Chapter 4: Loss carry forward

The treatment of carry forward losses departs from the benchmark of refundability

The Working Group has, in this report, considered the current tax treatment of losses against a benchmark of full refundability. Loss carry back is one means of moving closer to that benchmark. Targeted carry back could encourage risk taking and innovation and provide timely cash flow to businesses during economic downturns, acting as an automatic stabiliser.

In this chapter, we turn our attention to losses that are carried forward. There are two ways in which the treatment of carry forward losses departs from the benchmark of immediate refundability. First, losses carried forward can only be deducted against future taxable income if certain integrity rules are satisfied. Secondly, as losses can only be carried forward at their nominal amount, the value of losses to taxpayers erodes over time.

Overlaying both of these considerations is the fact that losses that are carried forward are often never able to be used. Even businesses that satisfy the integrity rules face the very real possibility of never generating sufficient future income to fully absorb the losses.

Facilitating adaptation and innovation should be paramount

There is no single, coherent policy that governs the tax treatment of carry forward losses. Our current system attempts to negotiate various competing policy considerations, not least of which is the impact the treatment of losses has on government revenues.

A key justification for loss integrity rules is that they remove incentives for 'tax driven' activities involving entities with losses. The challenge is how to frame these rules to discourage tax driven practices without impacting adversely on legitimate commercial activities.

The Working Group considers that the tax treatment of losses should reflect the broader policy that the tax system should not impede businesses from innovating or from adapting to changes in economic circumstances. Maintaining integrity in the tax system must be carefully balanced against the risk of stifling innovation.

The remainder of this chapter evaluates the current tax treatment of carry forward losses and suggests possible models for reform that reflect this broader policy consideration.

The loss integrity provisions have evolved over time

The rules governing the utilisation of tax losses have evolved considerably over time. Although tax losses can now be carried forward indefinitely, that is a relatively recent development. It was extended to primary producers in 1966 and was given general application in 1990. Before that time, most companies were only entitled to a deduction for losses from the preceding seven years. In the early decades of the federal income tax, losses could only be carried forward for four years.

Prior to 1944, the time limitations were the only restrictions that were imposed on the ability of companies to carry forward their tax losses to offset against future income. In 1944, the continuity of ownership test (COT) was established for private companies to address 'loss trafficking', that is, purchasing companies in order to gain a tax advantage from the carry forward losses.¹⁸ Loss trafficking was described by the Treasurer at the time as the practice 'of buying up shares in practically defunct companies and then operating those companies for purposes other than those for which they were originally registered'.¹⁹ The COT ensures that, broadly, a company cannot deduct its losses if there has been change in the identity of 50 per cent or more of its ultimate owners in the period since the loss was incurred.

The same business test (SBT) was first introduced in 1965 at a time when the COT requirements were being strengthened. It was intended to serve as a concession to the COT, aimed at ensuring that the COT did not interfere with bona fide attempts to take over, and rehabilitate, ailing businesses.²⁰

For consolidated groups, even where the COT and SBT are satisfied, the available fraction rule generally applies to spread the use of the losses transferred into the consolidated group over time, referable to the asset base of the acquired entity. This recognises the potentially more diverse nature of businesses within a consolidated group and applies a formulaic base for utilising new losses coming into the consolidated group for integrity purposes.

Other integrity rules operate alongside the COT and SBT to target specific behaviour that could lead to loss duplication, whereby multiple losses stem from one economic loss. Overlaying all of these rules is the general anti-avoidance rule contained in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) and other rules to target behaviour aimed at reducing tax liabilities.²¹

A timeline of the changes to the loss integrity rules is set out at Appendix E.

The continuity of ownership test

The COT is satisfied if the same persons have more than 50 per cent of the voting power, rights to dividends and rights to capital distributions at all times during the ownership period.²²

The ownership test period is generally the period between the start of the year in which the loss was incurred (the loss year) to the end of the income year in which the loss is sought to be recouped (the claim year). The point i
n time just before the COT is failed within the ownership test period is then used to compare the business to the SBT test period. A number of additional rules affect the application of the COT.

