House of Representatives

Explanatory Memorandum

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

Chapter 8 - Consolidation: revocation of certain choices and R & D tax offset

Outline of chapter

8.1 Schedule 8 to this bill:

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amends the consolidation provisions in the IT(TP) Act 1997 to allow certain choices to be revoked before 1 January 2005;

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amends the provisions in the ITAA 1936 dealing with eligibility for the R & D tax offset to ensure that they apply appropriately to consolidated groups; and

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makes minor technical amendments to the ITAA 1997 and the IT(TP) Act 1997.

Context of amendments

Revocation of certain choices

8.2 The consolidation regime provides for a number of choices that may be made by a head company in setting the tax cost of its assets or determining its ability to deduct losses. Once made, these choices are irrevocable. The rationale for making choices irrevocable is to minimise compliance costs and maximise certainty for taxpayers.

8.3 Allowing a period of time during which certain choices are able to be revoked will provide taxpayers with greater flexibility in the transition period while aspects of the consolidation regime are being bedded-down.

Research and development tax offset

8.4 A company may be eligible to choose the R & D tax offset if it meets certain threshold tests. Some of these tests measure the turnover and R & D activity of the company and other taxpayers with which it is grouped.

8.5 The amendments ensure that the grouping rules used to determine eligibility for the R & D offset apply appropriately in cases where an entity joins or leaves a consolidated group part-way through an income year.

Minor technical amendments

8.6 Two minor technical errors are corrected.

Summary of new law

Revocation of certain choices

8.7 Part 1 of Schedule 8 to this bill amends the consolidation rules to allow the following irrevocable choices to be revoked before 1 January 2005.

8.8 The choice to:

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retain the existing tax cost of a subsidiary's assets;

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utilise certain losses over three years rather than under the available fraction;

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utilise 'value donor' concessions to increase the available fraction for a bundle of losses;

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waive the 'capital injection' rules;

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cancel the transfer of a loss by the head company of a consolidated group; and

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cancel a loss by the head company of a MEC group.

Research and development tax offset

8.9 Part 2 of Schedule 8 to this bill amends the ITAA 1936 to ensure that the rules governing eligibility for the R & D tax offset apply appropriately in cases where an entity is a member of a consolidated group for only part of an income year.

Minor technical amendments

8.10 Technical amendments are made by adding an asterisk before a defined term in paragraph 721-25(3)(b) of the ITAA 1997 and correcting the heading to Division 707 of the IT(TP) Act 1997.

Detailed explanation of new law

Revocation of certain choices

The choice to retain the existing tax cost of assets or reset their tax cost ('stick' or 'spread')

8.11 Section 701-5 of the IT(TP) Act 1997 allows a head company to elect that an entity is a 'chosen transitional entity'. The assets that a chosen transitional entity brings into the group retain their existing tax costs instead of having these reset under the general consolidation cost setting provisions. Subsection 701-5(2) requires this choice to be made by the time the head company is required to notify of its choice to consolidate. Subsection 701-5(3) states that this choice is irrevocable.

8.12 An amendment allows the head company to revoke this choice before 1 January 2005 [Schedule 8, item 2, subsection 701-5(2)]. To ensure that taxpayers are provided with genuine flexibility, an amendment also provides an equivalent extension of time for making this choice [Schedule 8, item 2, subsection 701-5(4)].

8.13 Extending the period for making this and other choices covered in this bill is necessary to ensure that taxpayers are provided with genuine flexibility in the transitional period to consolidation. For example, without extending this time frame, a head company submitting its first consolidated return on the basis that it has chosen to retain the existing tax costs of a subsidiary's assets would be able to revoke this choice before 1 January 2005. However, a head company that submits its consolidated tax return on the basis that a subsidiary's asset tax costs have been reset would not have equivalent flexibility to vary the basis on which its tax costs are set.

8.14 A condition for revoking this choice, or making the choice after the period of time allowed for giving the Commissioner the choice to consolidate, will be that any entity that owns an asset, the tax cost of which is affected by the choice, must have agreed [Schedule 8, item 1, subsection 701-5(1); item 2, subsections 701-5(3) and (5)]. This condition is designed to protect the interests of any entity that has left the group with an asset that has its tax cost affected by the choice.

