Are you in the ATO’s sights over tax losses?

Hands up all those SMEs that have made losses over the last couple of years! It’s been a very difficult time for many businesses (and still is), so making a loss can’t be all that unexpected.

No doubt the Tax Office knows this, but it seems the extent of the losses being made is of some concern to it. And, of course, there are rules in the tax law that determine how losses can be claimed – and they’re not all that simple, meaning the ATO knows that some SMEs will get it wrong about their losses.

The ATO has announced that it is stepping up its compliance focus on losses following a large number of businesses in the SME sector reporting revenue losses in the aftermath of the global financial crisis.

The ATO said it will undertake two separate compliance campaigns in the near future:

The ATO will write to selected SME companies (via their tax agent) with carried forward losses in their 2009 income tax returns. These letters will provide “educational guidance” about common issues associated with revenue losses.
In early April 2011, the ATO will also write to selected SMEs (via their tax agent) that generated, deducted or carried forward significant tax losses in the 2008 or 2009 income years. The letter will notify recipients that the ATO may seek further verification of those losses through a questionnaire, or where necessary, a more formal review or audit process. The ATO said SMEs selected for verification purposes will be notified via their tax agents in late April or early May 2011.

The ATO said it will only select SMEs as part of one of these campaigns, not both. The ATO encourages SMEs to take this opportunity to check with their tax agent or accountant to ensure they are still eligible to use the losses.

The rules governing losses

As I mentioned above, there are a number of rules that govern claiming tax losses. They are not necessarily simple (why are we not surprised about that!) and it would not be difficult for SMEs to fall foul of the rules.

Taxpayers, including companies, are entitled to deduct tax losses incurred in one income year against assessable income derived in later years in accordance with rules set out in the tax law.

The entitlement of companies to deductions in respect of losses incurred in prior years is subject to certain additional restrictions designed to prevent trafficking in tax losses. The restrictions centre around what are known as the continuity of ownership test and the same business test. The general object of these restrictions is to maintain the principle that the persons who obtain the benefit of the loss deductions should, as far as practicable, be the same as the persons who owned and controlled the company during the year in which the losses were incurred.

There are also rules that dictate the order in which losses can be deducted. This gets very technical, which is why SMEs should consult their accountant or adviser to be certain of where they stand. The loss deduction rules can be stated as:

1. A company is required to first deduct a prior year tax loss from any net exempt income in the later income year. If there is no exempt income, the company can deduct so much of the tax loss as it chooses (subject to a loss limitation rule, which I won’t go into).

2. If the company has net exempt income and its assessable income exceeds its deductions (excluding the tax loss), the tax loss is first applied against the net exempt income and the company can then deduct the chosen amount of any remaining tax loss (again subject to the loss limitation rule).

3. If the company has net exempt income and its deductions (excluding the tax loss) exceed its assessable income, the excess deductions are applied against the net exempt income and the tax loss must then be applied against any remaining net exempt income.

You can see where the complexity of the rules rapidly becomes a major issue for SMEs. These rules are not simple.

Common mistakes about tax losses

It might help to be aware of some of the common mistakes the ATO has come across when looking at losses. These include:

losses used where the company does not satisfy either the continuity of ownership or same business tests. A company does not have to satisfy both tests. If a company fails to meet the continuity of ownership test, it can still claim the losses if it satisfies the same business test. The essence of these tests is that:

– the same persons owned the company in the year the loss was made as in the year the loss was claimed; or

– the company carried on the same business in the year the loss was made as in the year the loss was claimed;

This sounds simple enough in principle, but when it comes to applying it in practice, that simplicity tends to go out the window.

records not accurately kept to support or reconcile the loss;
losses that do not satisfy the same business test and result in further losses carried forward;
carried forward losses not checked to ensure they are correctly calculated, including: amendments to prior-year tax returns; and losses cancelled by the taxpayer.

It is also important to differentiate between revenue losses and capital losses, because capital losses can only be offset against capital gains.

It may be the case that many SMEs are correctly claiming tax losses, but it’s easy to get caught out by the many complex rules. With the ATO in the process of writing to SMEs, and the possibility of audits in the wind, maybe it’s a good time to check that all’s well with loss claims.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .