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Carry-back Saviour? – Please read the fine print!

Tax Telegraph, September Issue

Carry-back Saviour? Please read the fine print!The carry-back losses initiative introduced by the Federal Government in the Budget this year has come at a time of need, offering some salvation for the several small and medium businesses (SMB) feeling the pinch in a patchwork economy. The initiative has been aimed at the struggling SMB market, providing a $1million carry-back loss measure to provide these businesses with cash-flow during times of loss - when they need it most.

Previously, companies have only been able to carry their losses forward, provided they satisfy the stringent rules of the continuity of ownership test (COT) and same business test (SBT). However, the new initiative allows businesses that are currently experiencing losses to utilise these losses by carrying them back and applying them to previous years’ profits and receiving a tax offset for the current income year.

With the vast amount of small and medium businesses doing it tough in the current economy, are these changes the modern day saviour that these businesses need? Not entirely.

Please read the fine print!

To be eligible for the carry-back losses, business owners need to be aware of the following:

Only available to corporate tax entities

The carry-back losses initiative will only be available to corporate tax entities (CTEs) which include companies, corporate limited partnerships, corporate unit trusts and public trading trusts. This means that those operating their businesses through other entities (such as sole traders, trusts and partnerships) will not be eligible to carry-back their losses.

Limited by franking account balance

Many of those anticipating the relief of the carry-back losses scheme are unaware that the tax refunds are limited to the amount in a company’s franking account balance. This means that the maximum tax value of the losses carried back is limited by the positive balance in a company’s franking account at the end of the income year.

The franking account of a company increases when income tax is paid, and reduces when the company issues a franked dividend. The effect of the franking account limitation will be noticed by small and medium businesses as the payment of franked dividends will deplete the franking account balance which entitles them to use their carry-back losses.

This may be a particular issue for smaller businesses, where owners are reliant on their company making a profit to ensure their livelihood. The owners will pay themselves franked dividends from the current profits, only to find that there will not be any credits in the company’s franking account the following year to utilise the carry-back loss measure. Those businesses in this dilemma will have to plan the timing of dividends to ensure a positive franking account balance.

A $1million cap

There is a $1 million cap on the amount of losses that a company is able to carry-back in a particular income year. This cap translates to a maximum tax benefit of $300,000 at the current 30% company tax rate per year. As the cap applies to losses of a particular year, any losses over the cap may be used as carry-forward losses in future years.

Limited carry back period

It is intended that a transitional one-year carry-back period will be granted for the 2012 – 2013 income year. From 2013 onwards, a two-year carry-back period will be implemented. This means that a business will have to have one or two profitable years directly followed by a year of loss to be able to claim the carry-back losses. As such, the carry-back measures will decrease in benefit to those businesses that have been suffering losses for consecutive years.

Integrity rules

Similar to the use of carry-forward losses, the carry-back measures are subject to integrity rules. The Treasury has recently released Exposure Draft legislation - Benefits of the Boom Legislation Amendment (Loss carry-back) Bill 2012 (the Exposure Draft)- which provides the framework for which the carry-back offset operates and outlines that a modified COT and SBT will apply.

Modified Continuity of Ownership Test

The COT under Division 165 of the Income Tax Assessment Act 1997 (ITAA 97) has been modified for the purposes of carry-back losses to have the ownership period commencing at the beginning of the year in which the loss has been carried back to the end of the current year. In this period, the CTE must show that the same periods have maintained the underlying ownership of more than 50% of all voting, dividend and capital rights.

Same Business Test

Similarly with carry forward losses, if a company failed the COT, it may still be eligible for the carry-back offset if it satisfies the SBT. The CTE must ensure that they have maintained the same business throughout the current year as it did just before it failed the COT test.

Part IVA

The general anti-avoidance rule in Part IVA of the Income Assessment Act 1936 (ITAA 36) will also be modified to apply to schemes to obtain a carry-back offset. As such, the definition of ‘tax offset’ under this provision is amended to extend the definition to include a carry-back offset to a taxpayer. If Part IVA is found to be satisfied, the Commissioner of Taxation has the power to revoke the tax benefit.

Carry-back losses in practice

Due to the structure of the carry-back loss provisions, certain businesses will receive more benefits than others. The carry-back provisions are best suited to those companies which the Treasury describes are “experiencing a temporary shock”.  This refers to previously profitable companies which are experiencing temporary losses while they adjust to new market factors and economic conditions. Companies which continue to suffer sustained losses will not be able to receive the full benefit of the carry-back loss provisions.  

Further, the loss refund is returned in the form of an offset in year following the losses, after the company has finalised their tax return.

Below, we provide a worked example extracted from the Explanatory Memorandum accompanying the Exposure Draft, which helps illustrate these concepts:

Example: Eligible losses

Super Syed Pty Ltd has the following history:

Year Taxable income/ (loss) Tax liability Refundable offset Loss carried forward
2014-15 $2 million $600,000 0 0
2015-16 ($5 million) 0 $300,000 $4 million
2016-17 $3 million 0 $300,000 0

In 2015 - 16, Super Syed incurs a $5 million tax loss. Super Syed carries back $1 million of the loss with a tax value of $300,000 against its 2014 - 15 income tax liability.

In 2016 - 17 Super Syed deducts $3 million of the unutilised 2015-16 tax loss to reduce its taxable income to nil under Division 36.  Super Syed still has $1 million of its 2015-16 loss eligible for carry-back.  It chooses to carry it back to apply against the $300,000 unutilised income tax liability of the 2014 15 income year.

Modern day saint?

The benefit of carry-back loss provisions may not have been as broad as originally thought, however, for those businesses that are eligible to utilise their losses, a tangible benefit will be reaped. Unlike the existing carry-forward loss provisions, it will mean a cash-flow injection at a critical time when a business has suffered losses. Whilst providing cushioning for those businesses suffering a temporary shock, the safety net of the carry-back losses will also encourage businesses to take sensible risks and promote growth in the economy. The integrity rules that apply to the carry-back offset are more stringent than initially anticipated and may pose as a significant barrier to some companies seeking the aid of the carry-back measures.  

Public submissions on the exposure draft legislation released on 23 August 2012 have a closing date of 19 September 2012. In the joint media release with the Assistant Treasurer, David Bradbury and Minister for Small Business Brendan O’Conner, it was acknowledged that some previous submissions argued for more simplified integrity rules that did not mirror the carry-forward COT and SBT tests. Going forward, the Assistant Treasurer looks to tackle this issue by “overseeing targeted consultation to identify and further develop alternate integrity rules”. Until the final legislation is introduced into Parliament this Spring, many businesses will be sitting in anticipation to see whether the government has adopted a simpler and more practical integrity rules.

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