amount so that it

does not exceed the relevant tax

liability

This step involves reducing the converted

amount determined under step 3 so that it

does not exceed the maximum tax liability in

the income years to which the tax losses are

carried back



5 Reduce the step 4 amount so that it

does not exceed the quantitative cap

or any franking account surplus

This step involves reducing the amount

determined under step 4 to ensure that it does

not exceed the lesser of the corporate tax

entity’s franking surplus for the current income

year and the tax equivalent of $1 million

(currently $300,000 using the corporate tax

rate of 30%)

The application of the above method statement is demonstrated in the following worked

examples, which draw on the explanatory memorandum introducing the loss carry-back

measures. The below examples also touch on the exclusion applying to losses transferred by

an entity on joining a tax consolidated group.

4.6.8 Examples

Example 1 (carrying back losses to the middle year)

Argentum Pty Ltd (Argentum) derived taxable income of $500,000 in the income year ended 30

June 2014 (2014 Tax Year) and $2 million in the income year ended 30 June 2015 (2015 Tax Year). For the income year ended 30 June 2016 (2016 Tax Year), Argentum incurred a tax loss

of $5 million. Owing to previous payments of income tax (and instalments), Argentum had a

franking credit balance of $1.5 million at the end of the 2016 Tax Year. Argentum also derived

$100,000 of net exempt income during the 2014 and 2015 Tax Years. Argentum has never

failed to lodge an income tax return.

Argentum decides that it will carry back part of the tax loss incurred by it during the 2016 Tax

Year to offset some of its taxable income for the 2015 Tax Year. Argentum’s loss carry-back tax

offset would be determined as follows:

Step 1: work out the amount of the loss to be carried back

Argentum decides to carry back $1.1 million of its tax loss for the 2016 Tax Year to offset part of

its income tax liability in the 2015 Tax Year. Argentum’s step 1 amount is therefore $1.1 million.



Step 2: reduce the step 1 amount by net exempt income

As Argentum derived net exempt income of $100,000 during the 2015 Tax Year, it is necessary

to offset this amount against the quantum of tax losses carried back by Argentum when

determining the step 2 amount. Argentum’s step 2 amount is therefore $1 million (being $1.1

million of tax losses initially carried back, reduced by net exempt income of $100,000 derived in

the 2015 Tax Year).

Step 3: convert the step 2 amount to a tax equivalent

Argentum’s step 3 amount will be the tax equivalent of the amount calculated under step 2. This

is determined by multiplying the step 2 amount by the applicable corporate income tax rate.

Assuming the corporate income tax rate is 30%, Argentum’s step 3 amount should equal

$300,000 (being $1 million multiplied by 30%).

Step 4: reduce the step 3 amount so that it does not exceed the relevant tax liability

Step 4 generally requires the step 3 amount to be reduced so that it does not exceed the

unutilised income tax liability for the income years to which the tax losses are carried back.

In the present circumstances, step 4 should not have any application as the tax equivalent value

of Argentum’s carry-back tax losses (being $300,000) is less than Argentum’s unutilised income

tax liability for the 2015 Tax Year (being $600,000)

Argentum’s step 4 amount is therefore $300,000.

Step 5: Reduce the step 4 amount so that it does not exceed the quantitative cap or any

franking account surplus

Under step 5, Argentum will be required to reduce the step 4 amount to the lesser of the

quantitative cap and Argentum’s franking account balance at the end of the 2016 Tax Year. No

adjustment will be required where the step 4 amount does not exceed either of these

thresholds.

In the present circumstances, the quantitative cap should be $300,000 (calculated as $1 million

multiplied by the corporate income tax rate) and should not serve to reduce the step 4 amount

of $300,000.



Additionally, as Argentum had available franking credits of $1.5 million at the end of the 2016

Tax Year, the step 4 amount should not be reduced by reference to Argentum’s available

franking credits (given these exceed the tax equivalent amount determined under step 4).

Consequently Argentum’s final loss carry-back tax offset for the 2016 Tax Year will be

$300,000. As Argentum is not tax-paying in the 2016 Tax Year, this amount should be refunded

to Argentum. Argentum’s franking surplus will effectively be reduced to $1.2 million as a result

of receiving the refund pursuant to Division 205.

Argentum’s carried forward tax losses for the 2016 Tax Year should be $3.9 million (being the

tax loss of $5 million incurred during the 2016 Tax Year less the amount carried back of $1.1

million). Note that Argentum’s net exempt income for the 2015 Tax Year effectively absorbs

$100,000 of Argentum’s tax losses.

Example 2 (carrying forward and carrying back tax losses)

Assume the same facts as in example 1.

For the income year ended 30 June 2017 (2017 Tax Year), Argentum derives taxable income of

$2 million (prior to the application of carried forward tax losses) and net exempt income of

$50,000. Argentum satisfies the COT and chooses to apply its carried forward tax losses to

offset its taxable income of $2 million.

As Argentum derived net exempt income of $50,000 in the 2017 Tax Year, it must first reduce

its carried forward tax losses by this amount pursuant to paragraph 36-17(3)(a). Following this

reduction Argentum’s carried forward tax losses from the 2016 Tax Year will equal $3.85 million

(being $3.9 million initially carried forward, less net exempt income derived during the 2017 Tax

Year of $50,000). Argentum will subsequently apply part of the carried forward tax losses to

reduce its taxable income to nil in the 2017 Tax Year. After application of the tax losses in this

manner, Argentum’s remaining tax loss from the 2016 Tax Year will equal $1.85 million.

Having applied its carried forward tax losses first (consistent with the ordering rule under the

loss carry-back regime) Argentum may then choose to carry back up to $1 million of the

remaining tax losses to the 2015 Tax Year to offset its unutilised income tax liability in that year

(being $300,000). Pursuant to the method statement explained in example 1 above, should

Argentum choose to carry back its remaining tax losses to the 2015 Tax Year, Argentum will

receive a refundable tax offset of $300,000. As Argentum is not otherwise in a tax payable

position for the 2017 Tax Year, the full amount of this offset will be refundable to Argentum in

the 2017 Tax Year.



Note: although Argentum has an unutilised tax liability in the 2014 Tax Year, Argentum will not

be able to carry back its tax losses to this year, given it is outside of the 2 year loss carry-back

period.

Example 3 (consolidated group exclusion)

Raider Limited (Raider) is the head company of a tax consolidated group in Australia. Raider

has historically derived large profits in both the 2013 and 2014 Tax Years.

During the 2015 Tax Year, Raider decides to acquire all of the shares in an Australian resident

company, Trophy Pty Ltd (Trophy). Trophy has significant tax losses of $5 million which it has

accumulated over a number of income years.

Pursuant to Division 707, upon joining the Raider tax consolidated group, Trophy transfers its

tax losses to Raider on the basis that it satisfies the modified SBT. The tax losses are

transferred subject to an available fraction.

Raider Co wishes to carry-back the tax losses it inherits from Trophy to offset part of its

unutilised income tax liability in the 2013 and/or 2014 Tax Years. However, because the tax

losses have been transferred under Division 707 to Raider, loss carry-back will not be available

in relation to the tax losses. This is the case, notwithstanding that Raider will be deemed to

have incurred the losses on transfer under section 707-140.

4.6.9 Overview of the loss carry-back integrity measure

As mentioned previously, the ability to obtain a loss carry-back tax offset is subject to

satisfaction of a specific anti-avoidance rule which denies a corporate tax entity a loss carry-

back tax offset it would otherwise be entitled to where there has been a change of control in the

entity arising from the disposition of membership interests under a scheme and, considering all

of the relevant circumstances, one or more parties entered into the scheme to obtain access to

financial benefits associated with the loss carry-back tax offset.

Where the integrity measure applies, the corporate tax entity cannot carry back a tax loss.

However, subject to meeting the usual loss integrity tests, it may nevertheless be able to deduct

that tax loss in a subsequent income year. Note that application of the integrity measure will not

have any consequences for an entity that disposed of (or acquired) membership interests in the

corporate tax entity under an applicable scheme.



Consistent with the current administration of the integrity measures regulating the utilisation of

prior year losses in future periods, corporate tax entities will be required to self-assess whether

the loss integrity measure applies in the context of their particular circumstances.

