House of Representatives

New Business Tax System (Consolidation and Other Measures) Bill (No. 1) 2002

New Business Tax System (Franking Deficit Tax) Amendment Bill 2002

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation Definition
A Platform for Consultation Review of Business Taxation: A Platform for Consultation
A Tax System Redesigned Review of Business Taxation: A Tax System Redesigned
ACA allocable cost amount
ADI authorised deposit-taking institution
APRA Australian Prudential Regulation Authority
ATO Australian Taxation Office
CGT capital gains tax
Commissioner Commissioner of Taxation
COT continuity of ownership test
May Consolidation Act New Business Tax System (Consolidation) Act (No. 1) 2002
FDT franking deficit tax
GVSR general value shifting regime
IT(TP) Act 1997 Income Tax (Transitional Provisions) Act 1997
ITAA 1936 Income Tax Assessment Act 1936
ITAA 1997 Income Tax Assessment Act 1997
June Consolidation Bill New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002
MEC multiple entry consolidated
PAYG pay as you go
R&D research and development
SAP substituted accounting period
SBT same business test
TAA 1953 Taxation Administration Act 1953
TC group thin capitalisation group
Wallis Report Financial System Inquiry Final Report 1997

General outline and financial impact

Consolidated groups

The consolidation measure, which represents a significant change to the taxation of corporate groups, is being enacted progressively via a series of bills. The key elements to the measure were introduced in the May Consolidation Act and the June Consolidation Bill. The amendments contained in schedules 1 to 18 to the New Business Tax System (Consolidation and Other Measures) (No. 1) Bill 2002, which build on the legislative platform already in place, will:

modify the core rules to apportion, where necessary, income and deductions between a head company and a subsidiary member that is only in the consolidated group for part of an income year;
modify the membership rules to ensure that, in limited circumstances, a consolidated group will not cease to exist when the head company is replaced by a new head company. Similar amendments are also being introduced to cater for the replacement of one head company of a MEC group by another;
modify the general cost setting rules to:

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cater for situations where a consolidated group joins an existing consolidated group, multiple entities which are linked through membership interests join an existing consolidated group and where trusts join or leave a consolidated group;
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implement the measures to address revenue risks which were foreshadowed by Government on introduction of the June Consolidation Bill;
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ensure they apply in an appropriate manner to MEC groups;

apply cost setting rules to membership interests in eligible tier-1 companies of a MEC group that are held outside of the group;
modify the loss transfer provisions that will continue to exist outside the consolidation regime for a transfer of tax losses or net capital losses involving an Australian branch of a foreign bank so that:

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transfers can continue where the other party to the transfer becomes a member of a consolidated group after the loss that is sought to be transferred was incurred;
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the amount that can be transferred from a branch to a consolidated group approximates the amount that could have been transferred to members of the group had consolidation not occurred;

complete the removal of the current grouping rules for wholly-owned groups in relation to foreign tax credits, thin capitalisation, the inter-corporate dividend rebate and capital gains and losses;
ensure the thin capitalisation and foreign tax credit regimes will continue to operate as intended; and
make a number of technical and consequential amendments and refinements to the May Consolidation Act and the June Consolidation Bill to address issues raised through consultation. By way of example, these amendments will:

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rectify technical deficiencies in the consolidation loss rules;
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ensure the existing R&D deductions interact properly with the consolidation provisions and preserve the policies behind both regimes to the greatest extent possible.

Date of effect: The consolidation measure will allow wholly-owned entity groups to choose to consolidate under this regime from 1 July 2002. The existing grouping provisions will continue to operate in parallel with the consolidation regime until 1 July 2003, subject to special rules applying to consolidated groups with a head company that has a SAP. In general, such SAP groups will retain access to grouping provisions until the date of consolidation, provided that the head company chooses to consolidate from the first day of their next income year, commencing after 1 July 2003.

Proposal announced: The proposals were announced in the Treasurers Press Release No. 58 of 21 September 1999. The consolidation elements in this bill were foreshadowed in Minister for Revenue and Assistant Treasurers Press Release No. C72/02 of 27 June 2002.

Financial impact: The consolidation measure is expected to cost approximately $1 billion over the forward estimate period as follows:

2001-2002 2002-2003 2003-2004 2004-2005 2005-2006
nil $180 million $370 million $335 million $280 million

Further explanation of this impact was provided in the explanatory memorandum to the May Consolidation Act which received Royal Assent on 22 August 2002.

Compliance cost impact: The amendments in this bill are integral to the consolidation measure which is expected to reduce ongoing compliance costs to corporate groups by ensuring that:

intra-group transactions are ignored for taxation purposes, so that taxation and accounting treatments are more closely aligned;
administrative requirements, such as multiple tax returns and multiple franking account, losses, foreign tax credit and PAYG obligations are reduced; and
integrity measures aimed at preventing loss duplication, value shifting or the avoidance or deferral of capital gains within groups do not apply within a consolidated group.

The impacts were fully explained in Chapter 14 of the explanatory memorandum to the May Consolidation Act.

The consolidation regime will necessitate some initial up-front costs for groups as they familiarise themselves with the new law, update software and notify the ATO of a choice to consolidate. Large corporate groups may incur greater start-up costs in determining the market values of group assets. These costs will be alleviated by a transitional measure under which the group can elect, if they form a consolidated group prior to 1 July 2004, to bring assets into the group at their existing cost bases. Groups that form after the transitional period may use the market value guidelines developed by the ATO to minimise compliance costs.

Imputation rules - transitional and other amendments

Schedules 16 to 18 to the New Business Tax System (Consolidation and Other Measures) (No. 1) Bill 2002 contain amendments relating to the new simplified imputation system that commenced on 1 July 2002.

The amendments in Schedule 16 will amend the ITAA 1936 to remove the inter-corporate dividend rebate under sections 46 and 46A for:

franked dividends paid after 30 June 2002. The rebate has been replaced by the imputation offset; and
unfranked dividends paid within wholly-owned company groups after 30 June 2003, as a consequence of the introduction of the consolidation regime.

The amendments in Schedule 17 will amend the ITAA 1997 to:

broaden the exemptions from the benchmark rule, which requires that all dividends paid by a company in a certain period (a franking period) be franked to the same extent; and
replicate provisions in former Part IIIAA of the ITAA 1936 relating to distributions on non-share equity interests.

The amendments in Schedule 18 will amend the IT(TP) Act 1997 to provide transitional rules relating to:

franking periods for early and late balancing companies;
the conversion of franking accounts on a tax paid basis for early balancing companies; and
the determination of FDT liability for late balancing companies.

The New Business Tax System (Franking Deficit Tax) Amendment Bill 2002 will make consequential amendments to the New Business Tax System (Franking Deficit Tax) Act 2002. These amendments are required because of the transitional amendments to be made to the IT(TP) Act 1997 concerning the determination of FDT liability for late balancing companies.

Date of effect: These amendments will generally apply to dividends paid on or after 1 July 2002. However, the removal of the rebate under sections 46 and 46A for unfranked dividends paid within wholly-owned company groups will generally apply to dividends paid on or after 1 July 2003. If the date of consolidation occurs before 1 July 2003, the removal of the rebate will apply to dividends paid on or after the date of consolidation. For groups with SAPs, the removal of the rebate will apply to dividends paid after the date of consolidation if the date of consolidation is after 30 June 2003 and before 1 July 2004.

Proposal announced: These amendments are mostly consequential to the new simplified imputation regime that came into effect on 1 July 2002. The removal of the rebate under sections 46 and 46A for unfranked dividends paid within wholly-owned company groups is a consequence of the introduction of the consolidation regime. These measures were announced as part of the Governments business tax reform measures.

Financial impact: None.

Compliance cost impact: Negligible.

Chapter 1 - Cost setting rules - consolidated group and linked entities joining, trusts and other rules

Outline of chapter

1.1 This chapter explains the modifications to the cost setting rules contained in Part 3-90 of the ITAA 1997, that were included in the May Consolidation Act and the June Consolidation Bill.

1.2 This chapter explains the modifications to the cost setting rules for:

a consolidated group joining an existing consolidated group;
multiple entities, linked through membership interests, joining an existing consolidated group;
the assets of trusts that join a consolidated group; and
the interests that a consolidated group holds in a trust that leaves the group.

1.3 This chapter also explains the measures which address revenue risks arising from the cost setting rules.

Context of reform

Cost setting rules

1.4 The treatment of assets held by entities that join a consolidated group is based on the asset-based model discussed in A Platform for Consultation and recommended by A Tax System Redesigned.

1.5 This model dispenses entirely with the income tax recognition of separate entities within a consolidated group. It treats a consolidated groups cost of acquiring an entity that becomes a subsidiary member as the cost to the group of acquiring the assets of that entity.

1.6 A consolidated groups cost of acquiring an entity includes the cost of acquiring the membership interests in that entity. The cost also includes the liabilities of the entity that become liabilities of the consolidated group. Adjustments are made for retained earnings and losses that accrue to the consolidated groups interest in the entity whilst the consolidated group is acquiring the entity to prevent double taxation of gains and duplication of losses. Generally, these adjustments apply where the group holds some interests in the subsidiary member prior to consolidation. An adjustment is also made by deducting the value to the consolidated group of tax deductions that the consolidated group becomes entitled to because of an entity becoming a subsidiary member.

1.7 The cost setting rules for the basic case of a single entity joining a consolidated group are discussed in Chapter 5 of the explanatory memorandum to the May Consolidation Act. The cost setting rules for the case of a consolidated group forming and special rules on transition are discussed in Chapter 1 of the explanatory memorandum to the June Consolidation Bill.

1.8 A consolidated groups cost for membership interests in a subsidiary member when it leaves a consolidated group is based on the cost to the group for the net assets of the subsidiary. The rules for an entity leaving were discussed in Chapter 5 of the explanatory memorandum to the May Consolidation Act.

