Chapter 7 - Neutrality and integrity measures
7.1 A cashed-out loss can be thought of as an interest-free loan from the Government to be repaid from the taxpayer’s future taxable income; it is intended to provide a temporary cash-flow timing benefit when the company is in tax loss. However, if the R&D expenditure never results in a viable product, the interest-free loan effectively becomes a grant.
7.2 If the company or the shareholders make a return on their investment before they have repaid the value of the cashed-out loss, this will lead to an outcome that is concessionary to the taxpayer. In addition to the untaxed receipt, they also retain the benefit of the remaining cashed-out losses that have not yet been repaid. This also creates a fiscal risk.
7.3 R&D companies can make such a return on their investment through the sale of:
- intellectual property from R&D the company has performed;
- all of the shares in the company carrying out the R&D; or
- some of the shares in the company.
7.4 If an R&D company is able to sell intellectual property, sell shares in the company, or the company itself is sold, it is highly likely the R&D company will also no longer be constrained to the same degree by the market failures and cashflow constraints affecting small R&D-intensive start-up companies. In this situation, the original policy rationale will no longer apply, as the company will have funds available to pay back the value of the cashed-out loss. Rules are therefore required to recover the value of any remaining cashed-out loss to ensure the correct policy outcome. We therefore seek your views on suggested recovery rules set out below.
Sale of intellectual property
7.5 One way of realising a return on an R&D investment is to sell the corresponding intellectual property to a third party. It is proposed that if an R&D company has remaining cashed-out losses that have not yet been repaid, loss recovery income will arise from the sale of intellectual property up to the balance of any remaining cashed-out loss. The amount of the loss recovery income will then be reinstated, to become a loss to be carried forward. This preserves neutrality between companies that sell intellectual property before and after the cashed-out loss has been repaid.
7.6 If the R&D company has already derived sufficient taxable income to repay the balance of the cashed-out loss before it sells its intellectual property, this rule will no longer apply.
7.7 This is analogous to the depreciation rules. Depreciation deductions are given for depreciating assets, but to the extent the final sale price is more than the adjusted book value of the asset there is depreciation recovery income. A similar approach is suggested here to ensure the tax treatment of profits and losses is neutral.
Sales within the group
7.8 There is also the scenario when the intellectual property is sold to another group company; for example, in advance of an initial public offering of the new company. Currently the value at which the intellectual property is transferred does not matter as there is no tax on its sale. However, when losses are cashed out, we may need to consider whether there needs to be a requirement that transfers must be made at market value. Transfers below market value would enable taxpayers to avoid paying the full extent of any loss recovery income. An alternative option could be to ignore the transfer for tax purposes but move the potential liability to loss recovery income to the new company.
Sale of all company shares
7.9 The value of the intellectual property can also be realised through the sale of all shares in the company. As an integrity measure the “loss recovery income rule” will also be extended to the extent that:
- a profit is made on the sale of the shares; and
- the company has remaining cashed-out losses that have not yet been repaid.
7.10 In such circumstances taxable income will arise to the shareholder, in proportion to their shareholding, and up to the value of the remaining cashed-out losses. It will be taxed at the shareholder’s marginal tax rate.
A company that has cashed-out losses is sold to Purchaser A. The 1,000 shares in the company were held by Shareholder A (40% share), Shareholder B (40% share) and Shareholder C (20% share). The profit per share on sale is $10. A total of $300 of losses had previously been cashed out and there was also subsequent taxable income of $200 to the company before the sale.
The profit made by the respective shareholders is $4,000/$4,000/$2,000. The total loss recovery income, for the remaining cashed-out losses, is only $100 (being $300 less $200). As the loss recovery income is in proportion to the shareholding, Shareholders A and B will each have $40 taxable income and Shareholder C will have $20. This is then taxed at each shareholder’s marginal tax rate.