The choice by the head company of a consolidated group to cancel the transfer of a loss

8.15 Subsection 707-145(1) of the ITAA 1997 allows a head company to choose to cancel the transfer of a loss. A head company may wish to make this choice in order to avoid having to recalculate available fractions for its existing bundles of losses when a new loss entity joins the group or to avoid a possible detrimental impact under the cost setting rules.

8.16 Amendments allow the choice to be revoked before 1 January 2005. Because this choice may also affect the cost of assets held by entities that have left the group, a decision to revoke this choice must be agreed to by all entities that hold assets which have their tax cost affected by the choice. [Schedule 8, item 3, section 707-145]

The choice to utilise 'value donor' concessions to increase the available fraction for a bundle of losses

8.17 Subsection 707-325(5) of the IT(TP) Act 1997 allows a head company to choose to include all or part of the modified market value of a 'value donor' to increase the available fraction for a bundle of losses.

8.18 Amendments allow the choice to be amended or revoked before 1 January 2005 and provide an equivalent extension of time for the choice to be made. [Schedule 8, item 4, subsections 707-325(5) and (6)]

8.19 Where the value donor rules are used, section 707-327 of the IT(TP) Act 1997 allows the head company to also treat certain losses made by the value donor as being included in the real loss maker's bundle. Amendments also allow this choice to be revoked before 1 January 2005 and provide an equivalent extension of time for the choice to be made. [Schedule 8, item 5, subsection 707-327(5)]

8.20 Because a choice to apply the value donor rules in section 707-325 is a necessary condition for the choice in section 707-327, revoking the choice in section 707-325 will automatically invalidate a choice to apply section 707-327.

The choice to waive the 'capital injection' rules

8.21 Section 707-325 of the ITAA 1997 contains rules designed to prevent manipulation of the consolidation loss rules via a capital injection or non-arm's length transaction prior to consolidating (the capital injection rules).

8.22 Section 707-328A of the IT(TP) Act 1997 allows these rules to be waived in cases where the entities involved are eligible to use the value donor rules to achieve the same result upon entry to consolidation. The capital injection rules may be waived if the transferee chooses for section 707-328A to apply to the real loss maker.

8.23 Amendments allow this choice to be amended or revoked before 1 January 2005 and provide an equivalent extension of time for making a choice to waive the capital injection rules. [Schedule 8, item 6, subsection 707-328A(4)]

The choice to utilise certain losses over three years rather than under the available fraction

8.24 Section 707-350 of the IT(TP) Act 1997 contains an alternative regime for the utilisation of certain losses transferred to the head company. Under this regime, certain pre- 21 September 1999 losses that have satisfied the continuity of ownership test may be utilised by the head company over three years rather than in accordance with the available fraction methodology in Subdivision 707-C of the ITAA 1997. A head company can choose to apply this alternative regime where certain conditions are met.

8.25 Amendments allow this choice to be revoked before 1 January 2005 and provide an equivalent extension of time for the choice to be made. [Schedule 8, item 7, subsections 707-350(5) and (6)]

The choice by the head company of a MEC group to cancel a loss

8.26 When a new eligible tier-1 company joins a MEC group, the ongoing head company is required to calculate an available fraction for its prior group losses and adjust the available fractions of loss bundles previously transferred to it. In addition, the group's available fractions and transferred losses are capped so that their total does not exceed what would otherwise have been the available fraction for the group losses under section 719-315 of the ITAA 1997.

8.27 Subsection 719-325(1) of the ITAA 1997 allows the ongoing head company to choose to cancel all the losses in its group loss bundle and any of its existing bundles. Making this choice may enable the head company to achieve a better outcome under the capping mechanism or avoid the rule altogether if it cancels its group loss bundle.

8.28 An amendment allows this choice to be revoked before 1 January 2005. [Schedule 8, item 8, section 719-310]

Research and development tax offset

8.29 Under section 73J of the ITAA 1936, a company may be eligible to choose the R & D tax offset subject to the following threshold tests:

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the company's aggregate R & D amount (aggregate) for the tax offset year must exceed $20,000;

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the aggregate for the company for the tax offset year, and those taxpayers with which it is grouped (while they are grouped in that year), must not exceed $1 million; or

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the company's R & D group turnover for that year must be less than $5 million. The R & D group turnover is defined in section 73K of the ITAA 1936. Broadly, it is the value of supplies made by the company in the year of income and the value of the supplies made in the year of income by other persons while they were grouped with the company, reduced by intra group supplies.

