Business owner clients may need to be reminded that they should not get too creative if they’ve thought how handy it would be to absorb a business loss as a tax deduction — especially under certain circumstances as described below.
The ATO has the discretion to disallow the deduction of a tax loss if, during the relevant income year, the business attempting to make such a claim earned assessable income (or realised a capital gain) that would not have been derived had the loss been unavailable as a deduction (our emphasis, and see more details in ID 2010/48).
The tax law has measures in place to ensure such deductions are limited to those businesses that are legitimately eligible — such as the continuity of ownership and the same business tests. But there is also the “integrity” measure above that may result in a denial of a claim for losses that business owners should keep in mind.
There is some balance to the rules in that the Commissioner of Taxation is “prevented” from disallowing the deduction should “continuing shareholders” stand to benefit from the relevant income. However there is still a fair amount of discretion left to the Commissioner in how the business loss rules are applied (see more here).
In the above scenario, the loss will still be available subject to the satisfaction of the special rules applying to company losses (including Division 175 of the ITAA 1997).
Remember also that different business structures have different rules around loss claims.
Individuals can generally carry forward a tax loss indefinitely, but must claim a tax loss at the first opportunity. You cannot choose to hold on to losses to offset them against future income if they can be offset against the current year’s income.
Carried-forward tax losses are offset first against any net exempt income and only then against assessable income. Losses must be claimed in the order in which they were incurred.
If a partnership makes a tax loss, each partner has a proportionate share of the loss and treats it like a loss from any business activity (including applying the non-commercial loss rules).
If you operate your business as a trust and you incur a tax loss, you cannot distribute the loss to the trust’s beneficiaries.
Losses must be quarantined in a trust to be carried forward by the trust indefinitely until offset against future net income. It is possible to use those losses as deductions against income in the trust in future income years if the trust satisfies certain tests relating to ownership or control of the trust.
Companies can carry forward a tax loss indefinitely, and use it when they choose, provided they satisfy the above mentioned continuity and same-business tests.
As far as the ATO exercising the discretion to disallow, and of course circumstances of the business or businesses involved will have an influence, a business can mitigate the risk that the ATO will exercise this discretion to disallow a tax loss deduction by making sure that either (or preferably both) of the following contentions are supported:
- that the business would have derived the income or realised the capital gain regardless of the tax loss being available
- that continuing shareholders will benefit from the above in a fair and reasonable manner with regard to their rights and interests.
Make sure your business client is well aware of the issues should they flag that they are considering these type of tax deductions.