One of the government's recent COVID-19 relief measures was to relax the tax loss continuity rules which had prevented a company from carrying forward prior year tax losses where a greater than 51% change in ownership had occurred.
The change will allow a company to carry forward tax losses through a change of ownership provided that the company carries on the “same or similar business" following the ownership change.
This update sets out the background to the change and explores some of the issues likely to be encountered when applying the test based on the experience with a similar test in Australia.
Background to the change
New Zealand's current tax loss continuity rules prevent a company from carrying forward its tax losses if the company has experienced a greater than 51% change in ownership since the time that the tax loss arose.
The rationale behind the rule is to ensure that the group of shareholders who economically incurred the losses are (at least as to 49%) the same group who are able to benefit from those losses in future years when the company has become profitable. In the absence of these rules, various tax loss trading practices could (and previously did) occur. Such practices had been the subject of challenge under the general anti-avoidance rule, for example, in the Challenge Corporation litigation that led to the enactment of the original shareholder continuity requirements.
The somewhat arbitrary and brightline nature of the existing loss continuity rules has drawn criticism. The rules provide a disincentive for many start-up companies to seek significant capital investment. A typical profile of these businesses involves loss-making in the early phases and frequent shareholder movements, compromising the relief that those losses provide when the venture becomes profitable. This issue was addressed by the 2019 Tax Working Group in their Interim Report, where the Group suggested that the existing rules were not working well for start-up enterprises.
The impact of COVID-19 could see the issue exacerbated in a start-up context and extend beyond it to more established organisations as companies seek liquidity through capital raisings, resulting in movements in shareholder continuity following the introduction of new investors and the dilution of existing shareholders' interests.
Proposed amendments – significant in capital raisings and privates sales
The government has announced that the same or similar business test will be introduced in a tax bill in the second half of 2020. The test will apply with effect to the 2020-2021 and later income years.
The government has indicated that the test will be modelled on a similar rule in Australia. Public consultation on the rule will take place in the second half of 2020, after which the scope of the provision will be better understood.
Finance Minister Grant Robertson noted that the rationale behind the change is to make it easier for firms to raise new capital without losing the benefit of their existing tax losses. A contemporaneous Inland Revenue release however cautions that the changes will need to be carefully designed in order to prevent loss trading from occurring.
It is clear that the significance of the rule will go beyond start-ups and capital raisings. Existing tax loss balances will now have value in a private sale context depending on the purchaser's intentions with respect to the company. It will be interesting to see how those losses are valued by a purchaser. That will be influenced in part by the comfort that the parties have that the same or similar business test will apply to preserve tax losses through the ownership change.
The Australian rule
In November 2019 Australia amended its previous “same business test" to introduce a “similar business test". The Australian Tax Office (ATO) released a legally binding Law Companion Ruling (LCR 2019/1) (the Ruling) providing guidance on the amended test.
A company will satisfy the test if throughout the relevant period it carries on the same business as it carried on immediately before the “test time". The focus of the similar business test is on the identity of the business and its continuity of both its business activities and the use of the same assets to generate income, rather than solely on the type of business carried on.
Under the test, there are four factors which must be considered in determining whether a business is sufficiently similar:
the extent to which the assets (including goodwill) used in its current business are also used in its former business,
the extent to which the activities and operations from which its current business generated assessable income are also the activities and operations from which its former business generated assessable income,
the identity of the current and former businesses,
the extent to which any changes to the former business result from development or commercialisation of assets, products, processes, services or marketing or organisational methods of the former business.
The closer the factors tie to the former business the more relevant they will be. For example, the use of assets which are closely linked to the identity of the business will be of more relevant than those assets which are not (e.g., goodwill vs. generic office spaces or stationary). The weighting given to these factors will depend on the circumstances. Other factors may also be relevant.
The ATO Ruling provides a number of factual examples illustrating the application of the factors listed above. Those examples demonstrate some of the sensitivities of the test to factual variations. For example:
a bicycle parcel courier company that developed a new bike with an insulated compartment built into the frame and later realised the potential of the new design to deliver food, might satisfy the test, whereas
The “similar" business test was introduced in Australia to provide more flexibility and encourage business innovation. The “same" business test was considered to be inflexible and has historically been strictly applied by both the ATO and the courts. The term “same" has been held to mean identical in the context of the same business test; the business must be identical to the one prior to the change in ownership not just be of the same kind.
The relaxation of the standard will no doubt be welcomed, but applying the new similar business test will be more difficult and carries inherent subjectivity. The examples in the Ruling demonstrate the factually sensitive nature of the test. Any changes or innovation in the business will need to have evolved directly from the identity of the former business.
The scope of the New Zealand same or similar test will be an interesting development to monitor as the legislation progresses. One feature of the New Zealand test which may distinguish it from Australia's is the contemporaneous enactment of both the “same" and “similar" business tests. This could result in the “similar" component of test being given more independent force, rather than being tethered to an existing “same" business test that has been strictly interpreted, as appears to have been the case in Australia.
No doubt the introduction of the test in New Zealand will be a welcomed concession in the current environment. The test will provide relief for a number of companies who would otherwise have been prevented from being able to access historical tax losses following the raising of additional capital. The nature of test however will give rise to some difficult issues and a level of uncertainty relative to the current tests. It is easy to imagine the test taking on real significance in a sale context where a vendor might hope to realise some value from existing losses. Purchasers will need to take a view on the application of the test in valuing loss balances in light of what they have planned for the business going forward.
If you have any questions about the matters raised in this article, please get in touch with the contacts listed, or your usual Bell Gully adviser.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.