The same business test

A company satisfies the SBT if it carries on the same business in the claim year as it carried on immediately before it failed the COT. The SBT is intended to ensure continuity of the whole of the business activities carried on by the taxpayer just before it failed the COT and the whole of the business activities carried on by the taxpayer during the period of recoupment.²³

However, a company will not satisfy the SBT if it:

• derives assessable income from a type of business of a kind that it did not carry on before the test time (new business test); or
• derives assessable income from a transaction of a kind that it had not previously entered into in the course of its business before the test time (new transaction test).

The new business test and new transaction test are described as 'negative tests' that look to see whether the component undertakings or enterprises and the transactions of the overall business are of the same kind as previously undertaken.²⁴

Removing COT and SBT provides de facto loss refundability

The removal of the COT and SBT would move the treatment of losses closer to the benchmark of refundability. By removing the key restrictions on loss utilisation, the removal of the COT would increase the overall amount of losses that companies are able to put to use. Under the current system, losses incurred by a company that subsequently fails the COT and SBT are effectively trapped or wasted. The removal of the COT would also enhance the ability of company shareholders to be compensated for a company's tax losses by selling the shares at a price that reflects the value of the losses. This is illustrated in the following example.

As the example demonstrates, removing or relaxing the COT would, in theory, facilitate transactions to allow losses and profits in different businesses to be offset.

The Working Group considered such an approach but concluded that it had disadvantages relative to other options for improving loss recoupment. The Working Group has ruled out recommending refundability of losses as a viable option for the foreseeable future because of its revenue impact. Creating a tolerance for de facto refundability through the trading in loss entities is also therefore ruled out by the Working Group.

Most comparable tax jurisdictions have a COT

The removal of COT would theoretically enable the trading in loss entities in cases where there may be no other legitimate commercial motivation for a share sale transaction. This issue is particularly significant when the treatment of losses in Australia is compared with comparable tax regimes.

The Working Group notes that OECD countries typically use a similar provision to the COT as one component of their loss integrity rules. In a recent OECD report, a COT was a feature of 16 of the 17 countries surveyed, with the required rate of continuity ranging from 30 to 75 per cent.²⁵

The Working Group considers that introducing substantially less restrictive rules could create an incentive for multinational companies to bring their tax losses into Australia, putting greater pressure on transfer pricing rules and the thin capitalisation regime as revenue protection measures. This concern is shared by the OECD which noted that the opportunities for taxpayers to exploit differences among country rules are a source of tax risk.²⁶

The key features of the loss integrity rules of the surveyed OECD member countries are summarised in the table below.

Country	Restrictions	Exceptions
Australia	Change of ownership and activity	Ownership tracing concessions apply to widely held companies
Austria	Change of ownership and activity	Other (non-tax) considerations
Canada	Change of ownership and activity	Acquisition of corporations business activities
Denmark	Change of ownership and other criteria	Internal reorganisations
France	Change of activity	No
Germany	Change of ownership	Other (non-tax) considerations
Ireland	Change of ownership and activity	Internal reorganisations
Italy	Change of ownership and activity, mergers	Other (non-tax) considerations
Mexico	Change of ownership and activity, mergers	Inheritance, donation, internal reorganisation, merger and split off that are not considered alienations for tax purposes
Netherlands	Change of ownership and activity	Lack of tax avoidance motive
New Zealand	Change of ownership	Ownership tracing concessions internal reorganisations
Norway	Change of ownership and other criteria	Lack of tax avoidance motive
Spain	Change of ownership	Internal reorganisations
Sweden	Change of ownership	Internal reorganisations
Switzerland	Change of ownership and restart of activity	Financial restructurings
United Kingdom	Change of ownership and activity	Internal reorganisations
United States	Change of ownership	No

Source: Table adapted from OECD, Corporate Loss Utilisation through Aggressive Tax Planning (2011), p.34.

Changes to the SBT need to be considered

The SBT too narrowly prescribes the types of activities that a company can undertake without forfeiting its tax losses. In particular, the new business test and new transaction test (the negative tests) may create incentives for companies that have undergone a substantial ownership change to remain 'locked in' to an inefficient business model in order to avoid the risk of forfeiting those tax losses.

The Working Group considered three models for addressing deficiencies in the SBT:

• replacing it with a dominant purpose test;
• retaining the SBT but modifying it so that it better aligns with the modern business environment; and
• introducing a statutory drip-feed as a replacement, or alternative to, th
  e same business test.

Each of these options is considered in detail below.

