House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 2 - Consolidation: franking deficit tax offsets, MEC groups and enhancements to the cost setting rules

Outline of chapter

2.1 Schedule 2 to this bill enhances the consolidation regime by:

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making minor adjustments to clarify the cost setting rules;

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ensuring that MEC groups are given the same treatment as consolidated groups; and

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enabling the transfer of unapplied excess FDT offsets in a consolidated environment.

Context of amendments

2.2 With the introduction of the consolidation regime, a number of enhancements, mentioned in paragraph 2.1, are being made to further clarify the consolidation cost setting rules and to ensure that the income tax law that applies to head companies of consolidated groups also applies to the head companies of MEC groups. In addition, this bill introduces rules to permit the transfer of any unapplied excess FDT offset from joining entities to the head company.

Summary of new law

Cost setting rules

2.3 Parts 1 to 6 of Schedule 2 to this bill amend the cost setting rules to clarify that:

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the head company is required to choose an effective life for certain depreciating assets brought into a consolidated group where the prime cost method was used to determine the decline in value just before the joining time;

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the cost base for a pre-CGT asset that is rolled over is the same as the cost applicable to the originator of the roll-over for the purposes of the cost setting rules;

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new CGT event L8 will apply where there is excess allocable cost amount on joining that cannot be allocated to reset cost base assets;

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in certain cases an asset's entitlement to accelerated depreciation is preserved;

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the requirement that unfranked dividends have been paid (in working out the adjustment to the cost for certain 'over-depreciated assets') is met where unfranked profits are included in working out the allocable cost amount during the transitional period; and

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an anomaly that incorrectly imposes a penalty on the amount of the particular tax cost setting error instead of on the amount of tax associated with the tax cost setting error is removed.

MEC groups

2.4 Part 7 of Schedule 2 to this bill amends the measures to address unintended tax benefits that were introduced into the income tax law in New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 and the CGT provisions that were introduced in New Business Tax System (Consolidation and Other Measures) Act 2003 so that they apply to head companies of MEC groups. Currently, they only apply to head companies of consolidated groups.

Franking deficit tax offsets and consolidated groups

2.5 Part 8 of Schedule 2 to this bill contains rules to:

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transfer to the head company any joining entity's excess (unapplied) FDT offset;

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allow the head company to apply that FDT offset in accordance with the FDT offset provisions in the SIS contained in this bill;

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prevent the joining entity (now subsidiary) from applying any FDT offset whilst a member of a consolidated group; and

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ensure that any FDT offsets remain with the head company upon the departure of any subsidiary from the group.

Detailed explanation of new law

The cost setting rules

Where the prime cost method was used to determine the decline in value of an asset just before the joining time

2.6 Part 1 of Schedule 2 to this bill amends paragraph 701-55(2)(d) of the ITAA 1997 to ensure that where:

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a joining entity brings a depreciating asset into a consolidated group;

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the cost of the asset is increased pursuant to the consolidation cost setting rules; and

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just before the joining time the prime cost method applied for working out the asset's decline in value; then

the head company must choose an effective life for the asset as at the joining time.

2.7 The head company is effectively required to 're-choose' an effective life for the asset in these circumstances because the effective life previously used by the joining entity is no longer be appropriate where the cost of the asset has been increased under the cost setting rules.

2.8 Prior to this amendment the head company was required to choose an effective life for the asset in accordance with section 40-95 of the ITAA 1997 (other than subsections 40-95(2) and (5)). However, subsection 40-95(4) provides that where an asset is acquired from an associate, and the associate was using the prime cost method, an effective life must be used that is equal to any period of the asset's effective life the associate was using that had not yet elapsed at the time the acquirer began to hold the asset. In the consolidation context, it is arguable, given the deemed acquisition of assets by the head company at the joining time (paragraph 701-55(2)(a)), that subsection 40-95(4) could apply when an entity that is an associate of the head company, joins a consolidated group.

2.9 Similarly, subsections 40-95(4A) to (4C) and 40-95(5A) to (5C) may also give the same unintended outcome but with respect to assets eligible for an effective life subject to a statutory cap under section 40-102.

2.10 The amendments will remove these unintended outcomes by ensuring that only subsections 40-95(1) and (3) are taken into account for the purposes of paragraph 701-55(2)(d). [Schedule 2, item 1, paragraph 701-55(2)(d)]

Maintaining a pre-capital gains tax asset's cost base following a roll-over

2.11 Part 2 of Schedule 2 to this bill ensures that, for the purposes of the consolidation cost setting rules, the recipient of a pre-CGT asset (i.e. an asset acquired before 20 September 1985) that was rolled over inherits the originator's cost base for that asset where the asset was subject to roll-over relief under either Subdivision 126-B of the ITAA 1997 or section 160ZZO of the ITAA 1936. This clarification ensures that the consolidation provisions operate in respect of pre-CGT assets in the same way that they apply to post-CGT assets.