7.11 As a further integrity measure, all controlling shareholders of the immediate shareholder, whether direct or indirect, will be jointly and severally liable in the event the immediate shareholder does not pay the tax on this income. This is to prevent the company being stripped of assets before the tax falls due.
Sale of some company shares
7.12 The focus with the previous integrity measure involving the sale of all shares in the company was to the extent that any taxable income earned by the company was less than the losses cashed out and shareholders made a gain from the sale of their shares, the lesser of the two became loss recovery income. In other words, the appropriate time to claw back any residual timing benefit from the initial cashing out of losses is when a shareholder received a direct benefit from the company.
7.13 While the same principle should apply to partial sales, it becomes more difficult to apply in practice. The nature of R&D-intensive start-up companies is to seek additional capital throughout their life cycle, which means it can be unclear at what point the controlling shareholding actually changed.
7.14 The other difficulty is that to the extent that a part of any remaining cashed-out losses would be repaid as loss recovery income on sale, the total amount of the potential recoverable loss that is held in the company would need to be reduced.
7.15 For these reasons we suggest:
- The loss recovery income rule will also apply for the sale of part of the shares in the company, when the proportion of shares sold represents greater than 5 percent of the total shares in the company.
- The amount of loss recovery income will be pro-rated for the proportion of shares sold.
- The value of remaining cashed-out losses in the company is reduced by the amount of loss recovery income of the shareholders.
7.16 An anti-avoidance rule will also be needed to ensure the loss recovery income rule still applies when multiple shareholders separately sell less than 5 percent of their respective shareholdings, but the combined sale represents more than 5 percent of the total shares in the company.
Shareholder A sells half of its shareholding in the company (equivalent to 20 percent of the total shares in the company). The loss recovery income rule is therefore triggered. As before, a total of $300 of losses had previously been cashed out and there was also subsequent taxable income of $200 to the company before the sale of shares. The total amount loss recovery income is therefore $100, which is adjusted down to $20 reflecting that only 20 percent of the shares in the company have been sold. Shareholder A therefore has taxable income of $20 and the remaining cashed-out losses in the company is reduced by $20.
Shareholder B sells 10% of its shareholding in the company (equivalent to 4% of the total shares in the company). Given this is less than the 5% threshold to trigger the loss recovery income rule, there is no recovery on sale.
7.17 We recognise that there are practical limitations with this aspect of the suggested loss recovery rules. Claiming loss recovery income back from shareholders who are based overseas would pose collection challenges. Also, correctly assessing loss recovery income arising from the resale of shares (which, having been sold before, will not have the same amount of cashed out losses allocated) will be highly complex.
7.18 Given these difficulties, an alternative option is to keep the cashed-out loss within the company, with recovery income triggered by subsequent profits, a sale of intellectual property or a majority stake in the company itself.
Issue of new shares
7.19 The nature of small start-up R&D companies is that they will gain additional shareholders and additional equity funding through the firm’s life cycle. Generally speaking, however, this will involve the company issuing more shares for additional capital. While this will have the effect of both diluting the value of holding of the existing shareholders it will also increase the value of the company as it will have a stronger capital base. Thus the effect of the additional capital on existing shareholders will be balanced.
7.20 It is therefore not proposed that the value of remaining cashed-out losses be clawed back on the issue of new shares by the company and the loss recovery income rule will not apply. The loss recovery income rule will only be targeted at shareholders when the shareholders receive a direct benefit from the sale of their shares.
7.21 We may, however, need to consider whether this rule could be inadvertently or inappropriately used in an initial public offer situation to get around the rule relating to the sale of shares.
- Are there possible unintended consequences that have not been captured above?
- What other measures may be needed to minimise risk to the tax base?
- Would the proposed loss recovery rules be significantly less complex if the proposed rules governing the sale of company shares were not included, and the loss stayed within the company? If yes, how else could a neutral tax outcome be achieved, with lower complexity, for situations where some of the shares of the company are sold?