Company losses: continuity of ownership test - time of change in ownership of shares

In respect of the sale of a loss company, will the time of change in ownership of shares under the continuity of ownership test (COT) relating to company tax losses in section 165-12 of the Income Tax Assessment Act 1997 (ITAA 1997) necessarily be the same as the time of disposal of shares for capital gains tax (CGT) purposes?

No. A change in ownership for the purposes of COT occurs when there is a change in beneficial ownership of shares. For CGT purposes, a disposal of shares under a contract happens at the time when the contract for disposal is entered into, which may not be the time at which there is a change in beneficial ownership of the shares.

On 1 June 2002, individual X and individual Y entered into a written agreement. The agreement was expressed to be a 'heads of agreement' providing for the sale of a company by individual X to individual Y. The agreement did not specify certain fundamental terms and conditions of the sale but expressed that such terms and conditions would be agreed upon by the parties at a future date and expressed in a subsequent formal sale contract. On 1 November 2002, individual X and individual Z entered into a formal contract that was expressed to have been made pursuant to the agreement of 1 June 2002. The contract of 1 November 2002 contained detailed terms and conditions relating to the sale of the company by Individual X to individual Z, who is an associate of individual Y, but was not a party to the original agreement.

The company incurred a tax loss in the 2002-03 income year and it was claimed on behalf of the company that individual Z had been the beneficial owner of shares in the company during the whole of the 2002-03 income year for the purposes of COT under section 165-12 of the ITAA 1997. In this regard, it was claimed that the heads of agreement was the 'source of the obligation to dispose of the shares' in accordance with the High Court decision in Federal Commissioner of Taxation v. Sara Lee Household & Body Care (Aust) Pty Ltd (2000) 201 CLR 520; 2000, ATC 4378; (2000) 44 ATR 370 (the Sara Lee Case ).

A company cannot deduct a tax loss in an income year unless it satisfies COT (section 165-12 of the ITAA 1997) or, if cannot satisfy this test, it satisfies the same business test (section 165-13 of the ITAA 1997). The primary test referred to in section 165-12, which would be applicable in the present case, requires that persons must beneficially own shares carrying more than 50% of the relevant rights at all times during the period from the start of the loss year until the end of the income year. Therefore, in the present case, COT could not be satisfied in respect of the tax loss incurred in the 2002-03 income year (the loss year) unless it could be established that individual Z was the beneficial owner of the shares in the company from 1 July 2002 until the end of the income year.

The time of change in ownership of shares for the purposes of COT is not necessarily the same as the time of disposal of shares under the CGT rules. Under paragraph 104-10(3)(a) of the ITAA 1997, the time of disposal of a CGT asset under a contract is taken to be the time of entry into the contract. In relation to the CGT rules, it was held in the Sara Lee Case that, where two or more contracts are relevant to a disposal of assets: ...the identification of the contract under which the assets were disposed of, for the purpose of applying s 160U of the ITAA 1936, requires a judgment as to which of the contracts is properly to be seen as the source of the obligation to effect the disposal.

However, the identification of the contract that represents the source of the obligation to effect a disposal under the CGT rules is not the basis for determining the time at which there is a change in beneficial ownership of shares for the purposes of COT in respect of tax losses. Other principles will be relevant in this regard, such as whether or not a purchaser under contract can, by way of specific performance, compel a transfer of shares-for example, refer to R v. Australian Broadcasting Tribunal; Ex Parte Hardiman (1980) 144 CLR 13 at 31.

The distinction between the time of disposal of an asset for CGT purposes and the time of change in beneficial ownership was, in fact, recognised in the majority judgement in the Sara Lee Case when, in respect of the agreement that was identified as the source of the obligation to effect the disposal, it was stated that it 'did not effect a change in ownership, legal or beneficial, of the assets'.

The facts of the present case do not support the view that individual Z was the beneficial owner of shares in the company at any time before 1 November 2002 for the purpose of satisfying COT. Before that date, fundamental terms and conditions of sale had not been agreed and individual Z had not been a party to any agreement in respect of the shares.

Therefore, in respect of the sale of a loss company, the time of change in ownership of shares under COT relating to company tax losses in section 165-12 of the ITAA 1997 may not necessarily be the same as the time of disposal of shares for CGT purposes. Note: It is important to note that this ATO Interpretive Decision does not deal with the issue of what would be the time of disposal of shares under the CGT rules in the present case. It is sufficient to note that the present facts are different to those in the Sara Lee Case .