Private ruling: Tax losses
Date of advice: 17 June 2016
Published: August 2016

Ruling: Q1: Does Company X satisfy the transfer test contained in section 707-120 of the Income Tax Assessment Act 1997 (ITAA 1997) and the modified same business test (SBT) under section 707-125 of the ITAA 1997 to enable the transfer of its unutilised tax losses to the head company of a multiple entry consolidated (MEC) group of which Company X becomes a member? | A1: Yes

Relevant facts and circumstances: The scheme that is the subject of this ruling has been ascertained from the ruling application and subsequent correspondences with the applicant. Company X Company X was incorporated in Australia to undertake drug development activities leading to the commercialisation of potential new drug candidates for the treatment and management of a particular condition. The Company X business plan (Business Plan) provides its core strategy which was to in-licence promising drugs at an early stage of development and then add value to these by designing and implementing effective early drug development programs through clinical development before seeking a partnership with a major pharmaceutical company to complete clinical development. It is the directors' intention to pursue licensing agreements to realise the value of its projects. Company X's foundation technology was developed by Australian researchers, who identified a particular type of drug in preclinical models. Company X completed a round of fund raising by issuing shares to an Australian venture syndicate. Company X licenced the foundational IP and entered into a Commercial Ready Grant Agreement with the Commonwealth of Australia. Following lead drug candidate selection studies, and consistent with its strategic goals, Company X selected a particular drug as a development candidate; the intellectual property (IP) of which was assigned and all new IP generated by further R&D on the drug was the sole property of Company X. Company X outsourced most research and development activities related to the development of drug. Company X prepared for human clinical trials under an Investigational New Drug Application (IND) with the relevant Food & Drug Administration (FDA), and the existing Australian venture syndicate reinvested and was joined by two other companies. Company X successfully completed Phase I and Phase II clinical trials and went on to raise further capital to fund its further clinical development and drug discovery activities. The existing investor syndicate continued to participate and was enhanced by the addition of new venture investors. Funding was obtained on the basis that shares would be issued in an entity incorporated in an overseas country Throughout the relevant period, the main business activities of Company X have been research and development and commercialisation of pharmaceutical products. Company X's revenue for the relevant income years are made up of grants proceeds, interest and lease payments. Company Y and its acquisition of Company X Company Y was registered in an overseas country. Company Y and Company X entered into a Share Exchange Agreement, where all classes of stock previously issued by Company X were transferred to Company Y in exchange for equivalent Company Y shares issued to the previous Company X shareholders. Following the acquisition, Company X maintained responsibility for clinical trials worldwide and maintained ownership of all intellectual property. To complement the core Company X in-house team, Company X continued to engage consultants and contractors to carry out certain activities. The expansion of the activities and the move of the operations to the overseas country were consistent with the further progression of the development of drug under an IND with the FDA. Licence agreement between Company X and Company Y Company X entered into a licence agreement with Company Y. Under the licence agreement, Company X granted Company Y an exclusive licence in an overseas country to exploit the Licenced Technology (patent rights and know-how) for the purposes of conducting research and development and commercialising the products. Sale of Company X and Company Y to Topco Ausco, an Australian resident company, is the provisional head company of a MEC group (the Ausco MEC group). Topco, a foreign resident company, is the top company of the Ausco MEC group. Topco indirectly acquired Company Y, and hence Company X. Company X joined the Ausco MEC group at the time of the acquisition of Company Y by Topco. It is intended that the development of Company X's programs will continue through Phase IIb clinical trials in the overseas country.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 165-A | Income Tax Assessment Act 1997 section 165-10 | Income Tax Assessment Act 1997 section 165-12 | Income Tax Assessment Act 1997 section 165-13 | Income Tax Assessment Act 1997 section 165-210 | Income Tax Assessment Act 1997 section 166-5 | Income Tax Assessment Act 1997 Subdivision 707-A | Income Tax Assessment Act 1997 section 707-120 | Income Tax Assessment Act 1997 section 707-125