2.12 Where there is a roll-over of a post-CGT asset under Subdivision 126-B or section 160ZZO, the recipient company is deemed to have a cost base or reduced cost base for that asset equal to the originating company's cost base or reduced cost base.

2.13 However, in relation to pre-CGT assets, Subdivision 126-B and section 160ZZO do not require that the cost base of the pre-CGT asset is the same for the recipient as it is for the originator of the roll-over. Instead it just states that the recipient is taken to have acquired the pre-CGT rolled over asset before 20 September 1985. This is because the CGT regime disregards capital gains or losses made on pre-CGT assets.

2.14 Therefore, the CGT provisions may operate to give the recipient of a rolled over pre-CGT asset a cost base of either the consideration paid for the asset or the market value of the asset received.

2.15 This outcome is inappropriate because, in a consolidation environment the cost may be used to work out the allocable cost amount that is used in resetting the cost base for assets of a joining entity or the cost of membership interests in an entity that leaves a consolidated group.

2.16 Section 716-855 of the ITAA 1997 ensures that, where pre-CGT membership interests in a joining entity are rolled over and the receiving entity becomes a subsidiary member of a consolidated group, the post-roll-over cost base (or reduced cost base) used in resetting the cost of assets is the same as the originator's cost base (or reduced cost base).

2.17 Section 716-855 ensures that the post-roll-over cost base (or reduced cost base) of a pre-CGT asset that is used in resetting the cost of assets will be the same as the originator's cost base (or reduced cost base). This will be relevant, for example, in working out the cost base or reduced cost base of membership interests under step 1 of working out the allocable cost amount. In addition, the cost base will also be relevant where assets of an entity retain their existing tax values as a result of an election to be a 'chosen transitional entity' (under section 701-5 of the IT(TP) Act 1997). [Schedule 2, item 5, section 716-855; item 6, section 701-7]

2.18 A note is added to subsection 126-60(3) of the ITAA 1997 to alert readers to the amended operation of the CGT roll-over provisions for the consolidation regime [Schedule 2, item 2, subsection 126-60(3); item 3, subsection 126-60(3) (note)]. A note is also added to subsection 705-65(1) of the ITAA 1997 to refer to the operation of section 716-855 [Schedule 2, item 4, subsection 705-65(1)].

Excess of allocable cost amount on joining that cannot be allocated to reset cost base assets held on revenue account: CGT event L8

2.19 Part 3 of Schedule 2 to this bill modifies the ITAA 1997 to introduce CGT event L8. This event applies where there is an excess of allocable cost amount on joining that cannot be allocated to reset cost base assets after the operation (or successive operation) of section 705-40 of the ITAA 1997. Section 705-40 restricts the cost that can be allocated to reset cost base assets that are held on revenue account. If an amount of allocable cost amount remains, after the section 705-40 restriction operates, CGT event L8 will result in a capital loss equal to that amount. [Schedule 2, item 8, subsections 104-535(1) and (3)]

2.20 A 'reset cost base asset' is any asset that is not a retained cost base asset. The allocable cost amount remaining after deducting an amount equal to a head company's set costs, for the retained cost base assets of a joining entity, is allocated among the reset cost base assets other than 'excluded assets'. There is a proportionate allocation of the remaining allocable cost amount to each of the joining entity's reset cost base assets in accordance with their relative market value.

2.21 The amount of allocable cost amount that can be allocated to reset cost base assets that are held on revenue account is limited to the greater of the asset's market value or terminating value. It should be noted that for this amendment to apply, the joining entity must not have any reset cost base assets held on capital account, because there are no restrictions on the amount of allocable cost amount that can be allocated to reset cost base assets held on capital account.

2.22 The time CGT event L8 applies is just after the entity joins the consolidated group. This is to ensure that the capital loss that arises may be included in the head company's tax return. [Schedule 2, item 8, subsection 104-535(2)]

2.23 Certain tables in Divisions 104 and 110 are updated as a result of this amendment. Also the note to subsection 705-40(2) is updated. [Schedule 2, item 7, section 104-5 (at the end of the table); item 9, section 110-10 (at the end of the table); item 10, subsection 705-40(2) (at the end of the note)]

Preserving an asset's entitlement to accelerated depreciation

2.24 Part 4 of Schedule 2 to this bill amends sections 701-80 and 705-45 of the ITAA 1997 to ensure that the scope of a head company's entitlement to accelerated depreciation in relation to an asset that becomes an asset of the head company is retained in situations where:

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an asset (that was entitled to accelerated depreciation) was rolled over to a joining entity after 21 September 1999 and before the joining time; or

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an asset of a leaving entity that was entitled to accelerated depreciation through a previous application of section 701-80 or 705-45 becomes an asset of the head company of a consolidated group.