1.9 This treatment of the acquisition and disposal of subsidiary members by a consolidated group prevents the double taxation of gains and duplication of losses arising within the group and allows for assets to be transferred between members of the group without requiring cost base adjustments to address value shifting.

Summary of new law

Cost setting rules for a consolidated group or linked entities joining an existing consolidated group

1.10 Where a consolidated group joins another consolidated group, it is recognised that modifications are required to the rules for the basic case of a single entity joining an existing consolidated group. These modifications acknowledge that the consolidated group being acquired is treated as a single entity for income tax purposes.

1.11 Similarly, the basic case rules are modified where multiple entities, which are linked through membership interests join an existing consolidated group because of the acquisition of membership interests by the group in one of the entities. These modifications take into account that the rules need to apply to a number of entities becoming members at the same time.

Cost setting rules for trusts

1.12 Special rules are required to work out the tax cost setting amounts when trusts join or leave a consolidated group. The rules for working out the tax cost setting amount in the basic case does not deal with trusts, which are different to companies in a few respects.

Measures to address unintended tax benefits

1.13 Additional measures prevent, in certain circumstances, a consolidated group receiving unintended tax benefits from the application of the cost setting rules as a result of:

the tax values of trading stock receiving an uplift on consolidation;
internally generated assets giving rise to periodic tax deductions for the decline in value of the assets where the costs of creating the asset have already been previously allowed as deductions; and
the combined application of the current CGT provisions ascribing a market value cost base to membership interests that lose their pre-CGT status, and the consolidation cost setting rules that reset the cost of revenue assets such as trading stock and depreciating assets of an entity that becomes a subsidiary member of a consolidated group.

Comparison of key features of new law and current law
New law Current law
Cost setting rules to apply where a consolidated group joins another consolidated group that recognise that the joining consolidated group is treated as a single entity for income taxation purposes. The May Consolidation Act and June Consolidation Bill did not contain rules for a consolidated group joining another consolidated group.
Cost setting rules to apply where linked entities join a consolidated group that recognise that there are 2 or more entities joining at the same time. The May Consolidation Act and June Consolidation Bill did not contain rules for linked entities joining an existing consolidated group.
Cost setting rules to apply where a trust joins or leaves a consolidated group that recognise the different treatment of trusts. The May Consolidation Act and June Consolidation Bill did not contain rules for a trust joining a consolidated group.
Rules to ensure that the cost setting rules do not provide unintended tax benefits to groups on consolidation. The June Consolidation Bill contained a rule to prevent manipulation of the cost setting rules by certain asset rollovers after 16 May 2002.

Detailed explanation of new law

1.14 The new law explained in this Chapter is discussed under the following topics:

rules for a consolidated group joining another consolidated group (see paragraphs 1.16 to 1.29);
rules for multiple entities, linked through membership interests, joining an existing consolidated group (see paragraphs 1.30 to 1.46);
rules for the assets of trusts that join a consolidated group (see paragraphs 1.47 to 1.72); and
rules for interests that a consolidated group holds in a trust that leaves the group (see paragraphs 1.73 to 1.86).

1.15 This chapter also explains the measures which prevent unintended and inappropriate tax benefits arising from the cost setting rules (see paragraphs 1.87 to 1.114 and paragraphs 1.118 to 1.181).

Rules for when an existing consolidated group joins another consolidated group

1.16 When an existing consolidated group (the acquiring group) acquires another existing consolidated group (the acquired group) the entities in the acquired group become subsidiary members of the acquiring group. The cost setting amount for the assets is worked out on the basis that, the head company of the acquired consolidated group is treated as a single entity that becomes a member of a consolidated group. This allows the rules for the basic case of a single entity that becomes a subsidiary member of an existing consolidated group to apply as though the head company of the joining group were the only entity becoming a subsidiary member of the group. [Schedule 4, item 4, subsection 705-175(1)]

1.17 In order for the acquired consolidated group to continue to be treated as a single entity up until the time it becomes part of the acquiring consolidated group it is necessary to modify the operation of the core rules in Division 701. This is because under the normal operation of the consolidation rules the acquired consolidated group would break up because the head company, when it becomes a subsidiary member of another group, would cease to qualify to be a head company. This would result in each of the subsidiary members of the acquired consolidated groups being treated as leaving entities and the rules in Division 711 requiring the head company to work out the cost for the membership interests in each of the leaving entities. Each of these entities and the head company would then be treated as joining entities with the consequence that the cost setting rules in Division 705 would be required to be applied individually to each entity. [Schedule 4, item 4, paragraph 705-175(2)(a)]

1.18 Subdivision 705-C therefore operates to reduce compliance costs by simplifying the cost setting rules where an existing consolidated group acquires another by modifying the core rules and the cost setting rules for the basic case of a single entity becoming a subsidiary member so that they apply to treat the acquired consolidated group as a single entity (i.e. there is no break up of the consolidated group prior to it becoming a part of the acquiring consolidated group). [Schedule 4, item 4, paragraph 705-175(2)(b)]

Modifications to the core rules

1.19 The core rules in Division 701 are modified in the case of a consolidated group being acquired by another so that they:

ensure that provisions of the core rules which apply where an entity ceases to be a subsidiary member (other than section 701-25 which deals with tax neutral consequences of a head company ceasing to hold assets) will not apply where Subdivision 705-C applies [Schedule 4, item 4, subsection 705-180(1)] ;
modify the entry history rule so that in its application to the head company of the acquired group joining the acquiring group the history of the subsidiary members of the acquired group (including those which have previously ceased to be members) is included in the head companys history. The history of those members that have left the acquired group (including history from prior to joining the acquired group) is relevant if the assets, liabilities, or businesses of that entity have been transferred to entities that have not left the acquired group [Schedule 4, item 4, subsection 705-180(2)] ;
ensure that in working out the income tax consequences for the head company of the acquired group in the period up to the time it becomes part of the acquiring consolidated group there are tax-neutral consequences from the head company ceasing to hold the assets of the group [Schedule 4, item 4, subsection 705-180(3)] ; and
modify the operation of section 701-30 so that it applies to the case of a consolidated group joining another consolidated group to enable the income tax consequences for the period prior to joining the acquiring group to be determined [Schedule 4, item 4, subsection 705-180(4)] .

Modifications to the cost setting rules for the acquiring group

1.20 The cost of acquiring the assets of the acquired group is determined using the same rules that apply in the basic case of a single entity becoming a subsidiary member of an existing consolidated group subject to some modifications. The key principle is that Subdivision 705-A is applied on the basis that the only member of the acquired group that is a joining entity is the head company of the acquired group and that each of the subsidiary members of the acquired group are treated as parts of that head company. [Schedule 4, item 4, section 705-185]

1.21 Modifications to the cost setting rules are made where:

the acquired group has over-depreciated assets (see paragraphs 1.24 to 1.26);
certain rights and options have been issued by subsidiary members of the acquired group to members of the acquiring group (see paragraph 1.27); and
there are employee shares in a subsidiary member of the acquired group or certain rights and options issued by subsidiary members of the acquired group to entities other than the acquired group or acquiring group (see paragraph 1.28).

1.22 A modification is also made to the rules regarding the pre-CGT factors for assets of the acquired group (see paragraph 1.29).

1.23 Amendments are also made to Division 711 (about tax cost setting amounts for membership interests in an entity that leaves a consolidated group) to ensure that the provisions which treat certain membership interests as having been acquired before 20 September 1985, in both a single entity and multiple entity leaving cases, do not apply where a consolidated group is acquired by another consolidated group. [Schedule 4, items 6 and 7]

Adjustment for over-depreciated assets

1.24 Adjustments are required to the rules which restrict the amount that is treated as a cost setting amount for over-depreciated assets (section 705-50). An asset is over-depreciated, at a particular time, if there has been some depreciation (i.e. a reduction in its adjustable value) and its market value exceeds its adjustable value. The policy in relation to over-depreciated assets generally does not recognise the cost for those assets to the extent of the ongoing income tax deferral related to them. This policy is maintained where a consolidated group joins another consolidated group.

1.25 Where a consolidated group acquires another consolidated group the tax deferral that arose because of over depreciation can still be present. This can occur in two situations:

the asset was, just prior to the time of the original consolidation, held by the head company of the acquired consolidated group and is over-depreciated at the time that consolidated group is acquired by the acquiring consolidated group; or
the asset was brought to the acquired consolidated group by a joining entity where:

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the asset is still over-depreciated at the time the acquired consolidated group becomes a part of the acquiring consolidated group; and
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the original unfranked dividends paid prior to the date of the original consolidation were finally paid to an entity which was entitled to the section 46 rebate and was not the head company of the acquired consolidated group or a subsidiary member of that group (see Example 1.1).

1.26 Section 705-50 applies appropriately to the first situation mentioned above without modifications. However, section 705-50 is modified to apply appropriately in the second situation so that it will not apply if the dividend is finally paid to:

if the acquired consolidated group existed at that time - a member of the acquired group; or
otherwise - an entity that later became a member of the acquired group.