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) Company X will satisfy the transfer test contained in section 707-120 of the Income Tax Assessment Act 1997 (ITAA 1997) and the modified same business test (SBT) under section 707-125 of the ITAA 1997 to enable the transfer of its unutilised tax losses to the head company of the Ausco MEC group. | Detailed Reasoning - Detailed reasoning: Subdivision 707-A of the Income Tax Assessment Act 1997 (ITAA 1997) governs the transfer of losses to the head company of a consolidated group. Section 707-120 contains the test for transfer of losses from a joining entity to the head company of a consolidated group. Relevantly the section states: 707-120(1) Subject to subsection (1A), the loss is transferred at the joining time from the joining entity to the head company of the joined group (even if they are the same entity). 707-120(1A) The loss is transferred under subsection (1) only to the extent (if any) that the loss could have been utilised by the joining entity for an income year consisting of the trial year if: (a) at the joining time, the joining entity had not become a member of the joined group (but had been a wholly-owned subsidiary of the head company if the joining entity is not the head company); and (b) the amount of the loss that could be utilised for the trial year were not limited by the joining entity's income or gains for the trial year. The trial year is defined in subsection 707-120(2). It states: The trial year is the period: (a) starting at the latest of these times: (i) the time 12 months before the joining time; (ii) the time the joining entity came into existence; (iii) the time the joining entity last ceased to be a subsidiary member of a consolidated group, if the joining entity had been a member of a consolidated group before the joining time but was not a member of a consolidated group just before the joining time; and (b) ending just after the joining time. | Detailed Reasoning - Modified COT for transfer of losses: In order for a joining entity to transfer a tax loss to the head company of a consolidated group or MEC group, it must satisfy the conditions set out in Subdivision 165-A, as modified by Subdivision 707-A. Subdivision 165-A of the ITAA 1997 contains the conditions for determining if a company is able to deduct a tax loss under Division 36 of the ITAA 1997. Section 165-10 of the ITAA 1997 provides that a company cannot deduct a tax loss unless it meets the conditions in section 165-12 of the ITAA 1997 (that is, it satisfies the COT) or it meets the condition in section 165-13 of the ITAA 1997 (that is, it satisfies the same business test (SBT)). In the first instance the company must satisfy the COT in accordance with section 165-12, as modified by section 707-120. The COT was failed on acquisition of Company X and Company Y by Topco. As Company X is not able to transfer losses under the modified COT, consideration of the SBT in section 165-13, as modified by section 707-125, is necessary. | Detailed Reasoning - Modified SBT: Section 707-125 contains the modifications to the SBT for a company with post-1999 losses, which becomes a subsidiary member of a consolidated group and needs to satisfy section 707-120 to transfer its losses to the head company of the consolidated group. It states: 707-125(1) This section operates if: (a) the joining entity made the loss for an income year starting after 30 June 1999; and (b) section 165-13 or subsection 165-15(2) or (3) or 166-5(5) or (6) is relevant to working out (under section 707-120) whether the loss is transferred from the joining entity 707-125(2) Work out whether the loss is transferred on the basis that section 165-13 required the joining entity to satisfy the *same business test for: (a) the period (the same business test period ) consisting of: (i) the *trial year; and (ii) the income year that included the *test time worked out for section 165-13 for the joining entity (disregarding paragraph (b) of this subsection), if that income year started before the trial year; and (b) the time (the test time ) just before the end of the income year for which the loss was made by the joining entity. 707-125(3) Work out whether the loss is transferred on the basis that: (a) subsection 165-15(2) specified that the period (the same business test period ) for the *same business test consisted of: (i) the *trial year; and (ii) the income year in which the person began to control, or became able to control, the voting power in the company, if that income year started before the trial year; and (b) subsection 165-15(3) required the same business test to be applied to the company's business immediately before the time (the test time ) just before the end of the income year for which the loss was made by the joining entity. 707-125(4) If Subdivision 166-A would apply to the joining entity for an income year consisting of the *trial year, work out whether the loss is transferred on the basis that: (a) subsection 166-5(5) treated the joining entity as having satisfied the condition in section 165-13 if the joining entity satisfied the *same business test for the period (the same business test period ) consisting of: (i) the trial year; and (ii) the income year described in subsection (5) of this section, if that income year started before the trial year; and (b) subsection 166-5(6) required the same business test to be applied to the *business that the joining entity carried on at the time (the test time ) just before the end of the income year for which the loss was made by the joining entity. Note: Subdivision 166-A applies to widely held companies and eligible Division 166 companies unless they choose that Subdivision 165-A apply to them without the modifications made by Subdivision 166-A. 707-125(5) For the purposes of subparagraph (4)(a)(ii), the income year is: (a) the income year in which occurred the first time mentioned in subsection 166-5(6); or (b) the income year of the joining entity containing the time at which the joining entity is taken under subsection 707-210(5) to fail to meet the condition in section 165-12, if that subsection is relevant to working out whether the joining entity can utilise the loss. Note 1: Section 707-205 affects the start of the test period if the joining entity made the loss under a previous operation of this Subdivision. Note 2: Section 707-210 is about whether a company can utilise certain losses transferred to it under this Subdivision from a company. 