4.6.10 Key elements of the loss carry-back integrity measure

In order for the loss carry-back integrity measure to apply, the following elements need to be

satisfied:

• There must be a scheme (which is defined widely for these purposes to include any

agreement, arrangement, understanding, promise or undertaking, whether express or

implied and whether or not enforceable);

• Under the scheme, there must be a disposition of membership interests, or of an interest

in membership interests, in a corporate tax entity. For these purposes, a scheme for the

disposition of membership interests has the same meaning as in section 177EA of the

ITAA 1936 and includes issuing or creating membership interests and entering into

contracts that affect membership interests. Note that membership interests are taken to

include non-share equity interests in the corporate tax entity;

• The disposition of membership interests must have resulted in a change in the persons

who controlled, or were able to control (whether directly or indirectly) the voting power in

the corporate tax entity;

• In the absence of the integrity measure applying, an entity (other than the corporate tax

entity) must receive a financial benefit in connection with the scheme, which is calculated

by reference to one or more loss carry-back tax offsets that could reasonably be expected

to be available to the corporate tax entity at the time the scheme was entered.

Consequently, the integrity measure cannot apply if the corporate tax entity does not have

an unutilised income tax liability for any income year within the loss carry-back period, or

the corporate tax entity does not have, or expect to have, a franking credit balance at the

end of the current income year; and

• Having regard to the relevant circumstances of the scheme, it would be objectively

concluded that one or more of the persons who entered into the scheme did so for a

purpose (whether or not the dominant purpose, but not including an incidental purpose) of

the corporate tax entity obtaining a loss carry-back tax offset. The assessment as to

purpose is to be undertaken at the time the scheme is entered.



4.6.11 Relevant Circumstances

In order to objectively establish a person’s purpose under the integrity measure, it is necessary

to weigh up a number of relevant circumstances prescribed in the Tax Act. None of the

circumstances is determinative (of itself) and all must be considered collectively.

First relevant circumstance: extent to which activities remain the same

The first relevant circumstance is the extent to which the corporate tax entity continues to

undertake the same activities after the scheme for disposition of the membership interests as it

did prior to entry of the scheme. Activities in this sense are referring to the process adopted by a

corporate tax entity in deriving its assessable income.

Both the number of activities and their relevant importance to a corporate tax entity’s business

profile must be considered when examining the extent to which such activities remain

consistent. In this regard, a particular activity may have been undertaken to such an extent (or

have been of such importance) to the corporate tax entity that its termination following a change

of control under a scheme clearly demonstrates a non-incidental purpose of obtaining a loss

carry-back tax offset.

It should be noted that a corporate tax entity may continue to carry on the same activities

notwithstanding that it has expanded or varied its product lines (contrast the SBT). For example,

as noted in the explanatory memorandum, a restaurant that specialised in Chinese cuisine

which refocused its specialisation on Greek Cuisine following a change of control would still be

considered to undertake the same business activity for the purposes of the integrity measure.

Second relevant circumstance: extent to which assets remain the same

The second relevant circumstance is the extent to which the corporate tax entity continues to

use the same assets following a change in control.

If an entity that is subject to a change of control continues to utilise its existing assets following

the change, this may indicate that the purpose of the new owner in acquiring membership

interests in the corporate tax entity was to obtain access to the corporate tax entity’s assets

rather than the loss carry-back tax offset. As noted in the explanatory memorandum, this is

particularly likely to be the case where the corporate tax entity possesses assets with unique

characteristics, which would otherwise be difficult to access.



It should be noted that the second relevant circumstance does not put a limit on the corporate

tax entity’s ability to replace existing assets in the ordinary course of its business, nor does it

impose a restriction on the use to which the assets are put by the new owner following a change

of control. Conceivably, therefore, the assets may be used in a different manner without inviting

an adverse inference under this circumstance.

Third relevant circumstance: matters referred to in subparagraphs 177D(b)(i) to (viii)

The third relevant circumstance is the matters referred to in subparagraphs 177D(b)(i) to (viii) of

the ITAA 1936. The matters referred to in these subparagraphs are matters of reference for “the

dominant purpose” test in Part IVA of the ITAA 1936. However, in the context of the loss carry-

back measures, it is expected that they will facilitate an inquiry into whether a person has a non-

incidental purpose of obtaining access to a loss carry-back tax offset.

The matters referred to in subparagraphs 177D(b)(i) to (viii) of the ITAA 1936 broadly include

the manner in which the scheme was entered into or carried out, the form and substance of the

scheme, the timing of the scheme, the financial, tax and non-tax effects of the scheme and the

nature of any connection between the taxpayer and other parties to the scheme. The matters

are designed to cover the essential facts and circumstances of a particular scheme so that its

tax and non-tax objectives can be fully assessed and compared.

4.6.12 Examples

The potential operation of the loss carry-back integrity measure is demonstrated by the

following examples which are based on the explanatory memorandum introducing the loss

carry-back measures. The examples demonstrate how the above factors may be applied in

determining the question whether a particular scheme has been entered into for the non-

incidental purpose of obtaining a loss carry-back tax offset. For ease of reference, the examples

do not address each of the above factors individually, although this may be required in practice.

Example 1 (continuation of similar business)

Knightbridge Pty Ltd (Knightbridge) is historically a profitable company. However, its profits

are in long term decline. Its business activities principally consist of growing flowers for

wholesale supply to external vendors. It owns a large property in rural New South Wales on

which it has established a flower farm and associated flower shop. Knightbridge conducts

limited retail activities directly through the flower shop to interested members of the public.



In the 2014 Tax Year, all of the shares in Knightbridge are purchased by Gavin for $1.8 million.

At the time of purchase, Knightbridge had a franking account balance of $200,000. Recent

sales of comparable properties that had been used for agricultural (but not flower growing

purposes) suggest that a fair market value for the flower farm would be $1.5 million. However,

the properties available do not have the arterial road access that Knightbridge has and would

require substantial flower beds to be planted.

In accordance with his business plan, Gavin changes the strategy of Knightbridge and

increases its retail focus on sales through the flower shop. In this regard, Gavin refurbishes the

flower shop and adds a café. Gavin also expands the products sold from the shop to include the

work of local artists depicting native flora and fauna in the region. Taking into account the

revised strategy, Gavin anticipates Knightbridge will incur a tax loss of $600,000 in its first

income year but become profitable in the following income years. In modelling cash flows from

the business for the purposes of obtaining finance from an external lender, Gavin has included

the impact of the loss carry-back tax offset.

On the evidence available, Gavin’s purpose is to implement changes that he expects will lead to

Knightbridge being a more profitable business in the future. Whilst Knightbridge is undertaking

some new business activities, it has also continued its initial business activities of growing

flowers for sale. The company has retained most of its pre-existing assets albeit that some

have been refurbished.

Although Gavin paid a substantial premium over the fair market value of Knightbridge’s assets

(and in determining this premium, Gavin may have taken into account the availability of a loss

carry-back tax offset), other factors such as the existence of arterial road access and the

availability of existing flower beds suggest that obtaining a loss carry-back tax offset was merely

incidental in the acquisition of Knightbridge.

On balance, the integrity rule should not apply and any loss carry-back tax offset should be

allowed to Knightbridge.

Example 2 (disposal of assets)

Spurious Transport Pty Ltd (Spurious Transport) owns vehicles, plant and equipment valued

at $15 million. The company has a franking account balance of $600,000 as a result of income

tax liabilities in each of its two previous years of operation. Members of the Jones family

acquire all of the membership interests in Spurious Transport for consideration totalling $15.3

million during the 2014 Tax Year. The company is then renamed as Jones Plumbing Pty Ltd

(Jones Plumbing).



Within a matter of days, Jones Plumbing sells all of its existing assets to a company that is

associated with the former shareholders of Spurious Transport. The assets are sold for their

market value of $15 million. Jones Plumbing subsequently commences a new business that is

expected to incur tax losses of $2 million and $1.5 million respectively in its first two years of

operation.

The Jones family is conducting a very different business to that of the former owners of what is

now Jones Plumbing. Whilst very valuable assets were acquired with the company, the quick

sale of those assets demonstrates that there was never any intention to use them in an income

earning activity. The very substantial recoupment of the purchase price for the company by

selling its assets has effectively led to a situation where the net cost to the Jones family was

$300,000 (being the excess of purchase consideration paid over the proceeds recouped on

subsequent sale of the existing assets).

As the Jones family expects the company to have trading losses of $3.5 million, they can

reasonably expect to be able to carry back losses so that Jones Plumbing will obtain tax offsets

of $300,000 in both of the first two years of operation under their control.

It is probable that the availability of the tax offset over two years was a significant purpose of the

transfer of membership interests. Both tax offsets would therefore be denied.

