In recognising that companies have continued to be financially impacted by the effects of COVID-19, temporary loss-carry back rules have been a welcome announcement for small business owners. These rules are designed to monetise the value of revenue losses generated by companies now, rather than deferring their benefit, by waiting until companies return to a tax paying position.
Prior loss utilisation measures
Previous to these temporary rules, companies have been able to use the carry-forward tax loss offset in a particular year by satisfying either the continuity of ownership test (COT) or, if that fails, by satisfying the business continuity test (BCT).
Tax losses are generally calculated as such when the total deductions claimed for an income year by an entity exceeds its total assessable and net exempt income for the year.
In its most simplistic application, the COT requirement for a loss company has three components, being the maintenance (i.e. in the same owners) of more than 50% of the voting power, more than 50% of dividends and more than 50% capital distributions. For each of these components there is a primary and an alternative test. The application of COT is also subject to various anti-avoidance rules intended to counteract attempts to establish technical compliance with the continuity of ownership requirement, where that has not occurred in substance.
If a company fails the COT, the BCT requires a comparison between the business activities of the company during every income year of loss recoupment, with its activities immediately before COT was failed (Test Time). There are alternative tests revolving around the loss year if the time that COT was failed cannot be determined.
The requirements of the BCT for losses incurred since the start of the 2015/16 income year are that the company must carry on a similar business as it did immediately before the Test Time. For earlier loss years, the business must be the ‘same business’ which is not defined and has been strictly interpreted by the ATO. For losses arising in income years before 2015/16 when the same business test applies, there is an additional requirement that the loss company must not derive assessable income from a business or transaction of a kind, that it did not carry on before the Test Time.
The similar business test was introduced so that businesses that were not the same could still access losses provided they are sufficiently similar to the business generating the loss having regard to the extent to which income earning assets and activities and the identity of the businesses have remained the same, and the extent to which any change can be attributed to the ordinary commercial development of the former business.
In the circumstances, COVID-19 impacts may have resulted in companies changing their business models or activities, or worse, closing down business altogether. Although a company that may have temporarily closed may still be able to satisfy the BCT, a company that has had to completely close business with no intention to resume will fail the BCT.
Temporary loss-carry back rules
As a COVID-19 response, the loss carry-back regime, legislated by the Treasury Laws Amendment (a Tax Plan for the COVID-19 Economic Recovery) Act 2020, broadly allows companies with ‘aggregated turnover’ of less than $5 billion to ‘carry back’ tax losses made during the 2019-20, 2020-21, 2021-22, 2022-23 income years to be offset against tax paid in relation to the 2018-19 or later income years.
Whilst the carry-forward tax loss offset requires satisfaction of the COT or BCT, the carry-back offset does not. However, a specific integrity rule can apply where there has been a change of control from the transfer of membership interests. To be eligible to apply the loss carry back rules, a company must have had taxable income in one or more of the preceding income years no earlier than the 2018-19 income year. Because of this, start-up companies or companies who have only generated losses will not be eligible, as they will not have any prior income tax liabilities to use.
The offset cannot be claimed until the relevant tax return for the loss year has been lodged, and currently there is no monetary cap on the amount of tax offset that can be claimed, other than the fact that it is limited to the entity’s franking account balance at the end of the year in which the offset is claimed and the tax liability for the year to which it is carried back. The loss-carry back rules can also be applied in conjunction with other Budget measures. Consider the example below, from the Budget fact sheets:
Bogong Builders Pty Ltd has aggregated annual turnover of $60 million for the 2021-22 income year. On 1 July 2021, Bogong Builders Pty Ltd purchases a truck-mounted concrete pump for $1 million, exclusive of GST. The company’s taxable income for 2021-22 was $600,000 before the purchase. Without temporary full expensing, Bogong Builders Pty Ltd would claim a tax deduction of around $300,000, resulting in a taxable profit of $300,000, and a tax bill of $90,000.
Under temporary full expensing, Bogong Builders Pty Ltd will instead deduct the full cost of the asset of $1 million, resulting in a tax loss of $400,000. Under temporary loss carry-back, Bogong Builders Pty Ltd offsets this tax loss against profits in 2018-19, resulting in a tax refund of $120,000. Without the refund, the company may have had to defer the investment until their cash flow position recovered, or may not have purchased the new pump at all.
To carry back or carry forward losses?
The decision to carry forward or carry back tax losses is solely the decision of the company. The benefit of opting to apply the carry back offset is the immediate financial alleviation from a refund. However, carrying back losses may have negative impacts on a company’s franking account and ability to pay franked dividends in future. Alternatively, carry forward losses also bear the risk of losing losses where there is a change of ownership or the business carried on.