707-125(6) Subsection (4) of this section has effect despite subsection 707-210(6). Note: Subsection 707-210(6) modifies section 166-5 for working out whether a company can utilise certain losses transferred to it under this Subdivision from a company. The SBT is defined in section 165-210. It states: 165-210(1) A company satisfies the same business test if throughout the *same business test period it carries on the same *business as it carried on immediately before the *test time. 165-210(2) However, the company does not satisfy the *same business test if, at any time during the *same business test period, it *derives assessable income from: (a) a *business of a kind that it did not carry on before the *test time; or (b) a transaction of a kind that it had not entered into in the course of its business operations before the *test time. 165-210(3) The company also does not satisfy the *same business test if, before the *test time, it: (a) started to carry on a *business it had not previously carried on; or (b) in the course of its business operations, entered into a transaction of a kind that it had not previously entered into; and did so for the purpose, or for purposes including the purpose, of being taken to have carried on throughout the *same business test period the same business as it carried on immediately before the test time. 165-210(4) So far as the *same business test is applied for the purpose of Subdivision 165-B (which is about working out the taxable income and *tax loss for the income year of change of ownership or control), the company also does not satisfy the test if, at any time during the *same business test period, it incurs expenditure: (a) in carrying on a *business of a kind that it did not carry on before the *test time; or (b) as a result of a transaction of a kind that it had not entered into in the course of its business operations before the test time. Subsection 707-120(3) states that, in circumstances such as the current case: When working out whether the joining entity carried on the same business throughout the *trial year (or a period including the trial year) as it carried on at a particular time, assume that the entity carried on at and just after the joining time the same business that it carried on just before the joining time. In the current case, in working out whether the loss can be transferred by Company X to the head company of the MEC group, Company X must satisfy the SBT for: • the SBT period consisting of the trial year; and • the time just before the end of each income year in which a loss was made by Company X (test time). In accordance with subsection 707-120(3) it will be necessary to assume that the business carried on by Company X at and just after the joining time is the same as the business it carried on immediately before the joining time. | Detailed Reasoning - Modified SBT application: The joining entity must apply the section 165-210 same business test in respect of the identified test times to work out whether the loss is able to be transferred. TR 1999/9 sets out at paragraph 60, the following guidelines in determining whether a taxpayer has satisfied the SBT: • Identifying the business carried on by the taxpayer at the change-over involves identifying with specificity the actual business activities carried on and transaction entered into by the taxpayer at the change-over. The business of the taxpayer is not identified by reference to the kind of industry to which the taxpayer belongs, or by reference to certain activities only, on the grounds they constitute the heart or core of the business - all activities are relevant. • The business carried on by the taxpayer is not characterised by reference to business activities or transactions that the taxpayer intended to carry on or enter into before the change-over, or that the taxpayer had power or expressed the intent to carry on or enter into under its constituent documents before the change-over, if the evidence discloses the taxpayer did not, in fact, carry on those activities or enter into those transactions at or before the change-over. • There is a distinction between a change of business and a 'mere change in the process by which [the business] is carried on'. The second kind of change does not, of itself, result in a taxpayer not satisfying the SBT. However, when a change in the taxpayer's business operations or processes affects the identification of the taxpayer's business by going beyond a mere change in the way in which the business is carried on, it is likely to result in a change in the business itself. • An expansion or contraction of the taxpayer's business activities may not, in itself, result in a change in the identity of the business carried on by the taxpayer. However, the