Draft legislation has been released for comment to correct technical problems with the current tax legislation that can prevent companies with multiple classes of shares and tax consolidated groups recouping prior year tax losses. The draft legislation is retrospective and proposes to:

  • modify the continuity of ownership test (COT) for companies whose shares have unequal rights to dividends, capital distributions or voting power so that companies do not fail this test simply because they have multiple classes of shares; and
  • ensure the entry history rule does not operate in relation to an entity that is acquired by a tax consolidated group for the purposes of applying the same business test (SBT).

Who Is Affected?

Entities that are affected include:

  • Loss companies (and their subsidiaries) with multiple classes of shares carrying varying dividend, capital or voting rights;
  • Tax consolidated groups which:
    • are relying on SBT to recoup prior year losses; and
    • have acquired or are acquiring new active entities.

The rules will enable:

  • companies to reassess any past COT failure dates. For examples, companies may have concluded that the COT has been failed by virtue of the issue of preference shares; and/or
  • allow companies to raise finance by issuing different classes of shares.

When Do The Rules Apply?

The changes which modify the basis for working out voting power for the purposes of applying COT apply from an income year commencing on or after 1 July 2007.

The other changes to the COT broadly apply to any tax and capital losses (and bad debt deductions claimed) for an income year commencing on or after 1 July 2002. Special rules apply to losses for income years incurred in or before the 2002 income year.

The SBT changes apply from 1 July 2002.

Changes To The COT Tests

Generally, a company can carry forward and/or recoup its tax losses if it satisfies the COT or on failing that, satisfies the SBT.

Broadly, the COT is satisfied if shares carrying more than 50 per cent of all voting, dividend and capital rights are beneficially owned by the same persons from the start of the income year in which the losses were incurred up to the end of the income year in which part or all of the losses are recouped (the "test period"). This test becomes difficult where a company has different classes of shares carrying varying rights to dividends, capital distributions or voting power. i.e. a company may fail COT even though there has been no significant change of shareholding.

The modifications that may apply depend upon whether the company has:

  • shares with unequal rights to dividends or capital distributions. For example, a company may have preference shares which carries preferential rights to dividends and capital but do not carry any voting power; or
  • shares with different voting rights

Shares Have Unequal Rights To Dividends Or Capital Distributions

The modifications introduce concessions that apply in a hierarchical order.

Broadly speaking, under these modifications, if a company fails COT because it is unable to satisfy the 50% continuity of dividend and/or capital distribution conditions, it may reconsider the COT:

  • by disregarding debt interests (the "first concession"). Certain shares are treated as debt interests for tax purposes if they satisfy the "debt test" contained in the Income Tax Assessment Act 1997 (the "ITAA 1997");
  • if the company is still unable to satisfy COT, by disregarding secondary share classes, subject to certain valuation thresholds (the "second concession"). Generally, each secondary class of shares must not represent more than 10 per cent of the market value of the company, and all secondary classes must not be more than 25 per cent of the market value of the company; and
  • If a company continues to fail COT, the remaining shares may be taken to have fixed dividend and capital distribution rights for the purpose of applying the test (the "third concession"). This concession is useful for shares that cannot be disregarded under the second concession. Broadly, COT is applied using valuations of shares instead of measuring changes in dividend, voting and capital rights. Where it is not practical to value the shares, COT is tested by making a reasonable estimate of fixed dividend and capital rights.

The first concession (disregarding debt interests) would be particularly useful if a company holds preference shares or other similar shares that do not carry voting rights. A salient point to note is that the current section 165-180 of the ITAA 1997 allows certain shares to be disregarded but this section applies at the discretion of the Commissioner and is purported to be an anti-avoidance measure.

Shares With Different Voting Rights

Companies with multiple classes of shares often have different voting power on each class of shares depending on the matters put to shareholders. This makes it difficult to show that there has been a continuity of voting power over the test period.

To mitigate this problem, the proposed rules will test a shareholder's voting power in a company by reference to the votes that can be cast in a poll for:

  • the election of directors, where the election is determined by casting votes attached to shares; or
  • otherwise, the adoption or amendment to the company's constitution.

Changes To SBT

Broadly, SBT is satisfied if the company can be said to be carrying on the same business and the company has not entered into a new business or transaction since the COT failure date. For a tax consolidated group, when applying SBT, the company may need to take into account the history of a subsidiary before it joined the group. This may cause the group itself to fail SBT.

It is proposed to modify the same business test for the head company of a consolidated group to ensure that the entry history rule does not operate in relation to an entity becoming a subsidiary member of the group i.e. the subsidiary's history before entering the group is not taken into account.

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