Example 3 (generational change)

Paladin Pty Ltd (Paladin) is a family company that is owned as to 70% by Mark and 30% by

Jarrod (Mark’s son). Paladin carries on a successful tailoring business with net assets of $2.5

million and a franking account balance of $500,000. Mark is ready to retire but desires that

100% of the shares in Paladin remain family assets. Consequently, Mark disposes of his 70%

interest in Paladin to Jarrod, who thereafter becomes the sole shareholder for the company.

Jarrod acquires the interest in consideration for a payment of $2 million.

Jarrod is appointed as Paladin’s managing director and immediately changes the business

focus of the company in a manner that Mark had previously resisted. This includes selling off

most of the company’s assets. Jarrod expects that Paladin may be unprofitable for a number of

years following these changes; however, ultimately he considers that the fundamentals of the

modified business focus are sound and that the business will increase its profitability above

current levels. Jarrod has factored in the availability of a loss carry-back tax offset in his

forecasts in relation to Paladin’s business performance.



The business focus of Paladin has changed and very few of the assets have been retained.

The price paid for 70% of the company not previously owned could suggest that a financial

benefit was expected and calculated by reference to the loss carry-back tax offset. In this

regard, had Jarrod simply purchased the outstanding shares in Paladin without taking account

of the loss carry-back tax offset, he could have been expected to pay $1.75 million (being 70%

of the net asset balance).

However, the generational change is a significant factor that suggests that the availability of the

offset was at most an incidental purpose of Jarrod acquiring control of the company.

4.7 Proposed improvements to the company loss recoupment rules

As part of the 2011-2012 Budget, the Federal Government announced that it will improve the

operation of the company loss recoupment rules by simplifying the COT in certain

circumstances and removing some minor technical defects.

On 14 July 2011, the Treasury released a consultation paper on providing additional information

on how the proposed changes to the company loss recoupment rules might operate and to seek

feedback on their design and implementation.

Specifically, the consultation paper has identified the following areas for improvement:

4.7.1 Modifications to the continuity of ownership test

Proposed amendments to the ordinary COT will mean that a company will not be required to

trace ownership through a complying superannuation fund, a complying approved deposit fund,

a first home savers account trust, a special company or a managed investment scheme. These

proposed amendments are consistent with the scope of a similar exception that applies under

the modified COT.

4.7.2 Extension of the concessional tracing rules under the modified continuity of ownership test

Proposed improvements will be made to the modified COT to extend the circumstances in

which these concessional tracing rules apply (refer to Section 4.5.3 above for discussion of the

concessional tracing rules).



4.7.3 Holding company interposed between a direct stakeholder and the tested company

Where a stakeholder has a direct stake in the tested company that carries rights to less than

10% of the voting power, dividends and capital distributions, it is not necessary to trace through

to the ultimate beneficial owners. This is achieved by treating all direct stakes of less than 10%

as being held by a single notional entity that is a person.

A similar concession applies where a stakeholder has an indirect stake in the tested company

that carries rights to less than 10% of the voting power, dividends and capital distributions. In

these circumstances, the ownership tracing rules are applied as though the top interposed entity

is a single person.

A problem arises if, during the test period, a holding company is interposed between the tested

company and a less than 10% direct stakeholder. In these circumstances, the stake will be

attributed to the interposed company under section 166-230 from that time onwards, rather than

the single notional entity to whom the stake was initially attributed to under section 166-225.

Consequently, the tested company may fail the COT, even though the interposition of the

holding company does not change the ultimate beneficial ownership of the tested company.

The proposed changes will mean that the same single notional entity will be taken to hold the

stakes in the tested company before and after the entity is interposed between the direct

stakeholder and the tested company. Therefore, the interposition of a holding company between

the tested company and a less than 10% direct stakeholder will not, of itself, cause a failure of

the COT.

4.7.4 Demerger by a top interposed entity

Where a stakeholder has an indirect stake of less than 10% in the test company, it is not

necessary to trace through to the ultimate beneficial owners of the stake in the test company.

Instead, the indirect stake of less than 10% is attributed to the top interposed entity.

If the top interposed entity demerges shares in the tested company, or interests in another entity

interposed between itself and the tested company, the legal owner of the 10% indirect stake

changes. As a result, the concessional tracing rules cease to apply as the indirect stake is either



attributed to a different top interposed entity, or is a stake that is held directly, from that time

onwards (even though no change in the ultimate beneficial ownership of the stake arises as a

consequence of the demerger).

If the tested company applies the ordinary COT, it will need to trace ownership through to the

ultimate beneficial owners and, all other things being equal, will continue to pass the COT.

However, it will inappropriately lose access to the compliance cost benefits that arise under the

concessional tracing rules for widely held companies and eligible Division 166 companies.

It is proposed to amend section 166‐230 so that it will continue to apply where the top

interposed entity demerges. In these circumstances, section 166‐230 will apply as if, at the

times the entity that holds or is taken to hold the demerged shares or other interests is also

taken to have held that stake, the top interposed entity at all times held, or is taken to have held,

a stake in the tested company.

As a result, the same entity will be taken to hold the stakes in the tested company before and

after the demerger by the top interposed entity.

4.7.5 Entity interposed between a superannuation fund and the tested company

Concessional tracing rules also apply where a stake is held directly or indirectly by certain

specified entities (such as a complying superannuation fund or a foreign superannuation fund).

However, these concessional tracing rules cease to apply if a holding company is interposed

between the specified entity and the tested company (even though the ultimate beneficial

owners of the tested company remain the same following the interposition of the holding

company). This is because such an interposition will infringe the same share same interest rule

in subsection 166‐272(2), which requires that the only shares in the tested company that are

taken into account are exactly the same shares and are held by the same persons. The shares

in the tested company were held at the beginning of the tested company’s test period by the

specified entity, and at some point in the test period they start to be held by the interposed

holding company. To overcome this problem, the tested company must rely on the saving rule

in subsection 166‐272(8).



The proposed changes ensure that the condition in paragraph 166‐245(1)(a) (which requires a

specified entity to directly or indirectly hold a relevant stake in the tested company) will continue

to be satisfied for the purposes of applying section 166‐245 to the specified entity, without

infringing the same share same interest rule in subsection 166‐272(2) and thus not having to

satisfy the saving rule in subsection 166‐272(8).

4.7.6 Bearer depository receipts

Bearer shares are negotiable instruments which accord ownership of shares in a company to

the person who possesses the bearer share certificate. The owners of bearer shares are not

recorded in the share register. Rather, the transfer of bearer shares occurs through the physical

handover of the share certificate. Accordingly, it is not ordinarily practicable for a company to

trace ownership through bearer shares.

Consequently, a concessional tracing rule applies to bearer shares carrying voting, dividend or

capital stakes of 50 per cent or more in a foreign listed company that has a direct or indirect

stake in the tested company, provided that certain conditions are satisfied (section 166‐255). If

the tracing rule applies, a single notional entity (being a person other than a company) is taken

to control the voting power in, and have the right to receive any dividends or capital distributions

from the tested company, that are carried by the bearer shares.

Due to regulatory requirements relating to the transfer of shares that apply in the Netherlands,

shares in a Netherlands parent company are often held by a stichting (which has some legal

features of an Australian company and some legal features of an Australian trust).

In exchange for each share in the Netherlands parent company, the stichting issues a bearer

depository receipt. The bearer depository receipt represents an economic and beneficial interest

in the Netherlands parent company and is effectively equivalent to the ownership of a share.

The bearer depository receipts are listed for quotation in the official list of an approved stock

exchange.

Bearer depository receipts are essentially equivalent to bearer shares. However, the

concessional tracing rules do not apply to bearer depository receipts because they do not

satisfy the conditions in section 166‐255.

It is proposed to modify section 166‐255 so that bearer depository receipts issued by an

interposed foreign entity that are listed for quotation in the official list of an approved stock

exchange are eligible for the same concessional tracing rules as bearer shares.



4.7.7 Applying the modified COT following an issue of new shares

A corporate change can occur in a number of ways (section 166‐175). One way that a corporate

change can happen is if the company issues new shares resulting in an increase of 20% or

more in either the issued share capital of the company or the number of the company’s shares

on issue (paragraph 166‐175(1)(d)).

Currently, when a corporate change is brought about by the issue of shares, the corporate

change ends when the offer period for the issue of shares ends (paragraph 166‐175(2)(c)). In

some circumstances all the new shares may not have been issued before the end of the offer

period. If the test is applied before all the new shares are issued, all changes in ownership

arising from the issue of the new shares may not be captured.

