9/06/2021·5 mins to read
New business continuity test to help companies hold on to tax losses
A ‘business continuity test’ has been introduced to assist companies to carry forward tax losses, with the aim of helping to stimulate growth and innovation in the economy.
As always, the devil is in the detail, but the change will be welcomed by many start-ups and early stage companies and other companies with accumulated tax losses that require significant new equity investment, or even a complete change of control, to grow, survive, innovate or reorganise.
Carrying forward tax losses
If a company incurs tax losses in an income year, the tax losses represent a potential future tax benefit if they can be carried forward and used to shelter taxable income from tax in a later income year.
Until recently, a company could only carry forward tax losses into a later income year if there was at least 49% ownership continuity in the company, looking through (for the most part) to indirect, ultimate shareholders, from the time the loss arose (OC test).
The threat of “forfeiting” tax losses because of an OC breach has often acted as an impediment to rational decision-making, both by companies in growth mode and distressed companies. All too frequently the tax tail has wagged the commercial dog.
In recognition of this distortion, the OC test has now been supplemented by a business continuity test (BC test). The BC test may allow tax losses to be carried forward despite an OC “breach” if there is no major change in the company’s business activities during a “business continuity period”, unless the change is a permitted major change.
The BC test is a supplement to the OC test, because a loss will still be able to be carried forward if the OC test is met, without the need to consider the BC test.
What losses may be carried forward under the BC test?
The BC test is retrospective, but only to the extent of losses that were incurred no later than the start of the 2013/14 income year. This means that pre-2013/14 losses, and most significantly losses incurred in the GFC, are outside the scope of the BC test.
A loss will not be able to be carried forward if:
- an OC breach occurred before the start of the 2020/21 income year (which began on 1 April 2020 for most companies), which prevents a loss from being carried forward under the OC test; or
- an OC breach occurs on or after the start of the 2020/21 income year and business activity had ceased and had not revived before that OC breach.
The second exclusion is intended to forestall the development of a market for dormant loss companies, or what in times past was labelled “loss trading”, and is also buttressed by various anti-avoidance measures.
One such measure may deny the ability to carry forward a loss under the BC test where there is an arrangement for the owner to change the company’s business ahead of a sale to a party, where such a change after acquisition would breach the major change restriction. Additional restrictions also apply to losses of financiers.
“Major change” restriction
The BC test’s major change restriction is that there must be no disqualifying “major change” in the company’s business activities in the business continuity period. This period runs from immediately before the OC breach until the loss is utilised or the end of the income year which includes the fifth anniversary of the OC breach (where the loss is still not utilised).
If there is a further OC breach before the business continuity period expires, the clock is reset.
The BC test is not descriptive on what factors determine whether there has been a major change, except that the legislation expressly requires “the extent to which the assets used in deriving the company’s assessable income have remained the same or similar over the business continuity period must be taken into account.” The reason is that a significant change in asset base may indicate a major change in business activities.
IRD has indicated that other factors may also be taken into account in determining whether there is a disqualifying major change.
Those factors include business processes, scale of business activities, use of suppliers, markets supplied to, and type of products/services supplied. The benefit to taxpayers in being able to point to these other factors is that they may show that, while the company’s asset base has changed, the nature of the business has not changed - or has not changed in a major way.
Examples given by IRD include a wholesale change or upgrade of the computers used in a company that specializes in producing computer generated graphics, and an egg producer that shifts its egg production from battery farmed to free range hens, requiring the removal of battery sheds, the construction of a new roosting barn, new fencing and sowing of pasture.
These are provided as examples of companies who may significantly change their assets, but without there being a major change in the business activities.
Permitted major change
The BC test also permits the carry forward of losses where there has been a major change in business activities, if the major change is innovation or growth related.
A company that uses the same or largely the same assets (but ignoring land, other than buildings and fixtures) as used before in the business to introduce new products or services, is one type of permitted major change.
Other permitted major changes are the creation of new products or services that are “closely connected” with a product previously produced or provided by the company, or major changes that increase efficiency or scale, or help the company keep pace with technology.
There is likely to be a measure of overlap between whether a change in business activities is a permitted major change, or not a major change in the first place, once the scale of business activities and other factors are taken into account.
In either case, IRD and Government can be said to be favouring a big picture approach, where the overall significance of a change in business activities is assessed and, even where there is a significant change, losses may still be carried forward if that change can be put down to innovation or growth and there is a degree of continuity or relatedness in the business activity.
This explains why IRD has said that there is a presumption that losses can be carried forward under the BC test unless there is a disqualifying major change, which it contrasts with the Australian approach that denies loss carry forward under its BC test unless the “same or similar business” is carried on.
The NZ BC test appears more flexible and business friendly, so it is hoped that that is how it will be administered by IRD in years to come.
Potential transaction impacts
The introduction of the BC test is likely to result in a higher price being sought by a shareholder selling all, or a major stake, of a company replete with significant losses.
However, there is no certainty that the shareholder will derive a higher price. Buyers may be resistant, as the ability to use the losses in the future may depend upon making the company’s business activity profitable while not resulting in a non-permitted major change, and the time that this may take will in any event diminish the net present value of any carry-forward losses.
On the other hand, owners of a company with losses seeking new capital may find that a potential investor wants the owners to warrant that the losses are bankable and will not be challenged by IRD if the company becomes profit-making - whether or not the owners contend that the value of the company is increased by the tax losses.
What is certain is that the BC test will put tax losses on the agenda where a deal involves the sale of, or investment in, a loss company.
An article based on this content was published in NBR online on Tuesday, 7 June 2021.