A dominant purpose test would be uncertain in its application

Under a dominant purpose test, carry forward tax losses would not be utilised where the tax losses were obtained through a transaction undertaken for the dominant purpose of obtaining a tax loss.

A dominant purpose test would require an assessment of the purpose of a transaction and companies may be uncertain about its application. Even where a dominant purpose test is established using objective criteria, it would require the development of new interpretative guidance on its operation. Also, the current SBT performs (or is intended to perform) a similar function to a dominant purpose test. Like a dominant purpose test, the SBT is essentially a mechanism for distinguishing between commercial and tax-driven transactions. As taxpayers, tax practitioners and administrators are familiar with the current regime, modifying the SBT to accord with the current economic environment is likely to involve lower transitional costs than the establishment of a new dominant purpose test.

Carrying on the same business is an appropriate measure of commerciality

Although there are deficiencies in the SBT in its current form, it is effective in reducing the risks to the revenue including from inappropriate trading in losses. There is value in retaining a same business test as a means of determining whether carry forward loss can be used. However, the SBT should be modified so that it better reflects the types of changes that are commonly made to businesses to restore or enhance profitability.

The Working Group considers that there is scope to achieve substantial improvements to the loss integrity provisions by recasting the language of the SBT. The key design consideration in developing indicators of similarity is that the rule should tolerate difference to the extent that it is consistent with genuine attempts to rehabilitate an ailing business. It should also have regard to the current dynamic business environment which requires businesses to change and adapt.

Removing the negative tests will better allow companies to adapt and change

One component of reforms to the SBT would be to remove the two negative tests. Where a company can meet the positive same business test, which signifies that the overarching business is the same, the company would be able to deduct previous tax losses from assessable income, despite a new transaction or new businesses generating assessable income. It would be expected that if the magnitude of the impact of the new business or new transaction was increased, then there would be a subsequent failure of the same business test.

The two negative tests are intended to prevent the injection of income into a company (moving a profitable arm of a business into the loss making company and shielding profits). However, the two negative tests do not depend on the existence of a purpose of tax avoidance for their operation and are overly restrictive.

It follows that, as a first step, recasting the SBT to more closely reflect modern business realities should involve removing the two restrictive negative tests, the new business test and new transaction test.

The positive limb of the SBT allows for organic growth and adaptation

In the context of the SBT, the word 'same' is interpreted to mean 'identical' and not merely 'similar'.²⁷ It is this aspect of the SBT that is the subject of most criticism. The Working Group considers that a better model for a modified SBT²⁸ is that it should facilitate, and not hinder, genuine and creative attempts to enhance profitability.

The Working Group notes that the test has generally been applied by the courts and the Tax Office with some regard to business reality. The identity requirement was first advanced by Gibbs J in Avondale Motors (Parts) Pty Ltd v FC of T.²⁹ In that judgment, it was stressed that a business could be the same notwithstanding that there are changes in the way it is carried on. It was contemplated that organic changes in a business were permissible.

The Working Group has also noted that statements by the Commissioner of Taxation show a similar tolerance for 'organic' changes:

The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail the same business test provided the business retains its identity; nor would discarding, in the ordinary way, portions of its old operations. But if, through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by the either the acquisition or the loss of activities on a considerable scale a company may fail the test.³⁰

Instead of being replaced, the positive limb of the SBT could be retained as the primary test of whether a company that has failed COT should be able to use its losses. This test could ensure the appropriate treatment in most cases where the changes to the business came about because of genuine attempts to restore or enhance its profitability or to adapt to changes (or anticipated changes) to the business environment.

A further advantage of retaining the positive limb of the SBT as part of any amended test is that the existing body of case law and ATO opinion would continue to be a valuable source of guidance to companies seeking certainty as to the continued availability of their losses.

The positive limb does not produce the appropriate outcome in all cases

In its consultation with the stakeholders, the Working Group has identified a range of situations where a company would fail the positive limb of the SBT even though the 'trigger' for the COT failure (such as a takeover) was motivated by genuine commercial considerations.