It is likely that a company will have a significant change of ownership when a corporate change

happens. Therefore, the modified COT is applied at that time to determine whether it causes a

failure of the COT. Consequently, if the corporate change happens because of an issue of

shares, it is clear that all of the new shares that are issued need to be taken into account when

applying the COT.

It is proposed to amend paragraph 166‐175(2)(c) to clarify that, where a corporate change is

brought about by the issue of shares, the corporate change ends when all of the new shares are

issued.

4.7.8 Loss integrity rules – low value asset exclusion

Where a company owns CGT assets that are membership interests in another entity (such as

shares in a company or units in a unit trust), there is some doubt as to whether each

membership interest is treated as a separate asset for the purposes of applying the loss

integrity rules in Subdivisions 165-CC and 165-CD. If this is the case then the effectiveness of

the loss integrity provisions is compromised.

The proposed amendments will clarify that all membership interests in an entity which are

owned by the test company at the relevant time are treated as a single asset for the purposes of

applying the $10,000 threshold test.



4.8 Proposed tax loss incentive for designated infrastructure projects

In the 2011-2012 Budget, the Federal Government announced that it would introduce a new tax

incentive designed to remove impediments in the tax system that discourage private investment

in infrastructure projects. In this regard, the Federal Government wanted to attract private sector

investment in nationally significant infrastructure projects by:

• Uplifting the value of carry forward tax losses by the long term bond rate;

• Exempting companies from the COT and SBT; and

• Exempting fixed trusts from the trust loss and bad debt deduction tests.

We note that draft legislation and explanatory memorandum was released on 18 April 2013.

4.9 Common errors when utilising tax losses

4.9.1 Common errors

The ATO has published common errors when taxpayers seek to utilise tax losses. Such errors

include:

• Incorrect classification of the loss on either revenue or capital account;

• Losses being used where a company doesn't satisfy either the COT and the control test or

the SBT;

• Records not being kept to substantiate the loss;

• Incorrect claiming of tax deductions, in particular finance-related claims;

• Carried-forward losses not being checked to ensure they're correctly calculated including:

– Failure to reduce amounts carried forward by amounts previously claimed; and

– Tax losses carried forward despite having utilised all losses in the previous year.



4.9.2 ATO target areas

The ATO has stated that they are concerned with the following issues:

• Claims for losses that do not meet COT or SBT;

• Unexplained losses;

• Inappropriate creation of losses through debt forgiveness and other inter-group/entity

transactions;

• Inappropriate creation of losses through income omission or incorrect classification

(revenue or capital);

• Manipulation of loss entities in various ways, including using profitable trusts to distribute

income into loss entities;

• Inappropriate claims for losses derived from permanent establishments; and

• Claims for losses that do not reflect genuine commercial arrangements.

4.10 Record keeping

To support claims for losses, records should be retained at least until the end of the period of

review for the income year in which the relevant losses are fully applied.





5. Modifications

5.1 Tax losses and consolidated groups

5.1.1 Overview

When an entity becomes a member of a consolidated group (whether as head company or as a

subsidiary member), carried forward losses (revenue and capital) may be transferred to the

head company of the consolidated group.

Specifically, carried forward losses of an entity may be transferred to the head company

provided the losses satisfy modified versions of the COT or the SBT. The tests are applied as

though the 12 months prior to the joining time were the loss claim year (known as the trial year).

The carried forward loss is transferred to the head company of the group if the joining entity

could have utilised the loss in the trial year assuming it had sufficient income or gains of the

relevant type.

In addition, the rate at which transferred losses can be used by the head company of a

consolidated group is generally restricted to approximate the rate of use that the joining entity

would have experienced had it remained outside of the consolidated group. This is achieved

via the “available fraction”.

5.1.2 Transfer of carried forward tax losses

There are generally three steps to be followed by a joining entity seeking to transfer losses to

the head company of a consolidated group:

Step 1: The entity works out its taxable income or loss for the period up to the time it joins

the consolidated group;

Step 2: The entity identifies the amount of its carried forward losses as at the joining time;

and

Step 3: The entity then determines whether those losses satisfy the modified tests for using

them in the context of the trial year.



Thus, where the entity joins the consolidated group as a subsidiary member, it is required to

consider the general loss provisions in the course of establishing its income tax liability (if any)

to the point of tax consolidation, and to then consider them again as transfer tests (modified as

required) in the context of the trial year (which is defined in subsection 707-120(2)).

The tests generally require the joining entity:

• To have maintained a majority of the same ownership and control for the period between

the start of the loss year and just after the joining time (the continuity of ownership and

control tests); or

• In certain cases, to have carried on the same business as between the end of the loss

year and, at least, throughout the 12 months before the joining time (the SBT).119

A joining entity’s eligible losses are transferred to the head company at the joining time.

120 The

head company is then treated as having made the loss itself in the income year of the

transfer.121

Losses that have been transferred can be utilised (subject to limitations) for all income years of

the head company following consolidation, until the losses are either exhausted or rendered

non-utilisable.

Accordingly, the head company is then the only entity capable of utilising the loss.

For completeness, where carried forward losses of an entity are not transferred (whether

because the entity does not satisfy the transfer tests or the loss is cancelled by the head

company pursuant to section 707-145), the loss cannot be used by any entity for income years

after the entity became a member of the consolidated group.122

5.1.3 Utilisation of tax losses by head company of consolidated group

The eligible losses of a joining entity are transferred to the head company at the joining time.

The head company is then treated as having made the loss in that income year. This is

described as the “refreshing” of the losses. However, the head company must still test the

119 Sections 707-105, 707-120 and 707-125 120 Sections 707-105 and 707-120 121 Sections 707-105 and 707-140 122 Sections 707-105, 707-140 and 707-150



ownership of the loss entity from the beginning of the actual loss year if the loss entity is a

company and the loss was transferred because the COT was passed.

The head company is the only entity that can use the loss.123

Transferred losses can only be used after “group losses” (that is, losses incurred by the

consolidated group).

Losses that have been transferred

can be deducted, applied or taken into account (subject to some limitations) for all income years

following consolidation, including the transfer year, until they are either exhausted or rendered

unusable.

If the joining entity ceases to be a member of the consolidated group, all losses remain with the

head company of the consolidated group.124

If in respect of a particular year of income the head company of a consolidated group has failed

the COT, then the SBT in section 165-210 will be relevant when calculating taxable income to

determine the income tax liability of the head company. The single entity rule therefore will

apply in this context.

125

Under the single entity rule of subsection 701-1(1), subsidiary members of a consolidated group

are taken for the purposes of the SBT (among other purposes), to be parts of the head

company. In this context, the principles set out in TR 1999/9 in respect of the application of the

SBT to a single company apply equally to the head company of a consolidated group.

The Commissioner sets out his views on the application of the same business test to

consolidated and multiple entry consolidated groups in Taxation Ruling TR 2007/2.

When determining the one overall business carried on by the head company of a consolidated

group for the purposes of subsection 165-210(1) it is necessary to have regard to the activities

of the subsidiary members of the group. Applying the principles of TR 1999/9, one overall

business of the head company is to be identified by examining all of the activities, enterprises or

undertakings carried on:

• At the appropriate test time by all those entities that were members of the consolidated

group at that time; and

123 Subsection 707-140(1) 124 Section 707-410 125 See subsection 701-1 and TR 2004/11



• By all entities during that part of the SBT period when they were members of the

consolidated group.

When applying the new business test and new transaction test to the head company regard

must be had to the enterprises, undertakings and transactions that were carried on or entered

into before the test time by entities while they were members of the consolidated group. These

activities are then compared with the enterprises, undertakings and transactions carried on or

entered into by all entities while they are members of the consolidated group during the SBT

period. This comparison determines whether the enterprises, undertakings and transactions

before the test time and during the SBT period are different in kind.

In relation to the new business and new transaction tests, it is not necessary that a business

carried on or a transaction entered into during the SBT period by an entity in the group be of a

kind carried on by that same entity before the test time. In accordance with the operation of the

single entity rule, where an entity within the group undertook a business or transaction of that

kind before the test time when that entity was a member of the consolidated group, the new

business or new transaction test will be satisfied.

Activities, undertakings and enterprises taking place within a consolidated group (not involving

the derivation of income through dealings outside the group) will be relevant for characterising

the business of the head company. This will be the case notwithstanding the fact that individual

transactions between group members will not be recognised as happening under the SBT

because of the single entity rule which treats group members as parts of the head company for

the purpose of determining its income tax liability.

