When companies incur tax losses, they can utilise them to offset against future profits. The Shareholder Continuity rules disallow these losses to be carried forward into future income years when there has been a change in shareholding by more than 51% from the income year the tax loss was first incurred to the income year in which the tax loss is being recognised.
A breach of more than 51% shareholder continuity under section IA 5 of the Income Tax Act 2007 (“the Act”) limits a company’s ability to carry forward tax losses into future periods. With the introduction of a new test under section IB 3 of the Act, a company is able to offset current and future profits by utilising prior period losses despite breach in shareholder continuity as long as they meet the requirements of the new test.
Prior to the business continuity test, a change in shareholding of more than 51% would result in the forfeiture of a company’s losses. This straight cut rule has limited a business’s potential to introduce major equity injections or change in entire ownership to boost the economic efficiency and scale of the business.
With the introduction of the ‘Business Continuity’ test for the 2020 – 2021 income year, many businesses are permitted a major change in ownership and still receive the benefit of utilising prior period losses. This has opened the market up for businesses who seek significant equity funding without sacrificing historical tax losses. However, it is important to understand how this test works, the mechanisms in place and its limitations.
The business continuity test criterion indicate that post a change in major shareholding, the business must continue to operate in the same or similar manner it did prior to the shareholding change. There is a 5-year limit ending on the last day of the income year in which the ownership continuity breach occurred. The following transformations in a business post-shareholding change are acceptable:
- Increase in efficiency.
- Response to advances in technology.
- The scale of the business, including accessing different markets.
- Product or service range (excluding land), by either:
- Withdrawing unprofitable products or services.
- Adding new products or services that are related to those already being produced.
There are two types of companies excluded from the new test. These are:
Businesses in this sector with losses which mainly arise from writing off bad debt are excluded from the 5-year limit. This is to ensure no major shareholding change is allowed to utilise the losses that arise from bad debts in the ordinary course of business.
Mineral Mining Companies
The business continuity test does not apply to mineral mining companies. They must follow the shareholder continuity test.
The following examples help illustrate the legislative applications of the new business continuity test which could apply to your company.
Display NZ Limited (Display NZ) sells monitors to NZ businesses. They have been in business for the past 5 years since 2017. In the first 3 years of business, they incurred the following losses: 2018: $350,000, 2019: $200,000, 2020: $150,000. In 2021 and 2022 they generated a profit of $175,000 and $200,000 respectively. They are looking for a new business partner to join their venture.
Tech NZ Limited (Tech NZ) has approached Display NZ to collaborate as both companies are in the same industry, with a proposed acquisition of 60% ownership of Display NZ. Display NZ is positive that with Tech NZ’s logistical network, this deal has the potential to grow Display NZ’s business exponentially. They have engaged Bellingham Wallace on the tax implications of their prior period losses.
The above example highlights that this share acquisition breaches the shareholder continuity test as there is a shareholding change greater than 51%. However, we may apply the new business continuity test as the proposed acquisition of Display NZ by Tech NZ meets the requirements of “increase the scale of the business/increase in efficiency”. Display NZ is neither a Finance nor Mineral Mining company. The shareholders have indicated that there is no intention to change the product range nor radically change industry offerings. Based on the facts above, we can conclude that this acquisition will not impact the ability for the Display NZ to carry forward its historical losses to future periods.
It should be noted that the business continuity test is a subjective test and should be assessed along with the facts of each scenario.
Want to know more about how the new test affects your business and its future tax position? Get in touch with the team at Bellingham Wallace where we will go over the new continuity test and how it applies to your situation.
Author – Rukesh Chelliah