Having regard to these considerations, the Working Group consulted with stakeholders on a model for improving the same business test. Under this model, a company which fails the positive limb of the SBT would nevertheless pass the SBT if it carries on 'predominantly' or 'substantially' the same business having regard to a range of factors or indicators that would be set out in the law. These factors would reflect changes that are made to businesses for valid commercial reasons which might otherwise trigger a failure in the positive limb of the SBT. The factors would operate as alternatives, not cumulative requirements, and no particular weighting would be applied to one factor over another.

The Working Group considers the following factors could be incorporated into the modified test or be the basis for determining the meaning of 'predominantly' or 'substantially':

• the extent to which the same physical and intangible assets — including goodwill — are used for the purposes of producing assessable income;
• whether changes to the business are of a kind that might reasonably be expected to be adopted by a similarly placed business (for example, changes to the business to take advantage of unforeseen business opportunities); or
• the extent to which the company continues to generate a specified proportion of the total assessable income for the year from the same source.

The following examples illustrates how (and why), a modified SBT could lead to different outcomes than that provided for under the current law. The examples are extracted from the ATO's Taxation Ruling, TR 1999/9.

Reforming the SBT for new losses only may increase complexity

In developing this report, the Working Group's focus has been on reform options that relieve the taxation burden on new investments. This emphasis suggests that reforms should be given prospective application. While this may be the case for other reforms discussed in this report, the situation with the proposal to modify the SBT may prove to be more complex.

Adopting a prospective application date for changes to the SBT would mean that a company that has existing losses as at the start date and then subsequently incurs further losses would be subject to two concurrent loss integrity regimes. This would lead to added complexity and compliance costs. The Working Group encourages the Government, in the event that it pursues reforms to the SBT, to give careful consideration to the appropriate application date. One option would be to apply the modified SBT to all losses of companies that would pass the existing SBT at the commencement of the new rules. Another option would be apply the modified SBT to companies that pass the COT as at that date.

A statutory drip-feed may complement a modified SBT

The interim report suggested that a drip-feed mechanism akin to the available fraction rule used for consolidation could replace the COT and SBT. The Working Group has concluded that the COT should be preserved as the primary safeguard against loss trafficking and does not consider a general drip-feed approach to be a viable option. However, an alternative reform to the loss integrity measures might be to retain the COT in its current form and adopt a drip-feed mechanism in place of the current SBT.

A drip-feed mechanism lacks a clear rationale other than that it would provide certainty that companies would eventually be able to utilise their tax losses and may provide a means of reducing the incentive for loss trading if a sufficiently low rate of utilisation was enforced.

The replacement of SBT with a drip-feed mechanism may result in some companies utilising tax losses more slowly than they would have under the current integrity rules. This may be considered inequitable and undesirable, especially by affected companies.

The adoption of a drip-feed mechanism raises a number of issues in terms of design and practical administration. One issue relates to the choice of an appropriate rate of utilisation. A single statutory rate applicable to all taxpayers would have the advantage of reducing complexity and being easier to administer. However, such a provision would be arbitrary and would not have proper regard to the taxpayer's individual circumstances. On the other hand, a rate that has regard to individual circumstances is likely to involve high compliance and administration costs. For example, it may require costly valuations to be undertaken.

A more pressing challenge in the design of a drip-feed mechanism is the need to ensure that it minimises the incentive for tax-motivated trading in companies with tax losses. The need to address 'loss trafficking' suggests that the rate of utilisation under a drip-feed should be relatively low. However, setting a low rate would increase the disadvantage to a company that would have passed the SBT.

In light of its concerns, the Working Group considers that SBT should not be replaced with a drip-feed mechanism. However, there may be merit in making a drip-feed available to companies on an 'opt-in' basis in conjunction with a simple 'continuity of business' rule. That is, a company which has failed COT could be allowed to make a binding election either to deduct losses at a statutory drip-feed rate (subject to there being a continuity of business) or to continue to be subject to the SBT. A company that so elected would enjoy more certainty as to its ability to utilise its losses and avoid the compliance costs associated with the same business test.

For ease of compliance and administration, a drip-feed mechanism offered as an alternative to the SBT could be calculated on single statutory rate applicable to all companies. A recovery rate of ten per cent per annum over ten years may be reasonable.

A modified SBT would assist start-up companies and companies facing a temporary shock

The worked examples described earlier illustrate the situations in which companies may benefit from a modified SBT.