[Schedule 4, item 4, section 705-190]

Example 1.1: Over-depreciated assets A head company (HC1) and a joining entity (JE) formed a consolidated group on 1 July 2002. The JE had an over-depreciated asset (with a market value of $100 and an adjustable value of nil) on 1 July 2002 and has paid an unfranked dividend of $100 to HC1 prior to 1 July 2002.The members of another consolidated group (HC2) have always held 60% of the shares in HC1 and on 1 July 2004 acquires the remaining 40% of the shares. HC1 and JE join the consolidated group headed by HC2 on 1 July 2004. At that time the asset is over-depreciated to the extent of $60 (with a market value of $60 and an adjustable value of nil). The unfranked dividend received by HC1 had not been distributed as at 1 July 2004.The tax deferral of $100 present when JE and HC1 formed a consolidated group will be accounted for when HC1 and JE join the HC2 consolidated group as follows:

the over-depreciation has been reduced to $60 by 1 July 2004;
when HC1 joins HC2 the amount of the profit that accrued to interests of HC2 and added at step 3 when working out HC1s ACA will not include the dividend paid earlier by JE. This is because section 705-90 only adds profits to the extent that they can be franked; and
the amount paid by HC2 for the remaining 40% of the shares in HC1 will include an amount paid for the profits retained by HC1. Consequently, tax paid by the sellers of those shares on the proceeds will account for the balance of the tax deferral.

Adjustment for certain rights and options issued by subsidiary members of the acquired group

1.27 The cost to a consolidated group of acquiring a right or option (issued by an entity) will form part of the cost of acquiring that entity under subsection 705-65(6) in working out the cost of membership interests (step 1 of the ACA). The operation of subsection 705-65(6) in the basic case is modified where a consolidated group joins another consolidated group so that it treats as a membership interest in the head company of the acquired consolidated group a right or option created or issued by a subsidiary member of the acquired group where that right or option is held by a member of the acquiring group. [Schedule 4, item 4, section 705-195]

Adjustment for membership interests or certain rights and options issued by subsidiary members of the acquired group which are held by outside entities

1.28 Modifications are also required to the rules for the basic case to ensure that the step 2 amount (for liabilities) in working out the ACA is increased to treat, the following as part of the cost of acquiring the acquired consolidated group where they are not held by members of either the acquired consolidated group or the acquiring consolidated group:

certain employee membership interests in subsidiary members of the acquired consolidated group; and
certain rights or options to acquire membership interests in subsidiary members of the acquired group.

These modifications are required to ensure that interests or rights or options that are issued by subsidiary members of the acquired group (and not just those in the head company itself) are appropriately taken into account. [Schedule 4, item 4, section 705-200]

Working out the pre-CGT factor for assets of the acquired group

1.29 The pre-CGT status of membership interests that cease to be recognised when an entity becomes a member of a consolidated group is preserved by working out a pre-CGT factor and attaching this to certain assets of the entity when they become those of the head company. The pre-CGT factor for assets of the acquired group that was worked out when the assets became those of the head company of the acquired group are replaced with new pre-CGT factors determined by the application of section 705-125 to the acquisition of the group by the acquiring group. The pre-CGT factors are therefore worked out by reference to the pre-CGT status of the acquiring groups membership interests in the acquired group. [Schedule 4, item 4, section 705-205]

Rules for when multiple entities linked through membership interests join an existing consolidated group

1.30 When a consolidated group acquires an entity that either alone or together with one or more existing members of the consolidated group owns all of the membership interests (other than disregarded employee share interests) in other entities (the linked entities), all of these linked entities will become members of the consolidated group at the same time. The cost setting rules for this case are contained in Subdivision 705-D.

1.31 This case does not apply where the multiple entities that are linked through membership interests comprise a consolidated group, as the rules relating to a consolidated group joining an existing consolidated group (see paragraphs 1.16 to 1.29) will apply.

1.32 Example 1.2 provides a simple example of multiple linked entities.

Example 1.2

A simple example of multiple linked entities.

If the Fratton consolidated group acquires all of the membership interests in Portsmouth Co then both Portsmouth and Southampton companies will become members of the consolidated group. Portsmouth Co and Southampton Co in this case are linked entities because they become members of a consolidated group as a result of an event that happens in relation to one of them.1.33 A modification is made to the provision which excludes the operation of Subdivision 705-A where Subdivision 705-D applies to make it clear that Subdivision 705-D applies where one or more linked entities become subsidiary members of an existing consolidated group at the same time because of an event that happens to one of them. [Schedule 4, item 4, section 705-215] Modifications to the cost setting rules for the acquiring group

1.34 The cost of acquiring the assets of the acquired group is determined using the same rules that apply in the basic case of a single entity becoming a subsidiary member of an existing consolidated group subject to some modifications. The modifications are required to take account of the existence of multiple entities becoming subsidiary members at the same time. In this regard the modifications are similar to those required where a consolidated group is formed although it is necessary to take account that there are already subsidiary members of the consolidated group in existence at the time the linked entities become subsidiary members. [Schedule 4, item 4, section 705-220]

1.35 Modifications to the cost setting rules are made for:

determining the order in which tax cost setting amounts are worked out (see paragraphs 1.37 to 1.39);
working out step 4 of the ACA for successive distributions of certain profits (see paragraphs 1.40 to 1.41);
taking into account owned losses of certain linked entities (see paragraph 1.42); and
adjustments to the tax cost setting amount for certain assets where there has been a loss of pre-CGT status of membership interests in the linked entity (see paragraphs 1.43 to 1.45).

1.36 A modification is also made to the rules for determining the pre-CGT factors for assets of the linked entities (see paragraph 1.46).

Order of application of deemed purchase of linked entities assets

1.37 Where a consolidated group (the joined group) and another entity (the first linked entity) jointly own another entity (the second linked entity) and the joined group acquires the first linked entity such that consequently the second linked entity also becomes a member of the group, it is necessary to first apply the rules for working out the ACA for the first linked entity. This will then set a cost setting amount for those assets, including the membership interests in the second linked entity. The cost setting amount for the membership interests in the second linked entity will then determine the cost base for those membership interests for the purpose of determining the joined groups ACA in relation to the second linked entity and so on . [Schedule 4, item 4, subsections 705-225(2) and (3)]

Example 1.3 Market Garden Co is jointly owned by Sealion Co and a member of a consolidated group (the original member). The consolidated group acquires all of the membership interests in Sealion Co and consequently Market Garden Co also becomes a member of the consolidated group.First, work out the cost setting amount for Sealion Cos assets, including the membership interests Sealion Co holds in Market Garden Co.Then work out the cost setting amount for Market Garden Cos assets. For this purpose, part of the cost base of the membership interests in Market Garden Co is determined from the deemed purchase price payment for all of Sealion Cos assets. The other part will be determined from the cost base of the membership interests held by the original member of the consolidated group in Market Garden Co.

1.38 Applying the cost setting rules in a top down manner to membership interests in other linked entities held by a linked entity removes the need for the later operation of the value shifting rules in relation to these membership interests. [Schedule 4, item 4, subsection 705-225(4)]

1.39 Rights and options held by a linked entity, that were created or issued by another linked entity, to acquire membership interests in that other linked entity will be treated as if it were a membership interest in that other entity for the purposes of working out step 1 (cost of membership interests) of the ACA. [Schedule 4, item 4, subsection 705-225(5)]

Adjustments for successive distributions of profits

1.40 A modification to step 4 of the ACA calculation is required where linked entities join a consolidated group to prevent the duplication of reductions in the ACA for distributions that are effectively a return of the cost of acquiring membership interests. This duplication can occur if reductions are made separately for the distributions of the same profits through the linked entities.

1.41 Where there is a reduction to the ACA under step 4 because of a distribution of profits from a linked entity there will not be a further reduction under step 4 for any subsequent distributions of the same profits by other linked entities. [Schedule 4, item 4, section 705-230]

Allocation of ACA to membership interests in linked entities with certain losses

1.42 The rule for the allocation of the ACA to reset cost base assets is modified where a reset cost base asset is a membership interest in a linked entity (the first linked entity) held by another linked entity and the first linked entity has an amount of losses that will be deducted under step 5 in working out the ACA. For the purpose of allocating the ACA, the value to be used for the membership interest in the first linked entity is its market value plus the amount of that membership interests pro-rata share of the losses. [Schedule 4, item 4, section 705-235]

Adjustments to the tax cost setting amount for certain assets where there has been a loss of pre-CGT status of membership interests in the linked entity

1.43 Under measures discussed in detail in paragraphs 1.89 to 1.114 the head companys cost of certain assets are reduced in certain circumstances where the groups membership interests in that entity were previously pre-CGT membership interests. The main provision is section 705-57.

1.44 Section 705-240 is included to modify the operation of section 705-57 where linked entities join a consolidated group. In this case section 705-57 will only apply where the direct membership interests of the head company in a linked entity are modified by the operation of section 705-40. This is because section 705-240 requires that the original cost base of membership interests a linked entity holds in another linked entity is not applied when working out the ACA of the other linked entity. Rather it is the cost base of the direct membership interests of the head company that is applied to arrive at the cost base of membership interests that a linked entity holds in another linked entity. [Schedule 4, item 4, subsection 705-240(2)]

1.45 However, where section 705-57 has applied to the revenue type assets of a linked entity and the head company holds direct membership interests in the linked entity, any membership interests that linked entity holds in another linked entity is also treated as a revenue type asset. Accordingly, the cost of such a membership interest is reduced under section 705-240. The cost base of such membership interests can be reduced below the subsidiary linked entitys terminating value for the interests for this purpose. This reduction in the cost base of membership interests that a linked entity holds in another linked entity is referred to in the law as the notional section 705-57 reduction amount and also applies to membership interests lower level linked entities hold in other linked entities. [Schedule 4, item 4, subsections 705-240(3), (4) and (5)]

Determining the pre-CGT factor for certain assets of the joining linked entities

1.46 If any of the membership interests in an entity that becomes a subsidiary member are pre-CGT assets, the pre-CGT status of those interests is preserved by attaching a pre-CGT factor to certain assets of the subsidiary member at the joining time. A modification is made to the general operation of this rule for retaining the pre-CGT status of certain assets by attaching a pre-CGT factor to assets that underlie pre-CGT membership interests held by members of the joined group. This ensures that the pre-CGT factor is determined by regard to the pre-CGT membership interests of the consolidated group acquiring the linked entities. [Schedule 4, item 4, section 705-245]

Example 1.4 Continuing on from Example 1.3, assume that the membership interests held by Sealion Co and the original member of the consolidated group in Market Garden Co are both pre-CGT assets. Only the pre-CGT membership interests held by the original member of the consolidated group in Market Garden Co are taken into account in determining the pre-CGT factor to be attached to the applicable assets acquired from Market Garden Co.This is achieved by first determining the pre-CGT factor for the applicable asset of Sealion Co by taking into account the membership interests held by members of the joined group which are pre-CGT assets (in this example, the membership interests are not pre-CGT assets). Secondly, the pre-CGT factor for the applicable assets of Market Garden Co is determined by taking into account the membership interests held by members of the joined group which are pre-CGT assets. As the only relevant membership interests which are pre-CGT assets are those held by the original member of the consolidated group in Market Garden Co, then only the applicable assets acquired from Market Garden Co will have a pre-CGT factor attached to them.