Note that section 165-212E and the entry history rule in section 701-5 operate in such a way

that the activities of an entity during any period when that entity was not a member of a

consolidated group are ignored when determining either the “business” of the head company of

a consolidated group, or whether the new business test or the new transaction test have been

satisfied.

For the avoidance of doubt, the Federal Government introduced proposed modifications to

section 165-212E on 4 September 2009 clarifying that the entry history rule will be effectively

disregarded when applying the SBT to the head company of a consolidated group. Therefore,

where a subsidiary member joins a consolidated group, the head company will not need to take

into account the history of the subsidiary member (for example, in relation to certain pre-joining

time transactions undertaken by the subsidiary member) in assessing compliance with the SBT.

The modifications are proposed to apply from 1 July 2002.



6. Foreign Losses

Former section 79D of the ITAA 1936 required foreign income deductions to be “quarantined”

from domestic assessable income. This meant that these deductions could only be offset

against assessable foreign income. Originally, the section also required foreign income

deductions to be further quarantined into four foreign income classes:

• Interest income;

• Modified passive income;

• Offshore banking income; and

• Other assessable foreign income.

Accordingly, foreign deductions could only be offset against foreign income of the same class.

For example, foreign interest deductions could only be offset against foreign interest income. It

should be noted, however, that with the advent of the revised thin capitalisation regime in 2001,

interest income was effectively removed from the ambit of former section 79D.

The section, which had applied in various forms since the 1989 income year, was repealed with

effect for income years, statutory accounting periods and notional accounting periods starting

on or after 1 July 2008 (with the introduction of the foreign income tax offset rules).

The effect of the removal of these restrictions is that in utilising deductions, no distinction now

needs to be drawn between foreign and domestic income earning activities. The general rule,

under Division 36, is simply that where the combined foreign and domestic deductions exceed

assessable income, the excess is a tax loss that may be carried forward for deduction against

assessable income of subsequent income years in accordance with the general loss

recoupment rules.





7. Trusts

Trusts, though not taxpayers (with the exception of public trading trusts and corporate unit

trusts), are subject to specific restrictions set out in Schedule 2F of the ITAA 1936. These

restrictions then affect the amount which beneficiaries of the trust must include in their

assessable income.

Public trading trusts and corporate unit trusts are treated as companies for most income tax

purposes, but are subject to the trust loss rules in Schedule 2F of the ITAA 1936.

References to sections of the Tax Act in this section are to sections in Schedule 2F of the ITAA

1936, unless otherwise indicated.

7.1 A summary of the trust loss rules

Schedule 2F of the ITAA 1936 contains rules which restrict the utilisation of losses by a trust in

certain circumstances (referred to generally as the “trust loss rules”). In this regard, the trust

loss rules only apply to revenue losses, and not to capital losses. This is an important

distinction and one that has been mooted as being subject to review.

The trust loss rules apply differently depending on the type of trusts. The relevant types of

trusts, together with the applicable rules, are summarised in the following table:

Trust 50% Stake Non-fixed Trust Stake

Same Business

Pattern of Distribution

Control Income Injection

Fixed trust

other than a

widely held

unit trust

Yes Yes Yes

Unlisted Yes, on Yes



Trust 50% Stake Non-fixed Trust Stake

Same Business

Pattern of Distribution

Control Income Injection

widely held

trust

abnormal

trading and

at end of

each

income

year

Unlisted

very widely

held trust

Yes Yes

Listed

widely held

trust

Yes, on

abnormal

trading

Yes Yes

Wholesale

widely held

trust

Yes Yes

Non fixed

trust

Yes Yes Yes Yes

Family trust Yes

Excepted

trust (other

than a

family trust)

None applicable



7.2 Important definitions

There are several important definitions used in the trust loss rules that readers should first be

familiar with.

7.3 Fixed trust

A fixed trust is a trust where persons have fixed entitlements to all of the income and capital of

the trust.126

Broadly speaking, a trust will be a “fixed trust” under the current definition if persons have “fixed

entitlements” to all of the income or capital of the trust, which in turn requires that those persons

have “vested and indefeasible” interests in all of the income and capital of the trust. However,

as highlighted by the decision of the Federal Court in the Colonial First State Investments

Limited v Commissioner of Taxation

127

In recognition of this issue, the Treasury released a discussion paper on the meaning of “fixed

trust” in July 2012. The discussion paper aims to assist in developing a more workable

definition of what trusts will constitute a “fixed trust” for Australian income tax purposes. Very

broadly, the paper suggests that the current definition of a fixed trust could be replaced by

either:

, practically, very few trusts will satisfy this requirement

because beneficiary entitlements are commonly able (at least theoretically) to be defeated by

the exercise of a power in the trust instrument or by a statutory power. Accordingly, in order to

qualify as a “fixed trust”, almost all trusts currently need to rely on the Commissioner’s discretion

to treat them as such (as per subsection 272-5(3) of Schedule 2F of the ITAA 1936).

• “The clearly defined rights” test: whereby trusts with no material discretionary elements

would be considered fixed trusts for Australian income tax purposes; or

• “The vested and not defeated” test: whereby trusts with interests that are vested in

possession but have not been defeated at a particular test time would be considered fixed

trusts for Australian income tax purposes.

126 Section 272-65 of Schedule 2F of the ITAA 1936 127 2011 ATC 20-235



The paper also considers removing the concept of “fixed trust” completely from certain sections

of the Tax Act.

7.4 Non-fixed trust

A non-fixed trust is any trust other than a fixed trust. Such trusts are commonly referred to as

discretionary trusts.128

Example

The trust deed for ABC Trust provides discretion to the trustee to determine capital and income

distributions. ABC Trust is a non-fixed trust.

7.5 Closely held trust

A trust is closely held if either:

• No more than 20 individuals have; or

• No individuals have,

fixed entitlements to a 75% or greater share of the income or capital of the trust, directly or

indirectly, for their own benefit.129 An individual, her/his relatives and their nominees are taken

to be a single person for the purpose of this test.130

Example

John holds A class units in Trust XYZ. 49 other unitholders hold B class units. A class units

carry the right to 100% of the capital distributions of the trust and rank equally with B class units

for income distributions. As John holds fixed entitlements to at least 75% of capital distributions

from the trust, XYZ is a closely held trust.

128 Section 272-70 of Schedule 2F of the ITAA 1936 129 Section 272-105 of Schedule 2F of the ITAA 1936 130 Subsection 272-105(3) of Schedule 2F of the ITAA 1936



7.6 Widely held trust

A trust is a widely held unit trust if it is a unit trust that is a fixed trust and is not closely held

unless there is power (whether or not it is in fact exercised) to vary the rights attaching to any of

the units in such a way that the trust would become closely held.131

Widely held trusts (and their variants) are not considered further in this paper (apart from the

definitions below).

7.6.1 Unlisted and listed widely held trusts

An unlisted widely held trust is a widely held trust whose units are not listed for quotation on

the official list of an approved stock exchange132 and a listed widely held trust is one whose

units are so listed.133

7.6.2 Unlisted very widely held trust

An unlisted very widely held trust is a trust:134

• That is an unlisted widely held trust;

• That has at least 1,000 unit holders;

• Whose units all carry the same rights (that is, only one class of units);

• Whose redeemable units (if any) are redeemable for a price determined on the basis of its

net asset value; and

• That engages in an activity that is an investment or business activity conducted in

accordance with the trust deed (and any prospectus) and is conducted at arm’s length.

This can apply retrospectively in certain situations.135

131 Section 272-105 of Schedule 2F of the ITAA 1936

132 Section 272-110 of Schedule 2F of the ITAA 1936 133 Section 272-115 of Schedule 2F of the ITAA 1936 134 Section 272-120 of Schedule 2F of the ITAA 1936



7.6.3 Wholesale widely held trust

A trust is a wholesale widely held trust if:136

• It is an unlisted widely held trust but not an unlisted very widely held trust;

• At least 75% of its units are held by one or more of the following:

– Listed widely held trusts;

– Unlisted very widely held trusts;

– Life assurance companies;

– Complying approved deposit funds;

– Complying superannuation funds; or

– Pooled superannuation trusts;

• All units carry the same rights;

• Redeemable units (if any) are redeemable for a price determined on the basis of its net

asset value;

• The amount subscribed for units by each unit holder is at least $500,000; and

• The trust engages in an activity that is an investment or business activity conducted in

accordance with the trust deed (and any prospectus) and is conducted at arm’s length.