The Working Group has considered uplifting losses

The Business Tax Working Group's interim report identified that where losses are carried forward to be deducted against future income, the value of the tax loss carried forward erodes over time. As a result, the taxpayer will be deprived of the full value of the loss if it takes a number of years to generate sufficient income to offset the loss (assuming the integrity tests are met). This is a departure from the benchmark of refundability of tax losses.

A possible reform for the tax treatment of losses would therefore be to apply an uplift factor to tax losses as they are carried forward. The Working Group made it clear in its interim report that this would only apply to 'new' losses and not to the existing stock of losses. This is to ensure that reforms properly target removing the distortions on future decision making.³¹

Uplifting losses would move the treatment of losses closer to the immediate refundability benchmark. The uplift would preserve the value of the loss which is able to be used (deducted against future assessable income). It would therefore be of greatest benefit to those companies that make a tax loss but expect to generate taxable income in future years and are able to satisfy the relevant integrity tests.

An uplift would be of most benefit to a company that incurs significant expenditure while only generating limited income in its early years of operation, but subsequently becomes profitable. An uplift would allow such a company to shield a greater proportion of its future income against tax. Companies likely to fit this scenario may include start-ups³², explorers and companies undertaking infrastructure projects.³³ For these companies, a loss uplift would increase the projected after-tax returns on the investment.

An uplift would also benefit a company which suffers a temporary shock as it would ensure that the value of tax losses is maintained in the period leading up to its return to profitability. This would also be relevant for those medium to large businesses with limited access to loss carry back because they have run down their franking account balances or their loss exceeds a quantitative cap.

Uplift would not provide a cash flow benefit to struggling businesses at the time they are incurring losses.

Loss uplift should be targeted and sustainable

Based on the benchmark of refundability, there is justification for a loss uplift that continues indefinitely at a rate that preserves the value of losses whilst having regard to each company's particular circumstances.

However, the Working Group considered that any uplift should be relatively simple to administer and sustainable in the long term.

The Working Group has consulted on a number of key factors in the design of a loss uplift. They are:

• the choice of the uplift rate;
• the scope of the uplift or the types of losses to which it would be available;
• the duration of the uplift; and
• simplicity of administration and compliance.

An uplift factor of the long term bond rate is appropriate

The interim report suggested that the long term (ten-year) government bond rate may be appropriate as the uplift rate. In the course of its consultation with stakeholders, the Working Group also considered alternative uplift rates. One view that emerged in consultation was that the most appropriate rate of uplift would be one which reflects each company's cost of capital. Another view is that the consumer price index (CPI) would most accurately ensure that the value of a loss is maintained.

Having considered the various options, the Working Group considers that the long-term government bond rate should be preferred. Alternatives which reflect the company's individual circumstances such as its cost of capital would be uncertain in their application and difficult to calculate. The CPI, while having the advantage of ease of calculation, does not accurately capture the time value of money. By contrast, the long-term bond rate can be viewed as the cost of the Government retaining the value of a loss as it is carried forward rather than immediately refunding it in the year it is incurred. That is, it treats the value of the tax loss like a government security, and offers the same return the taxpayer would earn on an alternative government security.

The Working Group acknowledges that a disadvantage of an uplift rate equal to the government bond rate is that it does not recognise the remaining risk that the losses may not ever able to be accessed (for example, in the event the business defaults or fails the COT or SBT). However, the Working Group believes that this rate achieves the appropriate balance between moving closer to the immediate refundability benchmark while maintaining simplicity and sustainability.

The long term government bond rate also has certain practical advantages. As it is a single rate applicable to all companies, it would impose a low cost of compliance and administration. It would also align with the Government's announcement in the 2011-12 Budget that tax losses from designated infrastructure projects can be uplifted at the long term Government bond rate.

Uplifting revenue losses is a higher priority

In light of its broader objectives and the need to ensure revenue neutrality, the Working Group does not regard the uplifting of capital losses as a priority. The approach that is adopted should be designed to assist businesses that, after a period of making losses, start (or resume) generating positive revenue flows rather than irregular capital profits. Companies in this position would not benefit from the uplifting of capital losses which will, in any event, be quarantined. This approach would align with business priorities because companies (particularly those in a net loss position) are less often in a position to realise capital gains against which to offset capital losses.