Trusts joining a group

1.47 When an entity joins a consolidated group, the cost base of the groups membership interests in the entity normally forms the core of the ACA that becomes the cost to the consolidated group of the acquiring entitys assets.

1.48 This works well in the case of companies because all membership interests in a company will have a cost base. That is also true of many trusts but not of all. For instance, you might acquire rights that amount to a membership interest in a trust because an amount is settled on a discretionary trust, but not get a cost base for them. Usually, if someone acquires an asset without paying for it, subsection 112-20(1) of the ITAA 1997 will give them a cost base equal to the assets market value. However, that provision does not apply if the asset arises because someone created a right in them (subparagraph 112-20(1)(a)(i) and section 104-35), which is the case with rights arising from a settlement on discretionary trust.

1.49 If the normal cost setting provisions were allowed to apply, the assets of a discretionary trust that joins a consolidated group would get a nil cost base. And that would mean that the proceeds of realising the trust assets, which could have been distributed tax free to the beneficiaries before consolidation, would instead become taxable capital gains of the head company after consolidation. The first amendment to the tax cost setting rules is designed to prevent that outcome.

Example 1.5: Generating taxable gains if no change made Suppose the normal tax cost setting rules applied to trusts that join a consolidated group and that Amanda settled $100,000 on a discretionary trust, the eligible objects of which were Glennco Pty Ltd and Simonewsky Products Ltd. If the trust bought a block of land with the money, it could sell it at any time and distribute the $100,000 tax free to the companies. CGT event E4 (which usually applies to payments a trustee makes in respect of interests in a trust) does not apply here because the discretionary interests are not considered to be interests in a trust (Taxation Determination TD 97/15).Now suppose that Glennco and Simonewsky were a consolidated group. When the trust was formed, it would join that group. Because the companies paid nothing for their membership interests in the trust and because the market value rule does not apply in this case, the cost base of their membership interests would be nil. Consequently, the cost base of the land would be nil. If the land were sold for its $100,000 value, the head company would have to include a $100,000 capital gain in its assessable income.

Increasing step 1 of the allocable cost amount calculation

1.50 To avoid that outcome, the first amendment increases the ACA for a trust that joins a group. Step 1 of the ACA calculation is increased by the amount that was settled on the trust independently of the group and that could have been distributed tax free if the trust had not joined the group. That increase will then be pushed down to increase the cost base of the trusts assets.

Example 1.6: Fixing the problem In the previous example, the zero cost base of the companies membership interests in the trust would be increased by the $100,000 settled by Amanda. That amount would be pushed down to a $100,000 cost base for the land in the head companys hands. Therefore, there would be no capital gain if the land were sold for its $100,000 value.

What membership interests does the modification apply to?

1.51 The increase to the ACA only applies to a membership interest in the trust that, when the trust joins the group:

is neither a unit nor an interest in the trust;
has no cost base; and
only began to be owned because something was settled on the trust.

[Schedule 5, item 6, subsection 713-20(2)]

1.52 The first dot point deals with whether or not the amount could have been distributed tax free. CGT event E4 will treat a distribution from a trust as subject to the capital gains rules if it is made in respect of a unit or interest in a trust. So, the amount could only have been distributed tax free if the membership interest is not a unit and not an interest in a trust. Taxation Determination TD 97/15 explains that an interest as a discretionary beneficiary is not an interest in a trust for the purposes of CGT event E4, so the membership interests of discretionary objects will satisfy this pre-requisite.

1.53 The second and third points require the membership interest to be the result of a gift. That requires that they have no cost base. However, that alone is not enough because, it is possible, there could be a case where the cost base is nil but not a gift (e.g. purchasing for nothing an interest without value). So, the third point requires the membership interest to have arisen because an amount was settled on the trust. Amounts settled by the discretionary object would give rise to a cost base, so would fail at the second point. Effectively then, only amounts settled by someone else will satisfy these requirements.

Example 1.7: Which membership interests are affected by the modification Eric settles $1 million on trust for Inudex Pty Ltd and White Line Jewellery Pty Ltd in such proportions as the trustee considers appropriate. Inudex is in a consolidated group that later acquires White Line, at which point White Line and the trust join the group.What the group paid for its interest in White Line will in part be pushed down to form the groups cost base for White Lines membership interest in the trust. Because that membership interest has a cost base, it will not be eligible for the modification.However, Inudexs membership interest is not an interest in the trust (because it is only a right as a discretionary beneficiary), has no cost base (because it paid nothing to acquire it) and was acquired only because Eric settled the $1 million. Therefore, the modification will apply when working out the ACA for Inudexs membership interest in the trust.

How the modification is worked out

1.54 The modification compares 2 amounts and increases step 1 of the ACA calculation by the lesser of them. [Schedule 5, item 6, subsection 713-20(2), step 5 of the method statement]

1.55 The first amount starts as the sum of all amounts settled on the trust up to the joining time. If an amount was settled as property rather than cash, then its market value at settlement is used. A settled amount is not counted to the extent that it has formed part of the cost base of a membership interest in the trust that step 1 has already counted. For example, an amount settled by the head company to give it a membership interest in the trust would already have been counted under step 1, even though some of that settled amount might be distributed to holders of discretionary membership interests if the trust were brought to an end. [Schedule 5, item 6, subsection 713-20(2), step 1 of the method statement]

1.56 That amount is then reduced to leave just the part that would have been paid to holders of the membership interests that satisfy the pre-requisites discussed in paragraph 1.51 if, at the joining time, the trust had ended by realising all its assets and distributing everything to the beneficiaries. [Schedule 5, item 6, subsection 713-20(2), step 2 of the method statement]

1.57 In most cases this will mean working out how the trustee would have exercised his or her discretion in such circumstances. The trustee can be assumed to do what is most reasonable and further help can be found by examining the terms of the trust deed, the history of past distributions and who controls the trust. This is discussed in more detail in paragraphs 1.84 to 1.86.

1.58 Next, that amount is further reduced by the part of it that would have been included in the beneficiarys assessable income or would have been taken into account in working out the beneficiarys capital gain or capital loss. What is left will be the part of the settled amount that the trustee could have distributed tax free. This amount constitutes the first comparative amount. [Schedule 5, item 6, subsection 713-20(2), step 3 of the method statement]

Example 1.8: The tax free part of the settled amount Continuing the previous example, we need to work out the modification that applies to the trusts ACA because of Inudexs membership interest.Step 1 is the $1 million settled on the trust by Eric.Step 2 requires us to decide how much would have been distributed to Inudex if the trust had ended when it joined the group. In this case, we will assume that half would have gone to Inudex, so step 2 leaves us with $500,000.Step 3 takes away the part of the $500,000 that would have been included in Inudexs assessable income or formed part of a capital gain or loss. In this case, it would all have been tax free, so the result of step 3 is still $500,000.

1.59 The second amount is compared to the first (explained in paragraphs 1.55 to 1.58), to operate as a cap on the increase in the ACA. That second amount is the total amount settled on the trust either directly by the groups head company or by an entity that is independent of, and unconnected to, the group. Amounts settled as property use their market value at settlement. [Schedule 5, item 6, subsection 713-20(2), step 4 of the method statement]

1.60 Independent and unconnected entities include every entity that is not:

a current or past member of the group or an entity that, because of a scheme, may become a member of the group in the future;
an entity that was an associate of any such member when it settled the amount;
an entity that settled the amount in accordance with the instructions, wishes, etc. of any such member or associate;
a partnership that included any such member or associate when it settled the amount; or
a company or trust that, when the amount was settled, is controlled by a current, past or future member of the group for value shifting purposes, or would be if all such members and their associates were associates of each other.

[Schedule 5, item 6, subsection 713-20(3)]

1.61 The control for value shifting purposes test refers to the control tests proposed for the GVSR. It essentially treats a company or trust as controlled by another entity that (together with its associates) can control the voting power or the distribution of income or capital of the company or trust. In applying the test here, every current past or future member of the group is treated as an associate of every other such member.

Example 1.9: How the cap works Wiltord Pty Ltd capitalises Thierry Pty Ltd with $99. Thierry uses the $99 to purchase 99% of the shares in Outsider Pty Ltd. Mrs Hubbard purchases the remaining 1% for $1.Outsider settles $99 on the Parlour Trust, a discretionary trust whose objects are Wiltord and Thierry.Wiltord, Thierry and the Parlour Trust then consolidate.