expansion or contraction of activities may result in a change in the identity or character of the business, taking into account the nature and extent of the expansion or contraction. In particular, the organic growth of a business through the adoption of new compatible operations in the ordinary way and, similarly, the discarding of old operations in that way, may not cause a taxpayer to fail the SBT, but a sudden and dramatic change brought about by the loss or acquisition of business operations on a considerable scale is likely to do so. • Hence, the discontinuance during the period of recoupment, whether by way of cessation or sale, of a significant part of the business that was carried on by the taxpayer at the change-over, is likely to result in the company failing to satisfy the SBT. • The commencement or acquisition, by merger or otherwise, of new undertakings (including going concerns and similar or complementary undertakings) may cause a company to fail the SBT. • Other factors relevant to the issue of whether the same business is being carried on after the change-over include the name of the taxpayer, the location of the business, the existence of a period or periods of dormancy, and the circumstances accounting for the inactivity and in which activity is resumed. And, also, the extent to which there is continuity of, or change in, custom and goodwill. • Where the taxpayer's activities have wound down to the extent that justifies a finding of fact that the taxpayer had ceased to carry on a business, either at the change-over or before or during the period of recoupment, the taxpayer does not satisfy the SBT. • The business carried on by one company in a commonly owned or controlled corporate group is not characterised by reference to the business of the group as a whole. But changes in the businesses or identities of other companies in the group may result in a change of business. The Business activity of Company X The business activity of Company X for the test period has been research and development and licencing of the drug. As stated in its Business Plan, Company X's core strategy was to in-licence promising drugs at an early stage of development from academic and commercial institutions, add value to these drugs by designing and implementing effective development programs to Phase II clinical development before actively seeking a partnership with a major pharmaceutical or biotechnical company to complete clinical development, manufacturing, file for regulatory approval, and carry out marketing activities. This drug technology was in-licenced from the Australian research group. Company X selected a particular drug as a development candidate and outsourced most research and development activities related to the development of the drug and completed a successful Phase II trial of drug. Company X entered into a licence agreement with Company Y to realise value from its projects. This is supported by the Business Plan which states that the directors' intention is to pursue licencing agreements to realise value from its projects. Under the Licence Agreement, Company Y was granted a licence to certain intellectual property rights and know-how owned by Company X to conduct research and development and to undertake commercialisation of the drug in an overseas country. It is intended that Company X's programs will continue through Phase IIb clinical trials. New business test/new transaction test As previously highlighted, in addition to meeting the positive limb of the SBT, paragraph 165-210(2)(a) requires that the company has not, at any time during the SBT period, derived assessable income from a business of a kind which it did not carry on before the test-time (the new business test). In the 'new transactions' test in paragraph 165-210(2)(b), where a new transaction is considered 'of a different kind' from the transactions at the test time the test will not be satisfied. 'Transaction', in this reference incorporates every means or event by which income is derived. The test looks at all transactions, not merely those that are 'isolated' or 'independent' (TR 1999/9 paragraph 80). Derivation of small, insignificant amounts of income will not cause the company to fail the new transactions test. Having regard to Company X's revenue stream, which consisted mainly of interest and R&D grant proceeds, Licence fees could be construed to be new. However, the amounts received from Company Y under the Licence Agreement are for granting Company Y the rights and know-how owned by Company X to conduct research and development and to undertake commercialisation of the drug in the overseas country. Therefore, it is considered that these receipts are not derived from a business of a kind that it did not carry on before the test time. Additionally, as licensing of the IP was in the Business Plan, it is considered to be in the ordinary course of the business. Other factors There were no changes to Company X's business objectives. Company X focused on the clinical trials, and to build on these key indications to pursue a broad approval of the drug. Conclusion The same business has been carried on by Company X for the relevant period. Thus, Company X has satisfied the SBT as modified by Subdivision 166-A and section 707-125. As the SBT has been satisfied, unutilised tax losses of Company X for the relevant years can be transferred to the head company of the Ausco MEC group at the joining time.