While there is some theoretical justification for applying uplift to capital losses, it is also arguable that it is inappropriate considering the nature of the capital gains tax (CGT) regime. A particular concern with uplifting capital losses is its consistency with 'quarantining', that is, the requirement that capital losses can only be offset against capital gains. The quarantining of capital gains and losses reflects the concessional nature of CGT, particularly the fact that CGT is levied on a realisation basis and can therefore be de
ferred indefinitely.

The Working Group understands that providing an uplift for capital losses may render quarantining ineffective in some cases where capital losses can be realised and uplifted. It would remove the disincentive to realise capital losses early where there are no realised capital gains against which they can be offset.

It is also noted that while the quarantining rules only allow capital losses to be offset against capital gains, it would not prevent uplifted revenue losses from being deducted from net capital gains. This would give companies some scope to shelter capital gains from tax by using uplifted revenue losses.

A time limited uplift is the most sustainable alternative

The Working Group considers, in the absence of a time limitation, that the impact of uplift to government revenue would be unsustainable in the medium to long term. The Working Group considered two alternatives for maintaining revenue neutrality while ensuring that it targets those businesses which would benefit most from the uplift.

One alternative for limiting the impact of loss uplift is to allow uplift for a fixed period, with the condition that losses would become unusable at the expiry of that period.

After consulting with stakeholders, the Working Group has concluded that an uplift that involves forfeiture of losses would not be welcomed by the business community and should not be adopted. The Working Group considers that the forfeiture of losses would worsen the effects on investment of the existing asymmetric treatment of gains and losses.

The Working Group's preferred model is that tax losses should be able to be uplifted for a period of three to five years and then carried forward indefinitely without further uplift. A three to five year period would be of assistance to start-ups and other businesses that carry forward losses over a longer period. It would also assist those companies that are affected by the proposed quantitative cap or franking account limit on loss carry back.

Loss uplift is most suitable for incorporated businesses

In Chapter 3 of this report, the Working Group considered the arguments for and against extending loss carry back to unincorporated businesses, that is, sole traders, partnerships and trusts. It was concluded that, in light of administrative difficulties associated with extending carry back to non-corporate entities, and its limited benefits for partnerships and sole traders, it should initially be extended only to companies.

A proposal to implement loss uplift would require a similar examination of whether it should be extended to unincorporated business entities. This analysis gives rise to issues that largely mirror those that arise in relation to loss carry back.

Sole traders and partnerships allow for business losses to be offset against other income, so those entities may attach less value to uplift. Allowing loss uplift to trusts may present significant challenges in terms of design and implementation.

Loss uplift is a lesser priority for many businesses

The principal advantage of loss uplift is that it moves the treatment of losses closer to the benchmark of refundability. However, it would not improve loss recoupment or provide cash flow benefits to businesses at the time losses are incurred. In the context of the Government's broader objectives and the need to ensure revenue neutrality, loss uplift should represent a lower priority than other reforms outlined in this report.

As a result of consultation with stakeholders, the Working Group has concluded that, in general, businesses attach relatively less value to the ability to uplift losses. A number of stakeholders advised that uplift would not be a significant factor in determining whether to proceed with an investment. It was also noted that loss uplift would not provide additional cash flow to businesses undergoing a temporary downturn.

While it generally appears that businesses regard loss uplift as a lesser priority, this view is not universally shared. Loss uplift would be highly valued by businesses that endure lengthy periods of losses before achieving (or returning to) profitability. Businesses in this category include, notably, start-ups, explorers and stand-alone infrastructure projects.

Loss uplift would be of most benefit to start-up companies

The following examples illustrate the effects of loss uplift on each of the companies, with particular emphasis on the start-up company. The examples have been drafted to follow on from a loss carry back. An uplift rate of 5.75 per cent has been used in the calculations.