8.30 The policy aim of the latter two of the three threshold tests above is to ensure that the R & D offset is targeted towards 'small' companies, or companies that are in groups regarded as small in the relevant income year. The requirements for a person (including a company) to be grouped with another person are set out in section 73L of the ITAA 1936.

Effect of consolidation

8.31 Under the consolidation regime, R & D expenditure by a subsidiary company during its period of membership of a consolidated group is treated for income tax purposes as R & D expenditure of the head company.

8.32 However, issues arise when an entity joins or leaves a consolidated group part-way through an income year, these being that:

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a separate taxpayer is recognised (being the joining entity for the period prior to joining, or the leaving entity, for the period after leaving) with a less than 12 month year of income (i.e. a 'stub' year);

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under the 'entry history' rule in section 701-5 of the ITAA 1997, things that happened to the entity before it became a member of the group will be taken to have happened in relation to the head company; and

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under the 'exit history' rule in section 701-40 of the ITAA 1997, an entity 'inherits' the history in relation to assets, liabilities and businesses that it takes with it on leaving a consolidated group.

8.33 Situations where a threshold is applied to a stub period taxpayer are dealt with in the consolidation provisions by way of a rule in section 716-850 of the ITAA 1997. This rule operates differently depending on whether the non-membership period is before or after the company's period of membership of the consolidated group. A joining entity's eligibility for the pre-consolidation period is determined by grossing-up its amounts for the pre-consolidation stub year to a full year equivalent, without it being required to look forward to what happens after it joins the group. However, a company that has departed a consolidated group looks back to include the history of the business it takes with it on exit from the consolidated group.

8.34 Because the R & D grouping rules are, broadly, based on 50% rather than 100% ownership, entities may be grouped for R & D offset purposes while not being eligible to be members of the same consolidated group.

History for purposes of eligibility for tax offset: joining entity

8.35 Section 73BABA effectively turns-off the operation of the consolidation entry-history rule for the purposes of determining a head company's eligibility for the R & D offset. [Schedule 8, item 9, section 73BAA and item 10, section 73BABA of the ITAA 1936]

8.36 In the absence of this amendment, the entry-history rule will treat a joining entity's turnover and R & D aggregate for the pre-consolidation part of that year as having been incurred by the head company for the purposes of determining the head company's eligibility. This would be inconsistent with the way the R & D grouping rules apply to non-consolidated groups and would result in amounts being double counted in cases where the joining entity was already grouped with the head company under the R & D grouping rules in section 73L of the ITAA 1936.

Example 8.1

Half way through its income year, Head Co acquires all the shares in Sub Co. Head Co and Sub Co were not under common ownership or control before this time. Sub Co's turnover for the year is $2 million, of which half relates to the period before becoming owned by Head Co. Head Co's turnover for the year is $3.5 million.

If Head Co was not the head company of a consolidated group, Head Co's R & D group turnover for the year would be $4.5 million, being its own turnover plus Sub Co's turnover of $1 million for the part of the year when it was owned by Head Co. Subject to it satisfying the other threshold tests, Head Co would be eligible to choose the R & D tax offset for that year.

However, in the absence of section 73BABA, if Head Co was the head company of a consolidated group, the consolidation entry history rule would cause it to 'inherit' Sub Co's R & D history relating to the period before consolidation. Head Co's R & D group turnover would be $5.5 million and it would be ineligible for the R & D tax offset. Under section 73BABA, Head Co's R & D group turnover will be $4.5 million, consistent with the outcome in the absence of consolidation.

Under consolidation, Sub Co's eligibility for the R & D offset will be determined by grossing-up its R & D group turnover and its aggregate R & D amount for the first part of the year, as per section 716-850 of the ITAA 1997. The amendments do not affect this outcome.

Example 8.2

In this example, Sub Co was partially owned by Head Co for the first part of the income year such that the two entities were already grouped for R & D purposes before Sub Co became wholly-owned by Head Co. Head Co's turnover for the year was $2.5 million while Sub Co's turnover was $2 million, half of which related to the period before it became wholly-owned by Head Co.

Head Co's R & D group turnover in the absence of consolidation would be $4.5 million, being its own turnover plus Sub Co's turnover for the full year. Head Co would be eligible to choose the R & D tax offset subject to the other threshold tests being satisfied.