Diagrammatic representation of how the cap works

Thierrys $99 ACA is allocated between its assets (the shares in Outsider and the membership interest in the Parlour Trust) in proportion to their market values. The market value of all the shares in Outsider is now $1, so Thierrys shares are worth $0.99. We will assume that the market value of Thierrys membership interest in the Parlour Trust is half of the trusts $99 value, that is $49.50. Therefore, of the $99 ACA, $1.94 would be allocated to the shares and $97.06 to the membership interest in the trust.So, step 1 of the groups ACA for the Parlour Trust will be the $97.06 pushed down for Thierrys membership interest. Nothing is added for Wiltords membership interest because it paid nothing for it.The trust modification to step 1 can apply here because Wiltords interest meets the pre-requisites (Thierrys interest does not because it now has a cost base as a result of consolidation). Under the modification, step 1 of the groups ACA will be increased by the lesser of:

the total amount settled on the trust that would have gone to Wiltord tax free if it had been distributed; and
the total settled either by Wiltord (the head company) or by entities independent of, and unconnected to, the group.

If the second amount was not there as a cap, the step 1 amount for the Parlour Trust would have been increased by $49.50. That would have been the wrong outcome because the groups $99 expenditure would then have produced total asset values of:

$1.94 + $97.06 + $49.50 = $148.50

However, in this case the second amount is nil because all the trust capital was settled by Outsider and Outsider was controlled by a member of the group when it settled the capital. Therefore, step 1 of the groups ACA for the Parlour Trust will stay at $97.06.

Increasing step 3 of the ACA

1.62 The first trust modification to ACA dealt with amounts of trust capital that could have been distributed tax free if the group had not consolidated. The next amendment does the same thing with trust profits that could have been distributed tax free.

1.63 When a company joins a consolidated group, step 3 in working out its ACA increases that amount by the undistributed, but frankable, profits in the company that had previously accrued to the group. These are the only profits that a company could distribute tax free to its shareholders.

1.64 However, trusts cannot frank their distributions, so some proxy is needed to extend the same treatment to trust profits. To do that, the amendment introduces a new step 3 for trusts, except corporate unit trusts and public trading trusts (which can frank their distributions). [Schedule 5, item 6, subsections 713-25(1) and (2)]

1.65 The amount added under step 3 to the ACA for a trust that joins a consolidated group is its realised, but undistributed, profits that accrued to the group before the joining time, except to the extent that:

they would have been covered by CGT event E4 if they had been distributed as they accrued (i.e. they would have reduced the cost base of the membership interest concerned or produced a capital gain); or
they recouped losses that accrued to the group before the joining time.

[Schedule 5, item 6, subsection 713-25(1)]

Example 1.10: Undistributed profits Roddy settles $100,000 to create the Fitzwilliger discretionary trust, the eligible objects of which are the companies in the Fitzwilliger corporate group. The trustee purchases a property to rent to tourists. When that group later consolidates, the trust has earned rent of $10,000 that has not been appointed to any beneficiary.Step 1 of the groups ACA for the trust will be $100,000 because of the trust amendment to step 1. The trustee has a liability to pay income tax of $4,850 on the rent, so the ACA will be increased to $104,850 under step 2.Under the trust amendment to step 3, the ACA will be increased by $5,150 because that is the trusts realised, but undistributed, profit (i.e. $10,000 - $4,850). The profit would not have been taxed under CGT event E4 if it had been distributed as it accrued to the Fitzwilliger group because it would not have been a distribution in respect of a unit or an interest in the trust.The total ACA is therefore $110,000. $10,000 of that will be allocated to the cash (a retained cost base asset) and the remaining $100,000 will be allocated to the rental property.

1.66 The profits must be undistributed simply because distributed profits are irrelevant; their status is wholly determined before the trust joins the group.

1.67 Undistributed doesnt mean that the amount must have been physically distributed; a constructive distribution is sufficient. For instance, if a trustee appoints profits to beneficiaries of a discretionary trust but physically retains them, the profits will legally have been distributed, either by way of notional distribution and loan-back to the trustee or by way of settlement on a separate (bare) trust for the appointed beneficiary.

1.68 If the profits have been distributed but loaned back, the trusts ACA will be increased by the liability to repay the loan but that increase will be allocated to the extra cash or other assets the trust has acquired as a result. If the profits have been distributed by settling a separate trust for the beneficiary, the original trusts assets will be unchanged and the new trust will have an ACA equal to the amount settled. In either case, that the profits are not physically distributed will not affect the cost bases of the trusts underlying assets.

1.69 The profits must be realised profits because increasing the ACA for unrealised profits would mean that they could avoid being taxed in anyones hands. Normally, realised profits will already have been subject to tax in the trustees hands and the aim here is simply to prevent them being taxed to the group a second time.

1.70 The requirement for the profits to have accrued to the group maintains the same position for trusts as for companies.

1.71 The first exception mentioned in paragraph 1.65 discounts profits that would have produced a capital gain under CGT event E4 if distributed. This covers the requirement that the distributions could have been made tax free. Since distributions from trusts that have not already been taxed to the beneficiary are usually taxable as capital gains under CGT event E4, the profits that could be distributed tax free by a trust are therefore the amounts not covered by that event. Specifically, they are:

distributions not in respect of a unit or an interest in the trust (i.e. distributions to discretionary beneficiaries); and
distributions that are in respect of a unit or an interest in a trust but that section 104-71 excludes from calculating the CGT event E4 capital gain (e.g. distributions of amount already taxed to the trustee).

1.72 The second exception mentioned in paragraph 1.65 excludes profits that recoup losses that accrued to the group before the joining time. That maintains the same position for trusts as for companies.

Trusts leaving a group

1.73 As amendments are needed for trusts that join a consolidated group, a few amendments are also needed for trusts that leave a group.

1.74 The general thrust of the tax cost setting rules for an entity that leaves a consolidated group is to work out the tax value of its net assets when it leaves and (with some modifications for deductions, intra-group liabilities and losses) attribute that value to the groups membership interests in the entity. The amount allocated to each interest becomes the groups cost base for the interest.

Cost bases of discretionary interests

1.75 Some membership interests in trusts might have no cost base because they are discretionary interests acquired because an amount was settled on the trust. When such a trust joins a consolidated group, the trust amendment to step 1 will work out an amount equivalent to a cost base for those membership interests (see paragraphs 1.54 to 1.61). If the normal rules were then applied to such a trust when it left the group, the group would acquire a cost base for its interests in the trust simply because it had joined, then left, the group.

1.76 Consolidation would then be a mechanism for generating cost bases for membership interests that would otherwise have no cost base. That could allow the holders of discretionary membership interests in the trust to recognise a loss (e.g. when the trust ended) that was properly a loss of the trust or not even a loss at all.

1.77 That problem is fixed by decreasing the cost setting amount that such a membership interest would otherwise have to nil. The membership interests that qualify are those that:

are neither a unit nor an interest in the trust;
have no cost base; and
only began to be held because something was settled on the trust.

[Schedule 5, items 2 and 3, subsection 711-15(1)]

1.78 These exactly match the interests that qualify for an increase in the ACA when the trust joins a group (see paragraph 1.51).

1.79 The ACA for a trust that leaves a group is still allocated to these interests. The amendment reduces their cost setting amount (and therefore their cost base) to nil only after the allocation. This means that the amount is not allocated to other assets, which would defeat the purpose of the amendment.

Example 1.11: Reducing the cost base of discretionary interests in a leaving trust Evelyn settles $500 on the Nockwurst Discretionary Trust with Bratwurst Pty Ltd and Metwurst Enterprises Ltd (both companies in the consolidated German Sausages Group) as the only eligible objects. The trust must join the group.Because the membership interests of Bratwurst and Metwurst qualify under the first trust amendment, step 1 in working out the trusts ACA will be increased from nil to $500. If that is the full ACA, it will be pushed down to form the cost bases of the trusts assets.A day later, Bratwurst leaves the group, so the trust must leave too. If the tax values of the trusts assets are still $500, that will become the basis for setting the tax costs of the groups membership interests in the trust. Assuming $500 is also the final figure, it would be distributed between the membership interests of Bratwurst and Metwurst. The fourth trust amendment will apply to reduce the tax cost setting amounts to nil because those membership interests are not interests in the trust, had no cost base and only began to be owned because the $500 was settled on the trust.When the group works out the cost base of its shares in Bratwurst (the next stage) it will start with a nil cost base for Bratwursts membership interest in the trust. The cost base of Metwursts membership interest in the trust will also be nil.

Pre-CGT status of discretionary interests

1.80 When a group has membership interests in an entity that it acquired pre-CGT, the pre-CGT status of those interests is preserved if the entity joins the group. That is done by a mechanism that attaches a pre-CGT factor to the joining entitys assets. If those assets ever leave the group with a leaving entity (not necessarily the entity they came into the group with), their pre-CGT factor is converted into a pre-CGT status for some of the membership interests the group holds in the leaving entity.

1.81 That mechanism is prevented from creating a pre-CGT factor in respect of any pre-CGT membership interest in a joining trust if the membership interest is neither a unit nor an interest in the trust. [Schedule 5, item 1, subsection 705-125(4)]

1.82 That amendment is intended to prevent transferring the pre-CGT status of membership interests in discretionary trusts (that are unlikely ever to be sold) to other, post-CGT, interests that are much more likely to become the subject of a CGT event.

1.83 Where a trust leaves a group, the pre-CGT factor attached to any assets of the trust is prevented from being converted into a pre-CGT status for any membership interest in the trust that is neither a unit nor an interest in the trust. This is the mirror of the rule that applies to such membership interests in trusts that join a group. It ensures that the pre-CGT factor is not wasted by being allocated to membership interests that are unlikely to be subject to a CGT event. [Schedule 5, items 4 and 5, subsections 711-65(8) and 711-70(6)]

Notional distributions by discretionary trusts

1.84 A number of consolidation provisions require you to work out how much would have gone to which beneficiaries assuming that the trustee had distributed an amount. In some discretionary trust cases, this can amount to a difficult exercise in fortune telling.

1.85 The final trust amendment is intended to make that exercise easier. It says that some of the relevant factors that need to be taken into account are:

patterns of previous actual distributions; and
who controls the trust from time to time.

