Do you pass the ‘continuity of ownership’ (COT) test?
If your company has past tax losses that haven’t been used as a tax deduction, this tip is for you…
Check the conditions under which a company’s past losses may be claimed as tax deductions. The benefits may include significant reductions in corporate tax payable.
Owners and directors of companies need to be aware of the conditions under which a company has the ability to claim a past loss as a tax deduction. The gate keeper tests are the ‘continuity of ownership test’ (COT) and the ‘same business test’ (SBT). Passing either of those tests enables a company to deduct its unused tax losses.
The small print for the continuity of ownership test (COT) specifies that in order for a company to satisfy the test, more than 50% of the ownership and control of the company has to have remained constant ‘at all times’ from the year the unused losses were generated through to the year the company wishes to deduct them to reduce its tax bill. Special rules apply where ownership is held by other companies or trusts that require tracing ownership through to the underlying individuals.
Importantly, COT also requires that more than 50% of the ‘shares on issue’ in the year of the losses are held by the same shareholders and still account for more than 50% of the shares on issue at the time of deducting the unused losses. This is referred to as the ‘same share rule‘.
As a safety net, the COT rules also provide a ‘savings rule‘ that is designed to enable COT to be satisfied where more than 50% ownership and control has remained constant even though the same share rule was failed. Broadly the test requires that the shareholders have not, and are unlikely to generate, personal losses from the sale of their shares greater than 50% of the company’s tax losses.
The ‘same share rule’ and the ‘savings provision’ are an often overlooked part of the COT rules which can result in the incorrect use of company losses.
Overall, a failure of the COT rules will deny the unused tax losses being deducted unless the SBT is passed. In practice, passing the SBT test is generally difficult as the test is complex and the dynamics of business change make SBT difficult to satisfy.
Here are four steps you should take to manage your company’s unused losses and determine whether or not you satisfy the COT:
1. Summarise unused losses according to the year(s) in which they were generated. These should be recorded on the company’s annual tax return.
2. Categorise the tax losses into ‘revenue losses’ (from trading) and ‘capital losses’ (from investment-related activities). This information should also be recorded on the company’s annual tax return.
3. Review changes in shareholdings from the loss year(s) to the profit year(s).
4. Review changes in the nature of business conducted where the company has failed the COT. In particular, identify the business that existed immediately before COT was first failed and compare to the business conducted throughout the year in which the company wishes to deduct the unused tax losses.
These steps will help you determine whether or not the company satisfies the COT and/or SBT and whether you can claim a past loss as a deduction. However, I urge you to seek our advice too as there are other criteria that may be applied (to enable a deduction) if your situation does not immediately satisfy the COT.
The benefits of taking action are numerous.
Where you are able to use a past loss as a deduction, the company may receive a significant reduction in the corporate tax and corporate capital gains tax (CGT). Depending on the size of the losses, the potential tax saving could be significant.
For example, in a case where $1M of losses is taxed at, say, a corporate rate of 30%, the additional tax payable arising from not claiming the losses, is $300K. Missing out on that sort of money could deny a company much needed funds for expansion, working capital, payment to shareholders or to fund investment activities.
Furthermore, the diligent use of past losses puts in place safeguards that will enhance the ability of a company to satisfy the tax loss tests in the future to achieve the tax savings when the company ultimately generates profits.