Tax loss trading anti-avoidance rules

Draft interpretation statement (IS) PUB00461, titled ‘Income tax – arrangements involving tax losses carried forward under the business continuity rules’, has just been released by Inland Revenue (IR).

A supplementary order paper (SOP) to the Taxation (Annual Rates for 2020–21, Feasibility Expenditure, and Remedial Matters) Bill (March 2021) relaxed the loss carry-forward rules for companies, creating a fallback position where a breach of the requisite 49% ownership continuity rule would not result in a company's inability to carry forward its tax losses if the business continuity rule could be satisfied.

Naturally, the relaxation of the loss carry-forward rules also brought with it an opportunity for taxpayers to trade in tax losses. However, as such trading was against parliamentary intention, three specific anti-avoidance rules were introduced at the same time.

The draft IS provides more detailed commentary on the application of these provisions, and is essentially split into two parts. The first part of the IS is dedicated to sections GB 3BAB and GB 3BAC, which both act to counteract a specific type of arrangement that enables a person other than the loss company to enjoy the benefit of those losses when they would otherwise have been prohibited from doing so by the ownership commonality requirements of the loss grouping provisions.

These two provisions have been grouped together for the purposes of the IS commentary, as four out of five of the requirements to trigger application of the provision are identical. The fifth requirement under section GB 3BAB is that an effect of the arrangement is the company derives an amount of income and it is either certain, very likely or likely another person would have derived the income had the arrangement not been entered into. Whereas under section GB 3BAC, the fifth requirement is that an effect of the arrangement is a person other than the company is allowed a deduction for an amount of expenditure or loss, and it is either certain, very likely or likely the company would have incurred the expenditure or loss had the arrangement not been entered into.

Both sections GB 3BAB and GB 3BAC require that tax avoidance is the sole or main purpose of the arrangement (its chief, principal, pre-eminent, leading or most important purpose). If found to apply, section GB 3BAB will treat the amount of income the loss company derives under the arrangement as schedular income. As a consequence of this deemed characterisation, the loss company will have to compute the tax payable on the schedular income amount at 28%, absent the ability to offset any of its available loss balance against the income amount. On the other hand, section GB 3BAC will counteract the arrangement by treating the other person who actually incurred the expenditure as not having incurred it and the loss company instead as having incurred it directly. So, in effect, the other person has a larger income amount to be taxed (as it would have absent the tax-loss arrangement), and the income derived by the loss company from the arrangement is offset by the identical expense amount it is now deemed to have incurred.

The second part of the IS considers section GB 3BA, which is intended to prevent pre-emptive changes to business activities that enable a loss company to satisfy the business continuity rule where it otherwise would not. It applies when either a share in the loss company or a share in another company is subject to an arrangement that is entered into within the 2 years immediately preceding a continuity of ownership breach, where the arrangement allows the loss company to meet the requirements of the business continuity rule, despite the breach of the continuity of ownership requirements. The example given in the IS is a party transferring business leases (from which it derives its revenue) to a loss company before acquiring the shares in the loss company, which will trigger a loss of the 49% ownership continuity requirement. However, as the loss company would then satisfy the business continuity test, it would maintain its ability to carry forward its tax losses under the new owner. If section GB 3BA is triggered, then the tax loss company is treated as not satisfying the business continuity test at the time of breach of the ownership continuity rules and, consequently, loses its ability to carry forward its tax loss balance.

The draft IS does contain several useful examples to illustrate the application of the anti-avoidance rules. For example, permitted is intra-group recharges, which do no more than recover the cost of the performance of the function by the associated company (where such functions also used to be performed by the loss company itself – so a rationalisation of the costs to one provider entity). As opposed to a scenario where the functions (and associated costs) are removed from the loss company to be provided going forward by the associated company, however, the associated company does not charge the loss company for providing these services.

Somewhat interestingly (if my memory serves me right of the IR green light being given to a trust now subject to the 39% tax rate, transferring its income-producing assets to a wholly-owned company), IR does not like the thought of the associated company transferring its profitable business (naturally, of a similar nature to the loss company’s existing business) to the loss company post the shareholding change. Why would a successful business be transferred to a higher-risk entity (the tax loss company) other than for the sole or main purpose of tax avoidance?

Want to understand more, particularly with respect to the latter example? Well, it’s a 49-page document and the closing date for any submissions on the commentary is 1st November 2024.

This article from the 'A Week in Review' newsletter was originally published on Monday, August 5th 2024. If you have any questions or would like a second opinion on any national or international tax issues, please get in touch with me at [email protected].

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