[Schedule 5, item 6, section 713-50]

1.86 The rule will apply to Part 3-90 of the IT(TP)Act 1997 in the same way as it applies to Part 3-90 of the ITAA 1997. [Schedule 5, item 13, subsection 700-1(2) of the IT(TP) Act 1997]

Measures to address revenue risks

1.87 Three measures were announced in the Minister for Revenue and Assistant Treasurers Press Release C72/02 on 27 June 2002 to ensure that the cost setting rules do not provide unintended tax benefits to groups during transition to consolidation.

1.88 The measures prevent, in certain circumstances, the consolidated group receiving unintended tax benefits as a result of:

the tax values of trading stock receiving an uplift on consolidation (see paragraphs 1.123 to 1.130);
internally generated assets giving rise to periodic tax deductions for the decline in value of the assets where the costs of creating the asset have already been previously allowed as deductions (see paragraphs 1.131 to 1.174); and
the combined application of the current law ascribing a market value cost base to membership interests that lose their pre-CGT status, and the tax cost setting rules that reset the cost of revenue assets such as trading stock and depreciating assets of an entity that becomes a member of a consolidated group (see paragraphs 1.89 to 1.114).

As the first two measures are included in the IT(TP) Act 1997 they are discussed later in the application and transitional provisions section of this chapter.

Membership interests that were formerly pre-CGT assets

1.89 Where there is a change in majority ownership of an entity, Division 149 of the ITAA 1997 (or section 160ZZS and Subdivision C of Division 20 of Part IIIA of the ITAA 1936) resets the cost bases of any pre-CGT assets held by the entity. These assets could include membership interests the entity holds in subsidiaries. However, the values for calculating depreciation, including for the calculation of the full balancing adjustment amount (treated wholly on revenue account under the capital allowance provisions) are not reset; nor are values for trading stock or other revenue assets.

1.90 The effect of consolidation and the resetting of the cost of assets, in circumstances where the cost base of previously pre-CGT membership interests have been increased, would also increase the cost for tax purposes of revenue type assets. This increase would result in an immediate cost to the revenue and the purpose of this measure is to defer this cost to more closely approximate its usage outside of consolidation. The measures apply where an entity joins a consolidated group (see paragraphs 1.91 to 1.101) and when a consolidated group is formed (see paragraphs 1.102 to 1.105).

Application of pre-CGT membership rules on joining a consolidated group

1.91 For this purpose Subdivision 705-A is amended to include section 705-57. This section requires the tax cost setting amount for the head company of certain assets of an entity that becomes a subsidiary member to be reduced, but not below the entitys terminating value for those assets (see section 705-30), in circumstances discussed below, where the groups membership interests in that entity were previously pre-CGT membership interests.

1.92 The certain assets referred to in paragraph 1.91 are trading stock, depreciating assets and other assets that are dealt with under the revenue provisions of the income tax law referred to in this chapter as revenue type assets. [Schedule 3, item 1, subsection 705-57(2)]

1.93 There are three circumstances in which section 705-57 could apply. The first is contained in subsection 705-57(3) which applies where, before the entity became a subsidiary member of a consolidated group the operation of Division 149, or its predecessor (subsection 160ZZS(1) and Subdivision C of Division 20 of Part IIIA of the ITAA 1936), resulted in membership interests that another subsidiary member held in the entity ceasing to be pre-CGT membership interests. [Schedule 3, item 1, subsection 705-57(3)]

1.94 The second circumstance is where a subsidiary member acquired the membership interests in an entity that becomes a subsidiary member from a controlled entity or through a chain of controlled entities and Division 149 or its predecessor had applied previously to the membership interests. The control test is that used in the GVSR. Subsection 705-57(4) operates to prevent subsection 705-57(3) being avoided by disposing of the membership interests to which that subsection would have applied to a controlled entity. [Schedule 3, item 1, subsection 705-57(4)]

1.95 The third circumstance is where Division 149 or its predecessor has never applied to pre-CGT membership interests in an entity however a member acquired those pre-CGT membership interests from a controlled entity or through a chain of controlled entities and as a result the pre-CGT status of the membership interests is lost. [Schedule 3, item 1, subsection 705-57(5)]

1.96 If any of the circumstances referred to in paragraphs 1.93 to 1.95 are met and the tax cost setting amounts worked out under Subdivision 705-A, disregarding section 705-57, for any revenue type assets is greater than the entitys terminating value for that asset then section 705-57 applies.

1.97 In applying section 705-57 it is necessary to calculate and allocate the ACA for the entity twice. The first calculation and allocation of the ACA ignores the application of section 705-57.

1.98 In the second calculation of the ACA only the step 1 amount in the table in section 705-60 is varied. The varied step 1 amount is the cost base and the reduced cost base of the membership interest included in the first calculation of the ACA reduced by the loss of pre-CGT status adjustment amount. The loss of pre-CGT status adjustment amount is the difference between the cost base and reduced cost base of the membership interests just after they stopped being pre-CGT membership interests and the cost base and reduced cost base just before they stopped being pre-CGT membership interests.

1.99 The second calculated ACA is allocated to all of the assets of the entity applying sections 705-20 to 705-55. However if this has the effect of reducing the cost of revenue type assets below the entitys terminating values for those assets their cost is only reduced to the terminating values. In allocating the ACA, the amount allocated to the non-revenue type assets is disregarded and the amount allocated to the revenue type assets is the assets tax cost setting amount.

1.100 The difference between the first allocation of ACA to the revenue type assets and the allocation after applying section 705-57 is the reduction amount which gives rise to a capital loss of the head company. This capital loss is available to be offset against capital gains over a period of 5 income years starting with the income year in which the entity becomes a subsidiary member (see paragraphs 1.110 to 1.114). [Schedule 3, item 1, subsections 705-57(6) and (7) and paragraph 705-57(2)(b)]

1.101 A transitional rule applies in certain circumstances to bring forward the access to the capital loss (see paragraphs 1.175 to 1.181).

Modified application of pre-CGT membership rules on formation of a consolidated group

1.102 Subdivision 705-B is also amended by the inclusion of section 705-163 to modify the application of section 705-57 in the case where a consolidated group is formed.

1.103 On formation of a consolidated group, section 705-57 will only apply where the direct membership interests of the head company in a subsidiary member are modified by its operation. This is because section 705-145 requires that the original cost base of membership interests a subsidiary member holds in another subsidiary member is not applied when working out the ACA of the other subsidiary member. Rather it is the cost base of the direct membership interests of the head company that is applied to arrive at the cost base of membership interests that a subsidiary member holds in another subsidiary member. [Schedule 3, item 2, subsection 705-163(2)]

1.104 However, where section 705-57 has applied to the revenue type assets of a direct subsidiary of the head company, any membership interests that subsidiary member holds in other subsidiary members is also treated as a revenue type asset and reduced in order to apply section 705-57 to the revenue type assets of that subsidiary member. The cost base of the membership interests can be reduced below the entitys terminating value for the interests for this purpose. This reduction in the cost base of membership interests that a subsidiary member holds in another subsidiary member is referred to as the notional section 705-57 reduction amount and applies as well to membership interests that lower level subsidiary members hold in other subsidiary members. [Schedule 3, item 2, subsections 705-163(3) to (5)]

1.105 Section 705-57 is also modified on formation to ensure that it does not apply where, prior to the formation time, the head company has acquired membership interests in an entity and as a result of that acquisition Division 149 or its predecessor applied to membership interests that the entity held in a subsidiary entity and those membership interests are later transferred with rollover relief to the head company. Section 705-57 should not apply in this circumstance because the head company has paid market value for the indirect membership interests in the entity. If those interests had been acquired directly by the head company Division 149 would not have resulted in an increase in the cost base of the membership interests. For this modification to apply the following conditions must be satisfied:

at the formation time the head company holds all of the membership interests in the subsidiary member;
except for this modification, subsection 705-57(6) would result in the application of an adjustment amount in the circumstances covered by subsection 705-57(4); and
the head company acquired membership interests in an entity for market value, and that entity transferred previously pre-CGT membership interests in the subsidiary member to the head company with rollover relief. The acquisition of membership interests by the head company must be from an entity where the head company did not control the vendor or vice versa and both were not under common control.

[Schedule 3, item 2, subsection 705-163(6)]

Interaction with CGT provisions: loss of pre-CGT status of membership rules

1.106 As a result of the reduction under section 705-57 (see paragraphs 1.97 to 1.99), when a revenue type asset is later sold, the head company may incur a tax liability that is higher than it would be if section 705-57 did not apply. This is because the ACA that is available for those assets at the joining time is less than it would otherwise have been. In recognition of this result, a capital loss equal to the reduction under section 705-57 is allowed to the head company.

1.107 The capital loss arises as a result of CGT event L1 happening. CGT event L1 happens just after the entity becomes a subsidiary member of the group [Schedule 3, item 6, subsection 104-500(2)] . This is to ensure that the capital loss that arises may be included in the head companys tax return.

1.108 The capital loss is calculated with reference to consolidation concepts contained in Part 3-90 of the ITAA 1997. This is because the concepts of capital proceeds and cost base are not relevant when determining the tax cost setting amount for an asset [Schedule 3, item 3] . The references to cost base and reduced cost base in section 705-57 are only relevant at the time the pre-CGT assets become post-CGT assets, this event occurring before the entity that becomes a subsidiary member becomes a part of the head company of the consolidated group.

1.109 The amount of the capital loss is equal to the reduction amount calculated under section 705-57 (see paragraphs 1.97 to 1.99) [Schedule 3, item 6, subsection 104-500(3)] . That capital loss is used to calculate the head companys net capital loss for the income year in which the entity that becomes a subsidiary member joins the group. However, the head company is only able to utilise 1/5 of the CGT event L1 capital loss each year, over 5 years.