Year	2012-13	2013-14	2014-15	2015-16	2016-17	2017-18
Assessable income	$0	$1,000,000	$5,000,000	$7,000,000	$8,000,000	$10,000,000
Expenses — excluding depreciation	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)	($2,000,000)
Deductions — depreciation	($1,000,000)	($1,000,000)	($1,000,000)	($1,000,000)	($1,000,000)	($1,000,000)
Deductions — losses	$0	$0	($2,000,000)	($3,669,439)	$0	$0
Taxable income	($3,000,000)	($2,000,000)	$0	$330,561	$5,000,000	$7,000,000
Tax payable	$0	$0	$0	$95,863	$1,450,000	$2,030,000
Loss carried back	$0	$0	$0	$0	$0	$0
Carry back refund	$0	$0	$0	$0	$0	$0
Total value of carry forward losses	$3,000,000	$5,172,500	$3,469,919	$0	$0	$0
Uplifted carry forward amount	$3,172,500	$5,469,919	$3,669,439	$0	$0	$0

Year	2012-13	2013-14	2014-15	2015-16	2016-17	2017-18
Assessable income	$2,000,000	$2,000,000	$2,000,000	$1,200,000	$1,800,000	$2,500,000
Expenses — excluding depreciation	($200,000)	($200,000)	($200,000)	($1,000,000)	($500,000)	($200,000)
Deductions — depreciation	($200,000)	($200,000)	($200,000)	($800,000)	($800,000)	($800,000)
Deductions — losses	$0	$0	$0	$0	$0	$0
Taxable income	$1,600,000	$1,600,000	$1,600,000	($600,000)	$500,000	$1,500,000
Tax payable	$480,000	$464,000	$464,000	$0	$145,000	$435,000
Loss carried back	$0	$0	$0	$600,000	$0	$0
Carry back refund	$0	$0	$0	$174,000	$0	$0
Total carry forward losses	$0	$0	$0	$0	$0	$0
Uplifted carry forward amount	$0	$0	$0	$0	$0	$0

Year	2012-13	2013-14	2014-15	2015-16	2016-17	2017-18
Assessable income	$3,000,000	$3,000,000	$2,000,000	$1,000,000	$500,000	$1,000,000
Expenses — excluding depreciation	($500,000)	($500,000)	($500,000)	($500,000)	($2,500,000)	($500,000)
Deductions — depreciation	($1,000,000)	($1,000,000)	($1,000,000)	($1,000,000)	$0	($100,000)
Deductions — losses	$0	$0	$0	$0	$0	($400,000)
Taxable income	$1,500,000	$1,500,000	$500,000	($500,000)	($2,000,000)	$0
Tax payable	$450,000	$435,000	$145,000	$0	$0	$0
Loss carried back	$0	$0	$0	$500,000	$500,000	$0
Carry back refund	$0	$0	$0	$145,000	$145,000	$0
Total carry forward loss	$0	$0	$0	$0	$1,500,000	$1,186,250
Uplifted carry forward amount	$0	$0	$0	$0	$1,586,250	$1,254,459

Year	2012-13	2013-14	2014-15	2015-16	2016-17	2017-18
Assessable income	$25,000,000	$25,000,000	$12,000,000	$15,000,000	$20,000,000	$30,000,000
Expenses — excluding depreciation	($18,000,000)	($19,000,000)	($16,100,000)	($18,000,000)	($19,000,000)	($18,000,000)
Deductions — depreciation	($750,000)	($750,000)	($900,000)	($950,000)	($1,800,000)	($1,800,000)
Deductions — losses	$0	$0	$0	$0	$0	($8,875,439)
Taxable income	$6,250,000	$5,250,000	($5,000,000)	($3,950,000)	($800,000)	$1,324,561
Tax payable	$1,875,000	$1,522,500	$0	$0	$0	$384,123
Loss carried back	$0	$0	$1,000,000	$1,000,000	$0	$0
Carry back refund	$0	$0	$290,000	$290,000	$0	$0
Total carry forward losses	$0	$0	$4,000,000	$7,180,000	$8,392,850	$0
Uplifted carry forward amount	$0	$0	$4,230,000	$7,592,850	$8,875,439	$0

$6,904,494

Year	2012-13	2013-14	2014-15	2015-16	2016-17	2017-18
Assessable income	$500,000	$5,000,000	$1,000,000	$0	$0	$0
Expenses — excluding depreciation	($3,000,000)	($2,000,000)	($500,000)	$0	$0	$0
Deductions — depreciation	($1,000,000)	($1,000,000)	($1,000,000)	$0	$0	$0
Deductions — losses	$0	($2,000,000)	$0	$0	$0	$0
Taxable income	($3,500,000)	$0	($500,000)	$0	$0	$0
Tax payable	$0	$0	$0	$0	$0	$0
Loss carried back	$0	$0	$0	$0	$0	$0
Carry back refund	$0	$0	$0	$0	$0	$0
Total carry forward loss	$3,500,000	$5,701,250	$6,529,072	$0	$0	$0
Uplifted carry forward amount	$3,701,250	$6,029,072	$0	$0	$0

Conclusion

There is significant scope for improvements in the way the tax treatment of carry forward losses impacts on business decision making. Losses have real value to businesses and are taken into account in investment decision making.