2.25 A head company's entitlement to accelerated depreciation in relation to an asset, post-consolidation, is maintained where certain conditions are satisfied under sections 701-80 and 705-45. One of those conditions is that the entity must have acquired the asset at or before 11.45am by legal time in the Australian Capital Territory on 21 September 1999 and held it continuously until the entity became a subsidiary member of the group.

2.26 Prior to these amendments certain depreciating assets would have lost their entitlement to accelerated depreciation because they have not been held continuously by one entity for the period up to the joining time. This requirement is a problem where roll-over relief has been utilised and the recipient has maintained access to accelerated depreciation because the recipient will not be taken to have acquired the asset at or before 11.45am by legal time in the Australian Capital Territory on 21 September 1999.

2.27 The amendments operate by identifying whether the joining entity was entitled, under transitional provisions, to use accelerated rates of depreciation immediately before the joining time. [Schedule 2, item 11, subsection 701-80(3); item 12, paragraphs 705-45(a) and (aa)]

2.28 Sections 40-10(3) and 40-12(3) of the IT(TP) Act 1997 preserved the entitlement to accelerated depreciation in circumstances where plant being taxed under former Division 42 of the ITAA 1997 moved to being taxed under the uniform capital allowances regime in Division 40 of the ITAA 1997. In addition, where there was a roll-over under section 40-340 of the ITAA 1997, section 40-340 of the IT(TP) Act 1997 allows the recipient of the asset in certain cases to work out its decline in value of the asset using the accelerated rates of depreciation.

2.29 By referring to subsections 40-10(3) and 40-12(3) the amendments ensure that access to accelerated depreciation is available, in appropriate circumstances, where:

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plant was acquired at or before 11.45am on 21 September 1999 where there has been no roll-over;

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plant acquired at or before 11.45am on 21 September 1999 where there has been roll-over relief under former Division 42; and

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plant acquired at or before 11.45am on 21 September 1999 where there has been roll-over relief under Division 40.

Ensuring that an over-depreciation adjustment is made during the transitional period where unfranked or partly franked dividends are not paid out

2.30 Part 5 of Schedule 2 to this bill modifies the IT(TP) Act 1997 to remove an anomaly with the interaction of section 705-50 of the ITAA 1997 which restricts the cost allocated to certain assets that are 'over-depreciated' and section 701-30 of the IT(TP) Act 1997 which allows unfranked profits to be included in working out the allocable cost amount during the transitional period.

2.31 Section 701-30 of the IT(TP) Act 1997 requires that there be unfranked or partly franked dividends that could be paid to recipients entitled to the inter-corporate dividend rebate, it does not require that those dividends actually be paid. However, subsection 705-50(2) of the ITAA 1997 requires that the joining entity has actually paid one or more unfranked or partly franked dividends to recipients entitled to an inter-corporate dividend rebate. As such, in circumstances where section 701-30 applies, but no dividends were actually paid as required under subsection 705-50(2), the tax cost setting amount of the over-depreciated asset is not reduced.

2.32 The amendments remove the anomaly by treating the dividends as having been paid resulting in the unfranked profits being taken into account in working out the 'tax deferral amount' under section 705-50. [Schedule 2, item 13, subsection 701-30(3); item 14, subsection 701-30(4)]

Ensuring that an appropriate amount is used in working out penalties to be imposed as a result of certain errors made in the cost setting process

2.33 Part 6 of Schedule 2 to this bill removes an anomaly in subsection 8W(1C) of the TAA 1953 that incorrectly imposes a penalty on the amount of certain cost setting errors instead of on the amount of tax associated with the cost setting error.

2.34 Errors made in making tax cost setting amount calculations are reversed by means of an immediate capital gain or loss if it would be unreasonable to require the calculations to be re-done. However, if the errors reduce the amount of the tax payable because the taxpayer either made a false or misleading statement or entered into a scheme, a penalty should be imposed that is based on the reduction in tax resulting from this error.