Spreading the capital loss over 5 years

1.110 The capital loss made under CGT event L1 is spread over the 5 income years, starting in the income year in which the entity becomes a subsidiary member of the consolidated group. In each year the head company is entitled to use up to 1/5 of the entire CGT event L1 capital loss [Schedule 3, item 6, subsections 104-500(4) and (5)] . In certain circumstances, there are transitional provisions that allow the capital loss to be claimed earlier (see paragraphs 1.175 to 1.181).

1.111 The head company may make both a net capital gain and a net capital loss in the year the entity joins the consolidated group or the consolidated group is formed as a result of spreading the capital loss over 5 years.

1.112 Generally net capital losses are applied in the order that they are made (see section 102-15 of the ITAA 1997). The CGT event L1 capital loss forms part of the net capital losses for the year in which that event happens. The ordering rule will apply to the net capital losses (which contain CGT event L1 capital losses) even though the ability to use that net capital loss is spread over 5 years.

Example 1.12 The Extreme Sports Group makes the following capital gains and capital losses during the 2005/2006 income year:

Capital gains: $200,000
CGT event L1 capital loss: $500,000
Other current year capital losses: $80,000
The amount of CGT event L1 capital loss available to be used in the year is $100,000. If the head company chooses to use that capital loss together with the other current year capital losses the following will be made by the group in the 2005-2006 income year:
Net capital gain (200,000 - 180,000): $20,000
Net capital loss to be carried forward: $400,000
The net capital loss will be a capital loss of the 2005-2006 income year, even though an additional 1/5 of the net capital loss becomes available each year, over the next 4 income years.If in the 2006-2007 income year the group makes a net capital loss, this net capital loss is used to reduce capital gains of the 2007-2008 income year, before the available net capital losses of the 2005-2006 income year can be applied.

Tracking elements of the groups net capital losses

1.113 In the first 5 years after consolidating, the head company will need to track its use of the following capital losses:

net capital losses that form part of the transferred losses that are to be treated as a concessional loss under section 707-350 of the IT(TP) Act 1997;
that part of the net capital loss, made in the first year after the entity becomes a subsidiary member, that is attributable to the CGT event L1 capital loss amount that has either not been applied or is not available until a later year; and
that part of the net capital loss, made in the first year after the entity becomes a subsidiary member, that was not made under CGT event L1 or forms part of the concessional loss.

1.114 The various capital losses need to be tracked because the head company may not be able to use the entire amount of the available CGT event L1 capital loss or the available concessional loss.

Application and transitional provisions

1.115 The consolidation regime will apply from 1 July 2002.

1.116 This bill introduces transitional provisions that deal with:

2 measures to address unintended tax benefits from the cost setting rules:

-
treating certain trading stock as a retained cost base asset; and
-
allowing for reduced or no deductions for the decline in value of certain internally generated assets; and

allowing the balance of certain capital losses to be available where the pre-CGT membership interests provisions have applied.

1.117 Following the introduction of these transitional provisions and the transitional cost setting rules contained in the May Consolidation Act and the June Consolidation Bill, the structure of the cost setting transitional provisions will be as outlined in Table 1.1.

Table 1.1: Structure of cost setting transitional provisions
Division / Subdivision Content
Division 701

Subdivision 701-A

Subdivision 701-B

Modified application of the cost setting rules for certain consolidated groups that form in the 2002-2003 and 2003-2004 financial years:

Rules to identify consolidated groups and entities that are entitled to access to the transitional provisions; and
Modified application of cost setting rules on transition, including allowing the head company to choose that assets of subsidiary members retain their existing costs for tax purposes.

Division 701A Modified application of cost setting rules for entities with continuing majority ownership from 27 June 2002 until joining a consolidated group which have trading stock or certain internally generated assets.
Division 701B Modified application of the CGT consolidation rules to allow for immediate availability to a capital loss arising from the pre-CGT membership interest measure.
Division 702 Modified application of the capital allowance transitional provisions to ensure that they continue to apply to assets that an entity brings into a consolidated group.

Transitional measures to address revenue risks

Determining continuing majority ownership

1.118 Trading stock and certain internally generated assets of an entity will be treated differently upon consolidation where the entity is a continuing majority-owned entity. The reason for this different treatment (i.e. different to the treatment normally provided by Division 705) is to ensure that the cost setting rules do not provide unintended tax benefits to groups on consolidation.

1.119 A continuing majority-owned entity is an entity that was majority owned at all times from the start of 27 June 2002 until the entity became a subsidiary member of a consolidated group (the designated group). [Schedule 9, item 2, subsection 701A-1(1)]

1.120 A person or persons are majority owners of an entity if they are beneficial owners, directly or indirectly through one or more interposed entities, of more than 50% of the market value of all the membership interests in the entity [Schedule 9, item 2, subsection 701A-1(2)] . It should be noted that membership interests do not include debt interests (see section 960-135 of the ITAA 1997 as amended by the May Consolidation Act, when that Act has commenced).

Where an interposed entity is a non-fixed trust

1.121 Where one or more of the interposed entities are not fixed trusts, all of the objects of the trust need to be identified. For the purposes of determining whether majority ownership exists, each of those objects will be treated as if they were beneficiaries of a fixed trust with equal interests in the income and corpus of that trust. [Schedule 9, item 2, subsection 701A-1(3)]

1.122 A trust would be a hybrid trust where the trustee has a discretion as to the application of the trust income or capital but there is at least one beneficiary with a fixed interest in that income or capital which cannot be affected by the exercise of the discretion. Accordingly where a hybrid trust is an interposed entity, the test in subsection 701A-1(3) applies to the extent that there are no fixed interests.

Example 1.13: Working out majority ownership through an interposed hybrid trust In-the-Middle Trust is a hybrid trust that has one asset, a 100% shareholding in Rookie Co. Top Dog Co and Out-of-the-Way Co are the trusts 2 discretionary objects, and Deputy Co (a wholly-owned subsidiary of Top Dog) holds a 20% fixed interest in the income and corpus of the trust.Top Dog is a majority owner of Rookie as it is taken to hold, indirectly through interposed entities (being In-the-Middle and Deputy), 60% of the membership interests in Rookie. This is calculated as follows:

Top Dog is taken to have a 50% interest in 80% of non-fixed interests in In-the-Middle, therefore providing an indirect interest in Rookie of 40%; and
Top Dog has a 100% interest in the 20% fixed interest in In-the-Middle, therefore providing a further indirect interest in Rookie of 20%.

Trading stock as a retained cost base asset

1.123 When an entity becomes a subsidiary member of a consolidated group, its trading stock will generally be a reset cost base asset of that group. However that trading stock will be treated as a retained cost base asset for head company core purposes if that entity was, at the time of becoming a subsidiary member, a continuing majority-owned entity. [Schedule 9, item 2, subsections 701A-5(1) and (3)]

1.124 The purpose of this provision is to ensure that trading stock cannot be given an uplifted tax cost setting amount, thereby preventing unintended tax benefits (in this case, a tax deferral) arising on consolidation.

1.125 Section 705-40 restricts the tax cost setting amount for reset cost base assets that are revenue assets (which includes trading stock) to the greater of the assets market value or its terminating value. Those values effectively ensure a tax neutral result for entity core purposes when an entity becomes a subsidiary of a consolidated group. However a tax deferral will arise if the market value of the trading stock at the time of the entity becoming a subsidiary member exceeds its terminating value as this excess will not have been subject to tax in the hands of the entity prior to consolidation. This is because Division 70 of the ITAA 1997 calculates assessable income or deductions for trading stock by determining the difference between the values of closing and opening trading stock on hand.

1.126 The provision does not apply where a majority interest in the entity was acquired after 27 June 2002 because the cost to revenue from the increased tax value for the trading stock will have been substantially offset by a higher market value of trading stock being reflected in the sale proceeds of vendors of that majority interest.

1.127 Once the tax cost setting amount of the retained cost base asset has been ascertained, that amount reduces the ACA that is available for allocation to the entitys reset cost base assets in accordance with paragraph 705-35(1)(b). The balance of the ACA will then be allocated among the reset cost base assets in accordance with paragraph 705-35(1)(c).

What is the value of the retained cost base asset?

1.128 Generally, trading stock will be a reset cost base asset and like other reset cost base assets, it will have one value which is relevant for entity core purposes and another value for head company core purposes. For entity core purposes the emphasis is, in almost all cases, on ensuring that there is no tax consequence for the entity becoming a subsidiary member of the consolidated group. For trading stock this is achieved by subsection 701-35(4) valuing closing trading stock on hand at a tax neutral amount such as the opening value of trading stock on hand or the amount of the outgoing incurred by the entity in connection with the acquisition of the asset. That value for entity core purposes is generally not relevant for head company core purposes because trading stock, like other reset cost base assets, will be ascribed a new value as a consequence of the allocation of the entitys ACA to each of its assets.

1.129 The value for trading stock that is a retained cost base asset is worked out in accordance with sections 70-45 to 70-70 of the ITAA 1997 immediately before the entity holding the trading stock becomes a subsidiary member of a consolidated group. That time is, or is taken by subsection 701-30(3) to be, the end of the income year. So, where trading stock is a retained cost base asset, this enables the entity to value its trading stock on hand at the end of the income year. [Schedule 9, item 2, paragraph 701A-5(2)(b)]

1.130 Retaining the value of trading stock means that closing value of trading stock on hand immediately prior to consolidation will equal the opening value of the trading stock on hand immediately after consolidation. Consequently, subsection 701-35(4) does not need to apply to ensure that Division 70 does not give rise to any tax consequence for trading stock that remains on hand at the end of the income year preceding consolidation. [Schedule 9, item 2, paragraph 701A-5(2)(a)]

Internally generated assets

1.131 Depreciating assets (including those that are internally generated assets) will generally be treated as reset cost base assets when an entity becomes a subsidiary member of a consolidated group. When this occurs, the ordinary operation of Division 705 will allocate a proportion of ACA to each identified asset that the entity brings into that group. This occurs even though some or all of the costs incurred in creating the asset were deductible. As such, unintended tax benefits may arise where, upon consolidation, the asset is allocated a tax cost setting amount from which the head company can claim a deduction for the decline in value under Division 40 of the ITAA 1997. This unintended benefit represents a risk to the integrity of the consolidation regime.