However, in the absence of section 73BABA, if Head Co was the head company of a consolidated group, the entry history rule would cause it to 'inherit' Sub Co's turnover for the pre-consolidation part of the year, notwithstanding that the same amount is already counted towards Head Co's R & D group turnover under the R & D grouping rules. In this case, Head Co's R & D group turnover would be $5.5 million and it would be ineligible for the R & D tax offset. Section 73BABA prevents this double counting.

History for purposes of eligibility for tax offset: leaving entity

8.37 Section 73BACA ensures that the R & D grouping provisions apply appropriately in determining the eligibility for the R & D offset of a company that has left a consolidated group part-way through the income year.

8.38 Under the exit history rule, a subsidiary leaving a consolidated group part-way through an income year will inherit the R & D history of the business it takes with it on exit. However, under the single entity principle, the entity is not regarded as a separate taxpayer while part of the consolidated group. As a result, when determining the leaving entity's eligibility for the R & D offset for the part of the year after it leaves the consolidated group, it would not be treated as having been previously grouped with other entities, including other members of the consolidated group.

8.39 This outcome would be inconsistent with the intent of the R & D grouping rules, under which the turnover and R & D aggregate of the leaving entity would, in the absence of consolidation, be grouped with that of other entities for a part of the year when they were under common ownership or control.

8.40 Section 73BACA disregards the operation of the single entity rule in determining the leaving entity's eligibility so that it is required to include the turnover and R & D aggregate of other entities with which it would be grouped under section 73L of the ITAA 1936 but for the single entity rule. [Schedule 8, item 11, section 73BACA]

8.41 A rule is also needed to ensure that the leaving entity's own history is not double counted. This may occur because the exit history rule, which results in certain things being treated as having happened in relation to the leaving entity, does not mean those same things can not also be treated as happening in relation to an entity with which the leaving entity was grouped (i.e., the head company). To prevent this, things are not counted again where they are already taken into account as a result of the consolidation exit history rule. [Schedule 8, item 11, paragraph 73BACA(d)]

Example 8.3

At the beginning of an income year, Sub Co is a wholly-owned subsidiary of Head Co. Head Co sells its interest in Sub Co part-way through the year. Head Co's turnover for the year is $6 million, half of which relates to the part of the year when it owned Sub Co. Sub Co's turnover is $4 million and this amount is also evenly split between the two parts of the year.

In the absence of consolidation, Head Co's R & D group turnover for the year would be $8 million, being its own turnover plus Sub Co's turnover of $2 million for the part of the year when it was owned by Head Co. Sub Co's R & D group turnover would be $7 million, being its own turnover for the full year plus $3 million, which is the share of Head Co's turnover that relates to the part of the year when it was grouped with Sub Co.

Consolidation would not change the calculation of Head Co's eligibility. However, in the absence of section 73BACA, if Head Co and Sub Co had been a consolidated group for the first part of the year, Sub Co's R & D group turnover would be only $4 million, since the R & D grouping rules would not regard it as having been a separate entity capable of being grouped with the head company during this period. This may enable Sub Co to claim the R & D offset, notwithstanding that it would have been ineligible in the absence of consolidation.

Section 73BACA ensures that, in determining Sub Co's eligibility for the offset, Sub Co is treated as having been grouped with Head Co for the period when they were a consolidated group - consistent with the outcome that would arise in the absence of consolidation.

Minor technical amendments

8.42 Item 12 amends the ITAA 1997 by ensuring that the defined term 'approved form' in paragraph 721-25(3)(b) of the ITAA 1997 is identified by an asterisk. [Schedule 8, item 12, paragraph 721-25(3)(b)]

8.43 Item 13 amends to IT(TP) Act 1997 to correct an error in the heading to Division 707. [Schedule 8, item 13, Division 707 of the IT(TP) Act 1997]

Application and transitional provisions

8.44 The amendments discussed in this chapter will take effect on 1 July 2002 (being the commencement date of the consolidation regime). [Schedule 8, item 14]

8.45 The transitional nature of the provisions allowing revocation of choices that are in this bill (the provisions will only apply until 31 December 2004) will benefit taxpayers by providing additional time to consider the impact of consolidation before being required to make irrevocable choices.