2.35 These technical amendments remove an anomaly that incorrectly imposes a penalty on the amount of the cost setting error instead of on the amount of tax associated with the amount of the cost setting error. [Schedule 2, item 16, subsection 8W(1C) (formula); item 17, subsection 8W(1C) (definition of capital gain); item 18, subsection 8W(1C); item 20, subsection 284-80(2) (formula); item 21, subsection 284-80(2) (definition of capital gain); item 22, subsection 284-80(2); item 24, subsection 284-150(3) (formula); item 25, subsection 284-150(3) (definition of capital gain); item 26, subsection 284-150(3)]

2.36 Other minor technical corrections relating to cross-references and wording are also made:

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subsections 8W(1C), 284-80(2) and 284-150(3) of Schedule 1 to the TAA 1953 had incorrect references to 'subsection 705-230(2)' instead of 'subsection 705-320(2)'; and

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in paragraph 284-80(2)(b) and subsection 284-150(3) references to 'income tax return' are replaced with 'in a statement' to be consistent with the approach in subsection 8W(1C) of Schedule 1 to the TAA 1953.

[Schedule 2, item 15, subsection 8W(1C); item 19, paragraph 284-80(2)(b); item 23, subsection 284-150(3)]

Ensuring that the head companies of MEC groups are taxed in the same way as head companies of consolidated groups

2.37 Part 7 of Schedule 2 to this bill amends the measures to address unintended tax benefits that were introduced into the income tax law in New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 and the CGT provisions that were introduced in New Business Tax System (Consolidation and Other Measures) Act 2003 so that they apply to head companies of MEC groups. Currently they only apply to head companies of consolidated groups.

2.38 The amendments maintain the underlying principle of consolidation that the income tax law that applies to head companies of consolidated groups should also apply to the head companies of MEC groups (see Minister for Revenue and Assistant Treasurer's Press Release No. C67/03 of 30 June 2003).

Measures to address unintended tax benefits

2.39 In New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 provisions were included to ensure that there were no unintended tax benefits to groups during the transition to consolidation. The application of these provisions has been expanded so that they will equally apply to head companies of MEC groups.

2.40 The measures that were included in New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 prevent, in certain circumstances, the consolidated group receiving unintended tax benefits as a result of:

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the combined application of the current law and the cost setting rules that reset the cost of revenue assets of an entity that becomes a member of a consolidated group;

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tax values of trading stock receiving an uplift on consolidation; and

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internally generated assets giving rise to periodic tax deductions for the decline in value of the assets where the cost of creating the assets have already been previously allowed as deductions.

For further information about these measures see paragraphs 1.89 to 1.114 and 1.123 to 1.174 of the explanatory memorandum to the New Business Tax System (Consolidation and Other Measures) Bill (No. 1) 2002.

2.41 In relation to the provisions concerning membership interests that were formerly pre-CGT assets, the provisions that are found in Division 705 of the ITAA 1997 apply to head companies of MEC groups. This is by application of section 719-2 of the ITAA 1997. However, an amendment is made to CGT event L1 so that it applies to MEC groups [Schedule 2, item 27, section 102-30 (item 7A in the table); item 28, section 104-5 (table row relating to event number L1); item 29, Subdivision 104-L (heading); item 30, subsection 104-500(1)]. Another amendment is made to include a reference to MEC groups in the table in section 110-10 of the ITAA 1997 where it mentions CGT event L1 [Schedule 2, item 34, section 110-10].

2.42 The transitional provisions concerning pre-CGT membership interests (see Division 701B of the IT(TP) Act 1997) are also being amended so that they apply to head companies of MEC groups. Normally, this would not be necessary because reliance could be placed on section 719-2 of the IT(TP) Act 1997 to achieve the result that transitional provisions referring to ordinary consolidated groups would apply in the same way to MEC groups. However, in the case of Division 701B, the references are different from those in the rest of the transitional consolidation provisions, in that the consolidation provisions of the ITAA 1997 to which Division 701B refers expressly apply not only to ordinary consolidated groups but also to MEC groups (see item 30 of Schedule 2 which amends section 104-500 of the ITAA 1997). In order to avoid any argument that because of this the general provision in section 719-2 of the IT(TP) Act 1997 would not apply to the references in Division 701B, it is considered prudent to amend Division 701B directly, to make it clear that MEC groups are covered [Schedule 2, item 35, paragraph 701B-1(1)(b)]. As a consequence, section 719-2 of the IT(TP) Act 1997 has also been amended since it need not have application to Division 701B [Schedule 2, item 36, subsection 719-2(1)].

2.43 In order to ensure that the rules concerning the tax values of trading stock and internally generated assets apply appropriately to head companies of MEC groups (see Division 701A of the IT(TP) Act 1997), the MEC group general modifying rule in Subdivision 719-C of the IT(TP) Act 1997 has been expanded so that it can be applied to Division 701A of the IT(TP) Act 1997 [Schedule 2, item 37, subsection 719-160(2)]. In brief, the MEC group general modifying rule operates to treat each eligible tier-1 company of a MEC group as if it were part of the head company of the group, rather than a separate entity. By expanding the application of this rule, it ensures that when a MEC group joins another MEC group the joining entity's eligible tier-1 companies become part of the head company of the acquiring group.

Other capital gains tax provisions

2.44 Included in New Business Tax System (Consolidation and Other Measures) Act 2003 were six additional CGT events (see Schedules 4 and 21). These CGT events (CGT events L2 to L7) deal with capital gains and losses that arise when applying the consolidation cost setting rules. Because these provisions are outside Part 3-90 of the ITAA 1997, amendments have been made to extend their operation to include MEC groups.

2.45 In brief, this expansion to include MEC groups has been achieved by including in the relevant CGT provisions the words 'or MEC group' after the words 'consolidated group'. [Schedule 2, item 31, paragraphs 104-505(1)(a), 104-510(1)(a), 104-515(1)(a), 104-520(1)(a) and 104-525(1)(a); item 32, subsection 104-525(6); item 33, subsection 104-530(1); item 34, section 110-10]

Franking deficit tax offsets and consolidated groups

Transfer of excess franking deficit tax offset to head company

2.46 Part 8 of Schedule 2 to this bill provides that where an entity joins a consolidated group, any unapplied FDT offset, either from a previous year or the year ending at the joining time, is transferred to the head company. [Schedule 2, item 38, subsection 701-30(10); item 39, subsection 709-185(1)]

2.47 The transferred FDT offset then becomes either the excess FDT offset balance of the head company (where it previously did not have an FDT offset balance), or is added to the head company's existing excess FDT offset balance (where one already existed).

2.48 In either case, the transferred FDT offset amount is able to be applied by the head company consistent with the FDT offset provisions in the SIS contained in this bill. [Schedule 2, item 39, subsection 709-185(2)]

Joining entity prevented from utilising franking deficit tax offset in later income years

2.49 A joining entity is prevented from utilising, in later income years, an FDT offset it may have whilst a member of the group. This rule prevents any possible double application that could arise by virtue of applying the FDT offset provisions in the SIS, contained in this bill, to the subsidiary as well as the head company. [Schedule 2, item 39, subsection 709-185(3)]

Consequences for exiting subsidiary

2.50 The exit history rule does not apply to any amount of FDT offset which a joining entity may have transferred to the head company at the joining time. This section applies irrespective of whether the exiting entity transferred an excess FDT offset to the head company at the joining time. Thus, any subsidiary member that exits a consolidated group will exit with a nil FDT offset balance. [Schedule 2, item 39, section 709-190]

No rules for MEC groups

2.51 To avoid doubt, no special rules are required where a cessation event occurs in respect of a MEC group by virtue of subsection 719-60(6) of the ITAA 1997.

2.52 Unlike the specific rules relating to the transfer of franking account balances from one provisional head company to another, no equivalent rules are required to provide for the transfer of an FDT offset balance from one provisional head company to another as the offset entitlements are only relevant to the head company itself when it determines its income tax liability - not part way through the year as is the case with franking accounts.

2.53 This outcome arises because the entitlement to an FDT offset arises at the end of an entity's income year, and a provisional head company will become the head company of a MEC group at the end of the income year by virtue of section 719-75 of the ITAA 1997.

Application and transitional provisions

2.54 The amendments discussed in this chapter have a retrospective application date of 1 July 2002 (being the commencement date of the consolidation regime). [Schedule 2, item 40]

2.55 The amendments are either beneficial to taxpayers or correct unintended outcomes. All of the amendments to address unintended outcomes are consistent with the original policy intent for the consolidation regime and therefore have the same commencement date as the consolidation regime.

2.56 The transitional provisions inserted by this bill have the same application date as the changes to the ongoing provisions of the consolidation regime (i.e. 1 July 2002). Until this bill it has always been by implication that Part 3-90 of the IT(TP) Act 1997 has application as from 1 July 2002 (being the application date of Part 3-90 of the ITAA 1997). However, this implication has not been continued in this bill. Instead, an express provision has been included that states that the amendments contained in this bill apply on and after 1 July 2002 [Schedule 2, item 40]. The reason for the difference is purely one of drafting approach and it is not intended that there be any change to the date of commencement (i.e. 1 July 2002) of any provision contained in Part 3-90 of the IT(TP) Act 1997.