The effect of the same business test is that the advantages of making improvements to a business must be weighed against the disadvantage of its losses becoming unusable. The need for integrity in the treatment of tax losses must be tempered by consideration of the costs of locking businesses into inefficient structures. Subject to an evaluation of the costs and benefits of savings options, the integrity rules should, as a matter of priority, be changed to reflect modern business realities.

There is scope to improve incentives for businesses to innovate and adapt to change by reforming the SBT. The Working Group has considered a range of possible alternative approaches to reforming SBT that would better reflect the modern commercial environment. However, in the time available, we have not been able to settle on a preferred approach. We consider that the Government should undertake further work on possible reforms as a matter of priority.

Loss uplift is another potentially useful reform to the tax treatment of losses. Loss uplift is likely to have a positive impact on business risk taking and innovation but is a lower priority for Government in the short to medium term.

Recommendation

Recommendation 3:

The Working Group recommends that the Government, as a matter of priority, undertake further analysis with a view to developing a model for reforming the same business test. One model for improving the existing loss integrity rules could involve a combination of:

• modifying the existing SBT so that it better aligns with the modern business environment; and
• introducing an alternative statutory drip-feed mechanism calculated on a straight line basis.

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¹⁸ Asprey, K. W, 1975, Taxation Review Committee: Full report, Australian Government Publishing Service, Canberra, pp. 249 – 250 (‘Asprey Review’).

¹⁹ Asprey Review, p. 249.

²⁰ See Treasurer’s Second Reading Speech to Income Tax Assessment Bill 1965 (Cwth), cited in Lilyvale Hotel Pty Ltd v Federal Commissioner of Taxation 2009 ATC 9452.

²¹ Division 165 and 175 also include specific anti-avoidance provisions to protect the effectiveness of the COT by preventing share ownership being manipulated by arrangements aimed at reducing a tax liability (for example, by manipulating the ownership of shares to gain access to carried forward losses or injecting income into a business to utilise losses).

²² This is the ‘primary’ COT test. If one or more other companies beneficially owned shares, or interests in shares, in the company at any time during the ownership test period, then an alternative COT test which also examines voting, dividend and capital distribution rights to assess whether there has been a majority change in ownership where one or more companies beneficially owned shares or interest in shares in the company at any time during the ownership test period (subsection 165-12(6), 165-150(2), 165-155(2) and 165-160(2) of the ITAA 1997). A modified COT containing concessionary tracing rules that simplify the tracing of ownership interests is available for widely held companies and other types of companies (Division 166 of the ITAA 1997).

²³ Australian Taxation Office, Taxation Ruling TR 1999/9, Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132, para 25. (‘TR1999/9’).

²⁴ TR 1999/9, para 27.

²⁵ OECD, 2011, Corporate Loss Utilisation through Aggressive Tax Planning, Paris, pp. 34-6 (‘Corporate Loss Utilisation through Aggressive Tax Planning’).

²⁶ Corporate Loss Utilisation Through Aggressive Tax Planning, p. 30.

²⁷ Australian Taxation Office, Taxation Ruling TR 1999/9 Income Tax: the operation of section 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132 (‘TR 1999/9’), para. 13.

²⁸ The term ‘modified SBT’ is used in a different sense here than in certain provisions of the ITAA 1997 relating to consolidated groups.

²⁹ (1971) 124 CLR 97

³⁰ TR 1999/9, para. 13.

³¹ Interim Report, paras 143-7.

³² Noting that any eligible research and development (R&D) expenditure undertaken up such a company would already be refundable under the R&D tax incentive (provided the company has a turnover of less than $20 million). Such expenditure would therefore not form part of any tax loss the company carries forward.

³³ In the 2011-12 Budget the Government announced that tax losses associated with designated infrastructure projects would be uplifted as they are carried forward and would not be subject to the COT and SBT rules.