7.6.4 Family trust

A family trust is a trust that has a family trust election in force in respect of the trust.137




7.6.5 Excepted trust

An excepted trust is a trust that is:138

• A family trust;

• A complying superannuation fund, complying approved deposit fund or pooled

superannuation trust;

• In respect of certain deceased estates;

• A fixed trust that is a unit trust and exempt entities have fixed entitlements to all of the

income and capital of the trust, directly or indirectly; or

• A FHSA trust.

Broadly, an excepted trust is not subject to the loss rules in Schedule 2F of the ITAA 1936.

Accordingly, this paper does not focus on these trusts (even though family trusts may be the

most common trusts on which readers advise).

7.7 Fixed trusts, not widely held unit trusts or excepted trusts

A fixed trust that is not a widely held unit trust or an excepted trust must remain such a fixed

trust throughout the period starting at the beginning of the loss year and ending at the end of the

income year.139

In addition, the fixed trust must pass the 50% stake test or the non-fixed trust stake test in order

to be able to use its losses.

140 If these tests are not passed, the trust must calculate its taxable

income and tax loss for the income year as described in section 266-30 of Schedule 2F of the

ITAA 1936.141





The trust may still be able to deduct part of the loss.142

7.7.1 50% stake test

The 50% stake test requires that the same individuals have, directly or indirectly, fixed

entitlements to more than 50% of the income and capital of the trust (although different persons

may hold the entitlements to income from those who hold the entitlements to capital) from the

start of the loss year to the end of the income year.143

7.7.2 Non-fixed trust stake test

To satisfy the non-fixed trust stake test, the following conditions must be satisfied:144

• At all times between the start of the loss year and the end of the income year, non-fixed

trusts (other than family trusts) must hold fixed entitlements to a 50% or greater share of

the income or capital of the trust, or a fixed trust must hold all of the fixed entitlements to

the income or capital of the trust and non-fixed trusts must in turn hold fixed entitlements

to 50% or more of the income or capital of that fixed trust;

• The same persons holding fixed entitlements to the income and capital of the trust (or the

interposed fixed trust) must hold their entitlements at all times during the period;

• At the beginning of the loss year, individuals must not have had more than a 50% stake in

the income and capital of the trust; and

• Each non-fixed trust (other than an excepted trust) that holds a fixed entitlement must

itself not be prevented from utilising a loss and must not be required to work out its

taxable income and tax loss as described in section 266-30 of Schedule 2F of the ITAA

1936.

142 Section 266-50 of Schedule 2F of the ITAA 1936 143 Sections 269-50 and 269-55 of Schedule 2F of the ITAA 1936 144 Section 266-45 of Schedule 2F of the ITAA 1936



7.8 Non-fixed trusts

A trust that was a non-fixed trust at any time during the period commencing from the start of the

loss year to the end of the income year and was not an excepted trust can deduct losses only if

it satisfies all of the following:145

• The pattern of distributions test if the trust distributed income or capital in the income year

or within 2 months of its end and in at least one of the previous six income years;

146

• The pattern of distributions test in any prior income year in which the trust sought to use

tax losses;

147

• If there are individuals with more than a 50% stake in the income or capital of the trust,

those individuals must have held more than a 50% stake in the trust from the start of the

loss year to the end of the income year;

148

• A group must not begin to control the trust before the end of the income year.

and

149

If these tests are not passed, the trust must calculate its taxable income and tax loss for the

income year as described in section 267-60 of Schedule 2F of the ITAA 1936.

150

The trust may still be able to deduct part of the loss.

151

7.8.1 50% stake test

The 50% stake test is the same as described in above.

7.8.2 Pattern of distributions test

The pattern of distributions test is set out in Subdivision 269-D.

145 Section 267-20 of Schedule 2F of the ITAA 1936 146 Section 267-30 of Schedule 2F of the ITAA 1936; see also ATO Interpretive Decision 2003/174 147 Section 267-35 of Schedule 2F of the ITAA 1936 148 Section 267-40 of Schedule 2F of the ITAA 1936 149 Section 267-45 of Schedule 2F of the ITAA 1936 151 Section 267-50 of Schedule 2F of the ITAA 1936 151 Section 267-50 of Schedule 2F of the ITAA 1936



A trust passes the pattern of distributions test if:

• The trust distributed directly or indirectly to the same individuals, for their own benefit, a

greater than 50% share of all income distributed by the trust over a period commencing no

more than six years before the start of the income year; and

• The trust similarly distributed to the same individuals a greater than 50% share of all

capital distributed by the trust over a period commencing no more than six years before

the start of the income year,

where the persons receiving income and capital need not be the same. Expressed more

simply, the test is seeking to ensure that the majority of each distribution made by the trust in

the six year period was ultimately received by the same individuals (using this as a proxy for

majority ownership of a non-fixed trust).

If the share of income distributed to each individual varies from year to year, only the smallest

percentage distribution is taken into account.152

Example

Year 7 is the current income year. The loss year is Year 6. The trust made distributions of

income in Years 1, 2, 3, 4 and 7. It made no capital distributions. The income distributions

were made as follows:

Beneficiary % of income received

Year1 Year 2 Year 3 Year 4 Year 7

Jackie 30 60 20 50 10

Jerry 30 40 20 40 10

Mel 30 0 20 10 10

Bill 10 0 40 0 70




The end year is Year 7 plus two months (the current income year). The start year is Year 4,

being the year in which a distribution was made, closest to the loss year. The test year

distributions are accordingly as follows:

Beneficiary % of income received

Year 4 Year 7

Jackie 50 10

Jerry 40 10

Mel 10 10

Bill 0 70

To determine whether the pattern of distributions test has been passed, take into account, for

each beneficiary, only the lowest percentage distribution received — 10% each for Jackie, Jerry

and Mel, and 0% for Bill. As the final step, aggregate the minimum percentage distributions —

the aggregate, in this case, being 30%. On this basis, the trust fails the pattern of distributions

test, which calls for aggregated minimum percentage distributions to exceed 50%.

Note that as there were no capital distributions by the trust in Year 7, it was not possible to

apply the test to capital distributions.

7.8.3 Control

A group (comprising a person and her/his associates) is taken to control a non-fixed trust if,

directly or indirectly:153

• The group has power, by means of exercising a power of appointment or revocation or

otherwise, to obtain the beneficial enjoyment of the capital or income of the trust;

• The group is able to control the application of the income or capital of the trust;




• The group is capable of obtaining the beneficial enjoyment or control referred to above;

• The trustee is accustomed, under an obligation or might reasonably be expected to act in

accordance with the directions, instructions or wishes of the group;

• The group is able to remove the trustee; or

• The group acquires more than a 50% stake in the income or capital of the trust.

These concepts are very broad and, in most closely held trusts, there is some element of

control as defined above. So, the control test is looking to see whether such control changes

and is taken as a proxy for a change of ownership.

7.8.4 Income injection test

7.8.4.1 Introduction

Family trusts broadly have no restrictions on their ability to use losses. Excepted trusts (which

include family trusts) also have no restrictions on their use of losses.

However, an anti-avoidance test (the income injection test) in Division 270 applies to family

trusts to prevent income being injected into a trust in order to enable deductions to be claimed

as a means of obtaining a tax benefit, but not to other excepted trusts. The test also applies to

all other types of trusts.

7.8.4.2 Elements of the test

Broadly speaking, the income injection test will apply where an “outsider” to the trust that has

losses seeks to take advantage of the losses by providing a benefit to the trust (the injection of

income) in exchange for which the outsider receives a benefit (the generation of a deduction).

The income injection test does not apply to income injection schemes that take place wholly

within a family group. It also does not apply to complying superannuation funds, complying

approved deposit funds, pooled superannuation trusts, fixed unit trusts where all direct or

indirect unit holders are exempt from income tax, and deceased estates within a reasonable

administration period.



There are a number of elements that need to be met before the test applies. These are

explained below.

7.8.4.3 The trust must have an allowable deduction

The first element is that the trust must have an allowable deduction in the income year being

examined. This can include a deduction for a prior-year loss as well as current-year

deductions.154

7.8.4.4 There must be a scheme

For the test to apply, there also has to be a scheme under which the things set out below

happen.155

• The trust must derive assessable income in the income year (the “scheme assessable

income”).

• A person not relevantly connected with the trust (the outsider) must directly or indirectly

provide a benefit to the trustee or a beneficiary (or their associates).

