Loss carry-forward rules under a new spotlight

By Emma Marr & Patrick McCalman

Inland Revenue have released draft guidance on how they’ll interpret the new loss carry-forward rules that have been in place since 2020 (known as the Business Continuity Test). The draft interpretation statement focusses on the anti-avoidance rules that were not covered in their first interpretation statement, IS 22/06 released in 2022, so the new guidance is welcome, albeit not without room for improvement.

First, a recap of the loss carry-forward rules. Prior to the 2020/21 income year, selling more than 51% of the shares in a company with tax losses meant that the losses were forfeited. This had a negative impact on (among other examples) growing companies seeking to raise capital, and tax advisors and businesses had been asking for years for the rules to be relaxed. In 2020, in an effort to stimulate growth and innovation, the Business Continuity Test (BCT) was announced as part of a COVID-19 relief package. This test enables losses to be carried forward if there has not been a “major change”, other than a “permitted major change”, to the business. The 2022 interpretation statement, IS 22/06 outlined a wide range of changes that a business could make that Inland Revenue considered would be acceptable under the new rules.

The new draft guidance – Income tax -arrangements involving tax losses carried forward under the business continuity test – gives more context and guidance for how the rules can operate, and emphasises the need for commerciality in any arrangement that relies upon the BCT to access losses.

How the anti-avoidance rules work

There are three specific anti-avoidance rules that apply when a company carries a tax loss forward under the BCT:

1. GB 3BA: Prevents a company entering into a pre-emptive arrangement, including changing the nature of its business, within two years prior to a shareholding change, in a way that enables the company to use the BCT, if the purpose of the arrangement was to defeat the purpose of the BCT.
2. GB 3BAB: Prevents an arrangement to inject income into a loss company, with the main or sole purpose of tax avoidance.
3. GB 3BAC: Prevents an arrangement to remove deductions from a loss company, with the main or sole purpose of tax avoidance.
   

Fundamentally, the anti-avoidance rules counteract arrangements that enable a person, other than the loss company, to enjoy the benefit of the losses, when they would otherwise have been prohibited from doing so.

The second and third anti-avoidance rules, preventing income and deductions being added to or removed from the loss company, work in very similar ways:

The rules in effect unwind the tax advantage obtained, either by moving the deduction back to the profit company or treating income in a loss company as schedular income and therefore unable to be offset against losses.

Situations where the BCT legitimately applies could have a wide range of facts. Based on the draft guidance we consider there is a relatively low threshold for when the avoidance provisions may potentially apply. It is easy to imagine that if, for example, two businesses are combined to form a new business (by one company acquiring another), that costs or revenue may move from one company to another with the aim of achieving business growth and resilience. Afterall, if there was no need to change either business, there would have been no commercial reason for the acquisition. The key point to takeaway is that the commercial rationale must be demonstrable to support any arrangement that meets the criteria outlined in the legislative tests. If there is only a tax advantage to be gained, the anti-avoidance provisions will likely apply.

Examples and commercial application

In the draft guidance, Inland Revenue provides several examples of how it considers the rules should be interpreted, including instances when the anti-avoidance provisions will apply. One example discusses cost recharges within in a group of companies. Inland Revenue accepts may be appropriate, but requires that this be priced in a supportable, commercially acceptable way. This highlights that Inland Revenue will require parties to demonstrate that intergroup transactions are commercial and robust. The draft statement also emphasises the need to consider the Parliamentary contemplation test. This test applies specifically to anti-avoidance analysis, looking at both the purpose of the loss rules, which limit the ability to carry-forward tax losses, as well as the BCT, which enables the carry-forward of tax losses.

We consider that in at least one instance, the draft statement prioritises the former above the latter. Example 6 in the draft guidance illustrates what Inland Revenue views as an inappropriate movement of income from a profitable company to a loss company (considered to be anti-avoidance) – due to its length we don’t replicate the example here. Inland Revenue objects to the fact that “Profit Co received the benefit of Loss Co’s loss but did not to any extent suffer the burden of that loss when it was incurred.”

We would suggest that the BCT was designed to allow just this circumstance – a new shareholder, which may be a new company, will indeed be able to use losses that it did not suffer the burden of, in a very wide range of circumstance that were clearly contemplated by the BCT, and this was in fact a reason for its introduction.

While the draft guidance is helpful; we consider a wider range of circumstances could be described as “commercial” than is demonstrated in the statement. Further, based on the examples included, it seems to us that Inland Revenue is setting a very low bar as to what is artificial. In challenging economic times, when companies may well have accrued losses and find themselves with an appetite to find new business partners to make their businesses sustainable, it would be useful to see Inland Revenue giving more emphasis to the purpose of the BCT in the final version of the statement, as well as including more examples of commercially acceptable business changes that may involve moving income or expenses between companies.

It's also important to remember that the general anti-avoidance provision, section BG 1, can still apply, even if the specific anti-avoidance provisions in section GB 3BA, GB 3BAB or GB 3BAC do not.

Conclusion

It would be fair to say we have not observed, in the mergers and acquisitions (M&A) space, a large number of transactions in which a buyer or a seller placed a lot of value on losses that could be carried forward under the BCT. This could be due to uncertainty in how the rules would be applied. They are relatively new and there hasn’t been a lot of experience in formally testing how the rules are applied by Inland Revenue. As advisors and taxpayers see more activity in this space and test more scenarios with Inland Revenue, the rules may become more widely understood and used.

In releasing guidance on the anti-avoidance provisions, we now have relatively comprehensive commentary from Inland Revenue on the full BCT rules, which is a helpful step forward. Whether this will lead to an uptick in the use of the BCT and valuation of losses when companies are being acquired remains to be seen.

Finally, as a note of caution given the low bar that Inland Revenue seem to be setting as to when an arrangement is artificial, companies using the BCT test would be well advised to ensure that they are actively considering the commercial arrangements between group members when BCT losses are in existence to ensure that the use of those losses is not at risk under the specific anti avoidance provisions.

Please contact your usual Deloitte advisor for to discuss the BCT rules or other M&A issues further.