Claiming tax losses – be warned! The taxman is watching

The tax office is examining businesses that persistently report losses, and the SME sector has a high proportion of businesses that operate with on-going losses. By TERRY HAYES of Thomson Legal & Regulatory

By TERRY HAYES of Thomson Legal & Regulatory

No business, SME or otherwise, wants to make a loss – but it happens. The tax law allows a deduction for such losses, but the rules can be complicated and the tax office casts a particularly keen eye over claims for losses.

Many court cases have been fought over the issue and it is highly prudent for SMEs to be very sure of their position when claiming tax losses. So, what is the tax office doing about losses?

The tax office classifies an SME as a business with annual turnover of between $2 million and $100 million, although more than 85% of SMEs have annual turnover of less than $10 million.

In Australia, there are more than 95,000 SMEs, and although they pay about 11% of the total tax collected, including 35% of all GST, they account for around 25% of all carried-forward tax losses, mostly by companies. That’s a lot of tax – and a lot of losses – and the sector does not easily escape the taxman’s eye.

In 2006-07, the tax office is examining the tax performance of businesses that persistently report losses, and the SME sector has a high proportion of businesses that operate with ongoing losses. Running a business is never easy at the best of times, and it can be difficult for many SMEs to survive if they make losses for a number of consecutive years.

A supportive bank can keep the business afloat, but mounting losses will inevitably lead the tax office to question what is going on. Of course, companies in loss may finance that loss, stay in business and increase their net assets, but tax questions may still arise during that process.

Tax office analysis shows that a small proportion of taxpayers represent the vast majority of losses within SMEs — two-thirds of these losses are held within less than 3% of the overall SME sector. In 2006-07, the tax office is undertaking case reviews and audits where losses exceed $50 million, although it will still examine smaller losses as well.

Meet the tests … claim the loss

Critical areas that SMEs need to be aware of concern the tests they have to meet in order to be able to claim losses of previous years. In essence, a company can claim a carry-forward tax loss if its majority beneficial ownership remains the same or, if ownership does change, that it carried on the same business immediately before the change in ownership.

Although these tests may seem straightforward, they are quite technical in nature and SMEs with tax losses to claim should at the very least consult their accountant if a change in ownership is contemplated or if a change in business activities is planned. This can have a negative impact on claiming losses and can represent a financial disaster for the business if expert advice is not obtained.

Industries in the spotlight

In a pointer as to what industries it will look at, the tax office has flagged eight industries in which losses have exhibited significant changes between 2004 and 2005:

• An increase in losses in construction; finance and insurance; manufacturing; mining; primary production; property and business services; and
• A decrease in losses in accommodation and food services.

Of course, the mining industry has had an increase in exploration projects that require a substantial outlay of capital, so losses are not necessarily unusual there. An SME in this sector should take expert advice as tax losses can last years, but are nonetheless part-and-parcel of doing business in this sector.

Construction is affected by regional and economic conditions. Some areas of the industry have seen profitable activity in recent years. Other locations have highly competitive rates with low margins and are often at risk of break-even or loss-making outcomes. Careful record keeping is essential in this industry.

Many SMEs in the health care industry incur substantial up-front costs, generating losses over the short to medium term. Again, from a taxation point of view, careful attention to record keeping is essential. The losses can be justified and substantiated with good advice and attention to detail.

There may be cases in the manufacturing industry where SME subsidiaries in Australia are here for strategic reasons that will never make a profit in Australia. If this is the case, careful recording of a case to justify such a claim to the tax office will be needed. The business will need to be a commercially run enterprise, but it may be that it was set up not necessarily to make profits, at least in the short-term. Documentation should be kept to enable the tax office to be satisfied this is the case.

The checklist

The tax office has developed a tax loss checklist for its staff, which requires them to review the origin and substantiation of SME losses. Increasingly, tax office reviews will focus on these areas and SMEs will need to ensure they keep all documentation necessary to justify and track losses. This is all the more important as losses can have lives of several years until they are fully claimed.

A loss for tax purposes is not necessarily a bad thing. Of course, it’s not as good as a profit, but with careful planning, good advice from your accountant, and some perseverance, a business can survive and prosper.

Read this and other stories on how the taxman is going to find you. Click here.

Terry Hayes is the senior tax writer at Thomson Legal & Regulatory, a leading Australian provider of tax, accounting and legal information solutions; www.thomson.com.au