• The trustee or a beneficiary (or associates) must directly or indirectly provide a benefit to

the outsider or an associate of the outsider. However, if the test is being applied to a

family trust and this return benefit is being provided only to an associate who is not an

outsider to the trust, this element will not be satisfied.

154 Paragraph 270-10(1)(a) of Schedule 2F of the ITAA 1936 155 Paragraph 270-10(1)(b) of Schedule 2F of the ITAA 1936



7.8.4.5 There must be a connection between the deduction and one or more of the things that happen under the scheme

The final element is that it must be reasonable to conclude that any one or more of the following

has happened under the scheme:156

• The scheme’s assessable income has been derived wholly or partly, but not merely

incidentally, because the deduction is allowable;

• The benefit has been provided to the trustee or beneficiary (or their associates) wholly or

partly, but not merely incidentally, because the deduction is allowable; or

• The benefit has been provided by the trustee or a beneficiary (or associate) wholly or

partly, but not merely incidentally, because the deduction is allowable.

Whether a benefit has been provided merely incidentally because a deduction is allowable to

the trust depends on the particular facts and circumstances surrounding the scheme entered in

to. Many of the terms used above are similar to the phrases used in the general anti-avoidance

rules in Part IVA of the ITAA 1936 and would have the same meanings as in those rules.

7.8.4.6 Examples

The following example is drawn from the ATO’s website on the application of the income

injection test. The ATO provides other examples, which readers may refer to for further

elaboration.

156 Paragraph 270-10(1)(c) of Schedule 2F of the ITAA 1936



Example

The Farmer Family Discretionary Trust No. 1 was established to undertake a sheep grazing

business with the primary purpose of selling wool. The trustee is Mr Merino Farmer and the

beneficiaries include himself, his wife, their children and grandchildren. Other beneficiaries

include any other entities that may provide benefits from time to time to these persons.

The No. 1 Trust (income trust) has a history of profitable operations.

Merino's eldest son Zenith wants to expand the business by becoming a manufacturer of

woollen clothes. However, the business venture carries some potential risks and high start-up

costs in the early years. As a result of the potential risks and the expected losses in the early

years from the high start-up costs, it was decided to establish a separate trust (The Farmer

Discretionary Trust No. 2) to undertake the manufacturing business. The beneficiaries of this

trust include the same beneficiaries of the No. 1 Trust, as well as the No. 1 Trust.

The No. 2 Trust (loss trust) incurs losses in its first year of trading. During the same year, the

No. 1 Trust (income trust) derived assessable income leaving it with sufficient taxable income to

cover the losses of the No. 2 Trust.

Losses cannot be distributed from the No. 2 Trust to the No. 1 Trust. However, since the No. 2

Trust is a beneficiary of the No. 1 Trust, distributions of income from the No. 1 Trust can be

made to the No. 2 Trust to absorb losses it incurs.

Will the distribution be treated as an injection of income into the No. 2 Trust and, therefore, fail

the income injection test?

The first element is satisfied since a deduction is available to the No. 2 Trust for the income

year.

For the second element to be satisfied, there must be a scheme under which the following

happen:

• The loss trust must derive an amount of assessable income. The No. 2 Trust has derived

an amount of assessable income by way of the distribution it received from the No. 1

Trust;

• An outsider to the loss trust must provide, directly or indirectly, a benefit to the trust. The

No. 1 Trust is an outsider to the No. 2 trust as per the definition in subsection 270-25(2)

and has provided a benefit by way of an allocation of a distribution to the No. 2 Trust; and



• The loss trust must provide a benefit, directly or indirectly, to the outsider or to an

associate of the outsider. If the allocation of the net income from the No. 1 Trust to the

No. 2 Trust is used by the No. 2 Trust to fund a distribution to its beneficiaries, this

element will be satisfied. That is, a benefit has been provided to associates of the No. 1

Trust (same beneficiaries) by way of a tax-free (tax-preferred) distribution. (See also

paragraph 10.31 of the Explanatory Memorandum.)

If the distribution from the No.1 Trust was not used to make a distribution to the beneficiaries of

the No. 2 Trust, but instead was accumulated, the income injection test would not apply since

no benefit would have been given to an outsider, or associate of the outsider. However, if a

benefit did subsequently flow out of the No. 2 Trust under the same scheme, the income

injection test may apply. There is no time limit on the benefits flowing to the outsider.

If the beneficiary had a fixed entitlement in the loss trust and the net income distribution it

received was accumulated in the trust, there could be said to be a benefit provided to those

beneficiaries because of the increase in value of the beneficiaries’ interest in the trust – see

paragraph 10.32 of chapter 10 of the Explanatory Memorandum of Schedule 2F to the ITAA

1936 - Taxation Laws Amendment (Trust Loss and other Deductions) Act 1998.

The third element is whether it is reasonable to conclude that the No. 1 Trust distributed to the

No. 2 Trust, wholly or partly, but not merely incidentally because the No. 2 Trust had losses and

they would be deductible against the income distribution. This reasonable conclusion will

ultimately depend on the particular facts and circumstances of each individual case.

If, for example, distributions made to the No. 2 Trust are sufficient only to absorb losses

incurred by it, before any consideration is given to making distributions to any of the other

beneficiaries of the No. 1 Trust, (so that effectively it is a means of distributing the income of the

No. 1 Trust to its beneficiaries in a tax-free form by passing that income through the No. 2

Trust), it would be reasonable to conclude the distribution was made because a deduction was

available. Therefore, the No. 2 Trust would fail the income injection test.

If they fail the income injection test, the scheme’s assessable income is fully assessable to the

No. 2 Trust, but its losses will still be available to be carried forward to be offset against income

it may derive in a later year.



8. Restricting tax deductions for related party debt

In the 2011-2012 Budget, the Federal Government announced that it would amend the current

income tax treatment in relation to bad debts which are written off between related parties

outside of a consolidated group.

The announcements followed a number of high profile decisions of the Full Federal Court which

allowed significant revenue deductions for inter-company related party debts written off as

bad.157

As a consequence of the announcements, the Treasury released a discussion paper entitled,

Improving the tax treatment of bad debts in related party financing, on 16 July 2012, which

detailed the Federal Government’s proposed amendments and called for feedback from

interested stakeholders. The discussion paper highlighted the asymmetry that exists where a

related party debt is written off as bad and the creditor obtains a revenue deduction in respect of

the write off. In this regard, the discussion paper noted that, whilst the creditor may obtain a

revenue deduction for the write-off, no amount is generally included in the debtor’s assessable

income. Rather, the commercial debt forgiveness rules in Division 245 ordinarily apply to reduce

the debtor’s tax attributes in accordance with Subdivision 245-E.

The proposed amendments are designed to redress this perceived asymmetry.

8.1 Current Law

In order to appreciate the impact of the proposed amendments, it is first necessary to examine

the current position in relation to obtaining revenue deductions for writing off a debt as bad. In

this regard, the current position differs depending on whether the debt is subject to Australia’s

Taxation of Financial Arrangements (TOFA) regime.

157 See Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49; Commissioner of Taxation v BHP Billiton Finance Limited [2010] FCAFC 25



8.1.1 Debts which are outside of the TOFA regime

Outside of the TOFA regime, a creditor may currently obtain a revenue deduction in respect of

the write-off of a related party debt under section 25-35 or section 8-1.

Relevantly, a revenue deduction should be available under section 25-35 for a debt that is

written off as bad where either:

• The creditor has included an amount in its assessable income in respect of the debt;

and/or

• The debt is in respect of money that the creditor lent in the ordinary course of its business

of lending money.

A revenue deduction may also be available under section 8-1 to the extent that any loss arising

on the write-off of the debt was incurred in gaining or producing the creditor’s assessable

income, or was necessarily incurred by the creditor in carrying on a business for the purpose of

gaining or producing assessable income. This will be the case unless the loss is considered

capital or capital in nature.

Practically, the existence of the above sections means that a creditor who is engaged in the

ordinary business of providing loans or financial accommodation may be entitled to a revenue

deduction in respect of debts that are written off as bad (whether or not those debts are with

related parties). This was highlighted in the case of Commissioner of Taxation v BHP Billiton

Finance Limited [2010] FCAFC 25, where Edmonds J (with whom the other members of the

Federal Court concurred) allowed revenue deductions in respect of loans that had been

advanced by a dedicated in-house finance vehicle to a number of related parties in order to

facilitate the acquisition of depreciating assets.

Note

The Commissioner sets out his general views in relation to revenue deductions for bad debts in

Taxation Ruling TR 92/18 (TR 92/18). Relevantly, the Commissioner notes that a debt may be

written off as bad where, on an objective view of the facts, or on the probabilities existing at the

time the debt is alleged to have become bad, there is little or no likelihood of the debt being

recovered.

TR 92/18 also provides guidance as to the circumstances in which a debt may be considered to

arise in the ordinary course of a taxpayer’s business of money-lending. In this regard, the ruling



states that a taxpayer will be considered to carry on a business of money-lending where the

taxpayer lends money to certain classes of borrowers and does so in a businesslike manner

with a view to yielding a profit from its lending activities. Importantly, TR 92/18 indicates that it is

not necessary for a taxpayer to be ready and willing to lend to the public at large in order to be

treated as a money-lender.

However, it also appears that lending activities which are merely incidental or ancillary to some

other principal enterprise carried on by the taxpayer will not be sufficient to characterise the

taxpayer as a money-lender.

8.1.2 Debts which fall within the TOFA regime

Certain taxpayers may be subject to Australia’s TOFA regime in relation to some or all of their

financial arrangements (including related party debts). Where the TOFA regime applies, gains

and losses on financial arrangements are generally taxed exclusively under that regime.158

In the context of deductions for bad debts owing by related parties, the TOFA regime generally

preserves the requirements in section 25-35. Accordingly, in circumstances where such debts

are written off as bad by the creditor, a deduction should only be available under the TOFA

regime to the extent that:

• The amount which is written off was previously included in the creditor’s assessable

income; and/or

• The relevant debt was made in the ordinary course of the creditor’s business of money-

lending.

Notwithstanding the above, if the creditor elects to apply the fair value method under the TOFA

regime, a deduction may be allowed for losses incurred in restating related party bad debts to

their fair market value (or otherwise impairing such debts) in accordance with an applicable

accounting framework. The availability of this deduction is not affected by similar requirements

to those contained in section 25-35.

158 Section 230-15



For completeness, where the debtor is subject to the TOFA regime in respect of the relevant

debt, any gain arising to the debtor on forgiveness of the debt under the TOFA regime will

generally be reduced by the net forgiven amount picked up under Division 245.159

8.2 Impact of the proposed amendments

That is,

Division 245 effectively takes precedence over the TOFA regime.

Under the proposed amendments, a creditor will be denied a tax deduction on revenue account

for writing off a debt as bad where:

• The borrower is a related party of the creditor and is not a member of the same tax

consolidated group; and

• The amount that gives rise to the bad debt has not previously been included in the

creditor’s assessable income.

If the above requirements are satisfied, the deduction will be denied, irrespective of whether it is

being claimed under section 8-1, section 25-35 or the TOFA regime. Deductions for losses

relating to the impairment of bad debts under the fair value method will also be denied where

the borrower is a related party and the amount that is impaired has not previously been included

in the creditor’s assessable income.

Where an amount of a deduction is denied, a capital loss will be available to the creditor in

respect of the bad debt. The creditor will be able to offset this loss against capital (but not

revenue) gains derived by the creditor.

Additionally, the debtor will not be required to recognise any amount of assessable income if the

bad debt is subsequently forgiven by the creditor. In this regard, it is proposed to amend the

commercial debt forgiveness provisions in Division 245 such that these provisions will apply in

lieu of any provision which would otherwise include an amount in the debtor’s assessable

income on forgiveness of the debt. The only exception to this will be for cases where

adjustments to the debtor’s taxable income are required under Division 243 (which deals with

limited recourse debts that are used to fund depreciating assets).

159 Section 230-470



8.2.1 What is a related party?

As discussed above, the proposed amendments will only apply to deductions for bad debts in

respect of loans with a related party. For these purposes, it is proposed to insert a definition of

related party which includes:

• An associate (as defined in section 318 of the ITAA 1936); and

• An associate entity (as defined in section 820-905).

Specifically, the definition of related party is intended to ensure that the proposed amendments

will apply to debts arising in the context of the following relationships:

• The creditor is a partner of the debtor;

• One party, whether the creditor or the debtor (together with that party’s affiliates) is able to

sufficiently influence, directly or indirectly, the affairs of the other party; or is entitled to

acquire a majority voting interest in the other party; and

• An entity (together with its affiliates) is able to sufficiently influence the affairs of both the

creditor and debtor; or is entitled to acquire a majority voting interest in the creditor and

debtor.

The principle of this approach is to exclude immaterial relationships (for example, where a

person has a very insignificant shareholding) from the scope of the proposed amendments but

include situations where a party has significant ownership and control over another party.

Note

In its submission on the proposed amendments, the Institute argued (amongst other things) that

the related party test applicable under the proposed amendments is too broad. In this regard, it

was argued that a test based on majority voting interest sets too low a threshold for application

of the rules, and the concept of sufficient influence could inappropriately treat lenders as related

parties merely because of influence they hold in that capacity.

Consequently, the Institute advocated for the proposed amendments to apply only in

circumstances where the creditor and the debtor are 100% common owned. Alternatively, in the

event 100% common ownership is considered to be prohibitive, the Institute suggested the

related party test could be limited such that it would only apply where significant common



ownership exists between the creditor and debtor. Significant common ownership implies an

ownership interest of at least 80% (as under the scrip for scrip rules in Subdivision 124-M).

The detailed submissions made by the Institute in relation to this and other aspects of the

proposed amendments are available via the following link:

http://www.charteredaccountants.com.au/Industry-Topics/Tax/Exposure-drafts-and-

submissions/Submissions/Treasury/140812-Submission-on-improving-the-tax-treatment-of-bad-

debts-in-related-party-financing.aspx

8.2.2 Application date

As announced, the proposed amendments are intended to have effect for related party debts

which are written off as bad from 7.30 pm (AEST) on 8 May 2012.

Example

Fin Co is a company incorporated in Australia. Fin Co’s principal business involves the provision

of loans to external and related party debtors on interest-bearing terms.

Fin Co has not chosen to form a tax consolidated group for Australian income tax purposes but

has a number of wholly-owned Australian subsidiaries which conduct money lending activities in

continental Europe via their foreign branches. Fin Co has funded one of these subsidiaries,

Liberty Co, with an interest-bearing loan of $10 million. Interest accrues annually in respect of

the loan and is calculated at an arm’s length interest rate. Since the provision of the loan by Fin

Co, accrued interest of $1,600,000 has been included in Fin Co’s assessable income in relation

to the loan.

During the 2013 Tax Year, Fin Co determined that the loan (and the amounts of accrued

interest) would not be recoverable due to the significant downturn in the European lending

market. Accordingly, Fin Co decided to write off the loan principal and accrued interest

components as bad debts (in compliance with the approach set out in TR 92/18). Fin Co

subsequently sought to claim revenue deductions under section 25-35 in relation to the write-

offs.

Given that the write-offs occurred post 8 May 2012, the proposed amendments should apply to

the write-offs. Consequently, Fin Co should only be entitled to a revenue deduction in respect of

http://www.charteredaccountants.com.au/Industry-Topics/Tax/Exposure-drafts-and-submissions/Submissions/Treasury/140812-Submission-on-improving-the-tax-treatment-of-bad-debts-in-related-party-financing.aspx�





the write-off of the accrued interest component (on the basis that this component has previously

been assessed to Fin Co). Any revenue deduction arising in respect of the write off of the loan

principal would be denied under the proposed amendments as the loan is between related

parties that are not members of the same tax consolidated group and the amount of the loan

principal has not otherwise been included in Fin Co’s assessable income.

However, pursuant to the proposed amendments, Fin Co should still be entitled to claim a

capital loss in respect of the write-off of the loan principal component. Furthermore, no amount

should be included in Liberty Co’s assessable income where the loan is subsequently forgiven

by Fin Co. Rather, the commercial debt forgiveness regime under Division 245 should apply to

reduce the Australian tax attributes of Liberty Co by reference to the value of the debt forgiven.

This should be the case, irrespective of the fact that Liberty Co is itself engaged in the business

of lending money and may ordinarily be regarded as deriving a revenue gain in connection with

the forgiveness of the loan.160

160 See for example the discussion in Federal Commissioner of Taxation v Unilever Australia Securities Ltd 95 ATC 4117

Documents

Tax losses – carry-backs and carry-forwards, issues and ... · PDF filecarry-forwards, issues and challenges . June 2013 . ... 4.6.7 Calculation of the loss carry-back tax offset