CURRENT YEAR TAX LOSS ISSUES FOR SMES
| This article will attempt to breakdown some of the current issues facing SMEs who currently have carried forward tax losses.
For the company, the issue is that carry forward income tax losses will not be deductible unless the company satisfies either the continuity of ownership test ("COT”), or the same business test (“SBT”).
Basically, to satisfy the COT, a company must maintain continuity of majority ownership in its shares during the entire period from:
However, all is not loss if the COT cannot be satisfied, as the company can still carry forward its losses if it passes the SBT. Where there has been a re-structure and majority underlying ownership of the shares of the company has significantly changed, the SBT will become critical to the ability to utilise carried-forward tax losses in the future. |  |
Same Business Test
The first issue to consider is the potential application of the SBT. We have already been notified this year that the Australian Taxation Office (“ATO”) is already preparing itself for a deliberate focus on losses as a specific target in its audit activities for the 2009-10 year.
During the tough times of a recession, it is common for business owners to make significant changes, often out of necessity, to the structure and operational activities of the business. These changes are commonly required to help the business free itself from any unprofitable activities, and typically keep the business alive.
What happens if your business changes structure or operations?
When assessing the cost/benefit of a possible re-structure, one area we must focus on is the effect that new capital raisings may have on the utilisation of carried-forward tax losses. Re-structures may include capital raisings by introducing new shareholders to inject cash flow into the business, especially where bank finance may not be available.
In some unfortunate cases, this may involve the current shareholders losing control of the company. Furthermore, at the operational level, this may involve introducing new business lines. Both of these changes would have potential implications on the ability of the business to utilise existing carry forward tax losses.
Therefore, we strongly recommend that before making any change to the company’s activities or structure, business owners should carefully consider seeking advice on the potential impact of losing the ability to recoup prior year losses.
How do you pass the SBT?
The SBT will be passed where the company carries on the “same business” at:
- the time then the COT was failed; and
- all times during the income year in which the loss is sought to be recouped.
The problem we face in practice with the SBT test is that it is particularly difficult to satisfy, due to the narrow definition of “same business” adopted by the Commissioner of Taxation.
In addition, the Commissioner has given taxpayers more to be concerned about with the recent attack on the taxpayer’s losses in the recent case of Lilyvale Hotel Pty Limited v Commissioner of Taxation [2009] FCAFC 21.
The Lilyvale Hotel Case
In this case, the issue was on the whether the hotel business (ie. the taxpayer) was operating the “same business” and therefore whether carried forward tax losses could be utilised.
In summary, it concerned the operation and management of a hotel in Sydney. While the hotel freehold was owned by the taxpayer company, the hotel business was managed by a management company, which contracted with the taxpayer to run the hotel operations on its behalf.
During an agreement for the sale of all of the taxpayer’s shares, the management agreement was terminated and the taxpayer brought the operational management of the hotel “in-house”.
The Commissioner’s View
The Commissioner denied deductions for carry forward tax losses of approx. $10 million on the basis that the taxpayer did not satisfy the SBT because the taxpayer was now operating the hotel on a daily basis, as opposed to using a management company for its operations.
The Federal Court
When the matter went to the Federal Court, it was held that the prior year losses were not deductible because the taxpayer did not satisfy the SBT, as the taxpayer ceased to use a hotel management company to manage the daily operations of the hotel after the change in ownership of the shares. The Federal Court determined, on this basis, that the taxpayer was no longer carrying on the “same business”.
The taxpayer (obviously) did not approve of this outcome and appealed the matter to the Full Court.
The Full Court
The Full Court subsequently held that the matter more precisely depended on how the business was characterised. In this regard, the Full Court found that the business carried on was that of “owning and operating a hotel to derive revenue from its guests and profits from its operation”.
Accordingly, the fact that the taxpayer previously used a management company to operate the business before the change in ownership did not mean that it was carrying on a different business once the outsourcing of management was terminated.
The Taxpayer’s Outcome
Ultimately, the taxpayer in Lilyvale Hotel achieved the “right” outcome – the carry forward losses were available to be utilised against future taxable income.
While the result is good, taxpayers in general should be concerned about this case for two specific reasons:
- The Commissioner considered it appropriate to run the case, which demonstrates his willingness to challenge taxpayers who are simply trying to make sensible commercial decisions; and
- The Federal Court in the first instance agreed with the Commissioner’s narrow view as to what constitutes the “same business”.
Conclusion
For company owners, where tough times are suggesting a change to the business structure and operational activities may help to climb out of loss making activities, caution must be exercised before embarking on changes.
Any potential changes to revenue streams, business locations, products offered, and customer bases may mean that a company could lose its ability to utilise carried forward tax losses forever.
Email your knp representative, knp@knp.com.au or call to make an appointment on +61 3 9824 8111.