The test allows a company to carry forward tax losses through a change of ownership provided that no “major change" in the company's business activities occurs for a defined period following the ownership change. The changes may have been targeted at start-up and developing companies to remove one impediment to capital raising, but the new rules have much wider ramifications.
The now-enacted rules were announced as part of the Government's COVID-19 relief measures in 2020, and operate to relax the tax loss continuity rules which previously prevented a company from carrying forward prior year tax losses where a greater than 51% change in ownership had occurred.
The IRD has commented on the intended scope of the business continuity test in the commentary to the Supplementary Order Paper containing the draft legislation and in a draft Interpretation Statement. This update describes the new test, and provides comment on its intended scope by reference to the IRD's published views.
The business continuity test
The business continuity test applies to a company that is subject to a shareholder continuity breach (i.e., a greater than 51% change in ownership) from the 2020/21 income year onwards. The test enables such a company to carry-forward tax losses generated from the 2013/14 income year onwards, provided that certain requirements are satisfied.
The key requirements are that there must be no “major change" in the “business activities" of the company for the “business continuity period", except for a “permitted major change". With reference to each of those key concepts:
- In assessing whether there has been a major change, the legislation directs that one factor that must be taken into account is the extent to which the assets used in deriving the company's income have remained the same or similar. The IRD's commentary indicates that various other factors will also be relevant depending on the particular circumstances of the company, such as whether there is a change in business processes or the use of suppliers, in the scale of business activities or the markets supplied to, or in the type of products or services supplied.
- The phrase “business activities" was purposefully selected to ensure that the test did not operate too narrowly. It is intended to ensure that the broader nature of the taxpayer's operations is considered when determining whether there is a major change, rather than assessing the business at a more granular level (refer to the example below 'Bread production').
- For most taxpayers the business continuity period during which the test must be applied will commence from the continuity breach, and will end on the earlier of (i) the end of the income year in which the carried-forward losses are used or (ii) the end of the income year including the fifth anniversary of the continuity breach. There is an exclusion for companies with significant bad debt deductions (e.g., failed finance companies), who are unable benefit from the second of the above timeframes (i.e., the fifth anniversary will not end the business continuity period).
- The permitted major change rule is a concessionary feature which permits the carry-forward of losses even in cases where there has been a major change in business activities. In general terms, the permitted major changes are intended to cover organic changes in business activities which could have occurred irrespective of whether a change in ownership had occurred.
The IRD has been clear that the business continuity test is not intended to encourage loss trading activities. This objective is achieved through an express purpose provision for the subpart, through a variety of limitations within the rule, and through specific anti-avoidance rules.
Scope of the rule and examples
The intended scope of the rule is demonstrated through two examples included within the draft Interpretation Statement. Those examples indicate that a broad interpretation of the test appears to have been adopted by the IRD.
Example: Bread production
This example involves a company in the business of mass producing plain loaves of white bread through a fully-automated process for sale to supermarkets. Following a continuity breach, the business pivots towards the production of artisanal sour-dough loaves made using wood-fired ovens. The changes to the business includes a reduction in output (2,000 loaves to 500 loaves, albeit now at significantly greater margins per loaf), a change in inputs (from ordinary flour to organic flour made from heirloom wheat varieties), the replacement of automated bread production equipment with wood-fired ovens and additional staff, and a change in the ultimate customer type being high-end organic supermarkets, restaurants and cafés.
The IRD's view here is that no major change has occurred with respect to the company's business activities. With respect to the new assets deployed in bread production, they remain the same or similar to old automated production assets. The business processes have not changed – the company still bakes bread and sells it to retailers. Even though changes have occurred with respect to the specific inputs used, the product produced, the scale of production, and the ultimate customers, the character of the taxpayer's business activities involving the production and sale of bread has remained constant.
The key takeaway from this example is the apparent freedom afforded to taxpayers to adapt their business within the scope of its broader current activities, without necessarily being at risk of forfeiting tax losses generated prior to a continuity breach. Again, this emphasises the focus of the test on the wider “business activities" of the taxpayer (e.g., as a bread producer), rather than adopting a narrow focus when defining the business of the taxpayer (e.g., as a producer of plain white loaves through automated means).
A further example considers a company operating a bookstore, its key assets consisting of the store fit-out (shelving and display stands), its trading stock (books) and some office/IT equipment. Following a sale to a new owner, a decision is made to install a café counter to sell coffee and pastries to customers. Significant expenditure is incurred on a new coffee counter, a coffee machine and furniture, and a barista is hired (the expenditure on new items accounts for about 25% of the total store assets in terms of replacement value). Soon afterwards, the sale of coffee and pastries accounts for approximately 70% of the company's income.
The IRD's view is that while this is (on balance) likely to result in a major change to the company's business activities, the change is nevertheless a permitted major change. The view is taken that all of the existing assets of the company continue to be used in the business, and that the provision of the new products (being the coffee/pastries) uses mainly the same assets as were previously used by the bookstore. It is suggested that the existing store fitout and trading stock of books contribute to the backdrop and atmosphere of the café, and that customers will read the books while enjoying their coffee. This is enough to suggest that the coffee and pastry products are provided using mainly the same assets as were originally used for the bookstore, and therefore the change is permitted.
This example again evidences a broad intended scope to the operation of the test. The nature of the business in this case has been the subject of a significant change (with 70% of income attributable to an entirely new product), but the view is expressed that the business continuity test will nevertheless be satisfied. This again demonstrates the prevailing intention of the rule, being to permit the organic development of a business without the penalty of forfeiture of tax losses in most cases, so long as there is no suggestion of tax loss trading.
Impact on business acquisitions and capital raisings
The new business continuity test and its broad intended operation can only be of assistance for taxpayers seeking to sell/acquire businesses or to raise capital through significant share issuances. The shift towards the international norm of permitting tax loss carry-forward in such cases is a sensible policy change, and the broad scope of the rules as evidenced through the IRD commentary is encouraging.
Parties seeking to sell or issue shares should be emboldened by the fact that doing so will now be far less likely to result in the forfeiture of prior year tax losses. Vendors may also now be able to extract value for existing tax losses as an asset in a share sale process, provided that the purchaser intends to operate the company in a consistent manner going forward. Parties who anticipate that losses will survive a share sale will need to consider what value (if any) is placed on those losses, and what protections are appropriate to build into sale arrangements addressing their availability after the sale.
While encouraging statements have been released by the IRD to date, the real test of the operation of the rule will become evident through IRD practice as it develops in the coming years. The shareholder continuity test operates in a binary and well-understood fashion. However, the new rule will involve an intensely fact-dependent analysis and will require advisor judgment. For any company that is carrying forward tax losses following an ownership change and anticipating a change in the nature of their business operations, the operation of the new rule may be a good candidate for early IRD engagement through the binding rulings or indicative view processes.
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.