1.132 The unintended tax benefit is, however, only a timing issue. This is because, but for consolidation, the tax system would not recognise that part of assets cost that has already been allowed as deductions. As the ACA has been allocated to the asset, the head company is entitled to be able to use that ACA, but only to reduce a gain or recognise a loss that arises from the disposal of the asset. It should not be able to use that ACA to give rise to more immediate deductions through deductions for the decline in value of the asset. In that regard, this measure treats the tax cost setting amount allocated to internally generated assets in much the same way as it does for shares or land that are not trading stock.

1.133 Section 701A-10 prevents this unintended tax deferral in certain cases by ascribing a dual cost to these assets upon consolidation:

a cost that is used when working out the decline in value under Division 40 and which is based on the entitys terminating value for the asset (which is calculated in accordance with subsection 705-30(3)); and
a cost that is used when a balancing adjustment event occurs or if the asset leaves the group with a leaving entity and which is based on the assets tax cost setting amount less any decline in value that has since been calculated.

1.134 Where an internally generated asset is given a dual cost, and a balancing adjustment event occurs for that asset a further deduction will be allowed . The amount of the deduction may further increase a deduction, or reduce or offset an assessable amount, calculated under the balancing adjustment provisions. Alternatively, where the asset leaves the consolidated group with an entity, the groups ACA for the entity will be increased. The amount of the increase is essentially the difference between the sum of the deductions for the decline in value that have been allowed and the sum of those deductions for the decline in value that would otherwise have been allowed.

1.135 The decline in value and balancing adjustments are calculated in accordance with Division 40 of the ITAA 1997.

What is an internally generated asset?

1.136 An internally generated asset is an asset for which more than 50% of the total amount of expenditure incurred in constructing or creating it that were of a revenue nature was claimed as deductions by the entity that constructed or created the asset. It should be noted that the entity that claimed the deductions does not have to have been the continuing majority-owned entity. [Schedule 9, item 2, paragraph 701A-10(1)(d)]

When this rule applies

1.137 An internally generated asset will be subject to reduced deductions for decline in value where:

it is a depreciating asset that becomes a depreciating asset of the head company of a consolidated group (because of the single entity rule in subsection 701-1(1)) at the time a continuing majority-owned entity becomes a subsidiary member of that group;
it was in existence at the start of 27 June 2002;
the continuing majority-owned entitys terminating value for the asset is less than the assets tax cost setting amount; and
for each balancing event that occurred for that asset prior to the continuing majority-owned entity becoming a subsidiary member of the group, there was rollover relief under section 40-340 of the ITAA 1997.

[Schedule 9, item 2, subsection 701A-10(1)]

1.138 The rule also applies where the head company disposes of the assets either directly or through the disposal of an entity to a buyer that is a controlled or controlling entity. In those cases, the dual costs mentioned above are worked out in a slightly different manner. The application of this rule is extended to cover these cases so that inappropriate opportunities to access these tax deferral benefits will not arise.

1.139 The rules will however cease to apply when the asset ceases to be held or any other balancing adjustment event occurs in relation to the asset and from that time, the relevant control tests do not continue to be satisfied.

1.140 The reduced deductions for the internally generated assets decline in value , as calculated under Division 40, will also be reduced where the conditions in paragraph 1.137 are satisfied and:

the internally generated asset is held by the head company because subsection 701-1(1) applies;
the asset is acquired from the head company by an entity and the relevant control tests are satisfied; or
the head company ceases to hold the asset because an entity ceases to be a subsidiary member of the group and the relevant control tests are satisfied; or
there is a subsequent direct disposal of the asset and the relevant control tests continue to be satisfied in relation to the new holder of the asset.

When the internally generated asset is held by the head company

1.141 When section 701A-10 applies and the asset is held by the head company, deductions for the assets decline in value are determined on the basis that the assets tax cost setting amount is taken to be equal to the continuing majority-owned entitys terminating value for the asset. The terminating value of an internally generated asset is its adjustable value just before joining time (as per subsection 705-30(3)). [Schedule 9, item 2, paragraph 701A-10(2)(a)]

Example 1.14: Head Company working out the decline in value Melro Co is a continuing majority-owned entity and joins the Glam consolidated group on 1 July 2003. As a consequence, Glam (the head company) is taken to hold Melros internally generated asset.The tax cost setting amount of the internally generated asset is $200,000, which is greater than the $50,000 adjustable value of the asset in Melros hands immediately before consolidation. (The $50,000 is the assets terminating value.) Assuming the remaining effective life is 5 years, the prime cost method of calculating the decline in value is used, and the asset is used only for a taxable purpose, the Glam Group is allowed a deduction for the assets decline in value of $10,000 for the income year ended 30 June 2004.

1.142 The decline in value will still be calculated for the asset where the continuing majority-owned entitys terminating value for the asset is greater than zero. For this to occur:

some of the costs incurred in creating or constructing the asset must not have been deductible because they were capital or of a capital nature; and
at least some of those capitalised costs have not already been subject to a decline in value calculation.

1.143 Thus, the assets actual tax cost setting amount, as calculated by Division 705, is disregarded for the purposes of calculating the decline in value that will or may be deductible after accounting for whether or not the asset was used for a taxable purpose.

When the head company ceases to hold the asset

1.144 The head company may cease holding the internally generated asset either through:

a direct disposal of the asset to another entity; or
the asset leaving the group when the leaving entity ceases to be a subsidiary member of the group.

A direct disposal

1.145 A balancing adjustment event occurs where the asset is sold or disposed of directly by the head company. The balancing adjustment effectively reconciles, at the time of the event, the assets adjustable value for tax purposes with its actual value, and any difference will be an assessable or deductible amount.

1.146 For the reasons noted in paragraph 1.132 the assets actual tax cost setting amount is used to provide the correct reconciliation of adjustable value to actual value of the asset. For the purposes of section 701A-10, this reconciliation is a 2 step process.

1.147 Firstly, a balancing adjustment calculation is made based on what would have been the assets adjustable value if the decline in value was worked out using its actual tax cost setting amount (even though this section prevents some or all of that decline from being deductible).

1.148 Secondly, for the income year in which the balancing adjustment event occurs, a deduction equal to the shortfall (as calculated in paragraph 1.149) is allowed for the head company.

1.149 The amount of the shortfall is the difference between:

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment event occurs (as worked out as if the tax cost setting amount was equal to the continuing majority-owned entitys terminating value for the asset); and
the deductions that would have been worked out using the internally generated assets actual tax cost setting amount.

[Schedule 9, item 2, subparagraphs 701A-10(2)(b)(i) to (iii)]

Example 1.15: Head Company working out a balancing adjustment Carrying on from example 1.14, assume the asset was sold to Yay Co for $180,000 on 30 June 2004. Yay is an entity Glam controls for value shifting purposes. At this time, a balancing adjustment event has occurred and Glam records assessable income of $20,000 arising from its balancing adjustment calculation. The balancing adjustment amount is the difference between the assets termination value ($180,000) and its adjustable value just before the event ($160,000 - which is the assets adjustable value worked out using its actual tax cost setting amount of $200,000).This balancing adjustment overstates the tax relief that was actually provided for the decline in value of the internally generated asset. As such, Glam is also allowed a claw back a deduction of $30,000. This is equal to the difference between the assets actual decline in value allowed as deductions ($10,000, based on the tax cost setting amount for decline in value purposes of $50,000) and the deductions that would have otherwise been allowed ($40,000, based on the actual tax cost setting amount of $200,000).Accordingly, the net tax effect upon Glam ceasing to hold the asset is a deduction of $10,000.

1.150 This calculation is performed on the basis of deductions that are allowed or would be allowed, as opposed to the amount of the decline in value of the asset calculated, and in doing so, accounts for the fact that the asset may not have been used solely for a taxable purpose.

Where an entity leaves the group with the internally generated asset

1.151 Division 711 applies when an entity ceases to be a subsidiary member of the consolidated group, and as a result the head company is ascribed a cost base for the membership interests it holds in the entity immediately before it leaves the group. The cost base for the membership interests is calculated by pushing up onto those membership interests the values of the assets the entity takes with it when it leaves the group.

1.152 So, where the head company ceases to hold the asset because an entity ceases to be subsidiary member of the consolidated group, the groups ACA worked out under section 711-30 for the leaving entity is increased by the amount of the shortfall calculated under paragraph 1.149. [Schedule 9, item 2, subparagraph 701A-10(2)(b)(iv)]

Where the internally generated asset is acquired from the head company

1.153 Ordinarily the cost of acquiring a depreciating asset will form the basis of calculating its future decline in value for the purposes of Division 40 of ITAA 1997.

1.154 The cost will however be prevented from forming the basis of decline in value calculations where the entity that acquired the internally generated asset (the new asset holder):

acquired it from the head company;
at the time of acquisition:

-
either the head company or the new asset holder controls (for value shifting purposes) the other; or
-
another entity controls (for value shifting purposes) both the head company and the new asset holder; and

the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(3)]

1.155 The assets rollover adjustable value is the internally generated assets adjustable value just before it was acquired from the head company by the new asset holder. That adjustable value is worked out on the assumption that the head company had acquired the asset for an amount equal to the continuing majority-owned entitys terminating value for the asset. [Schedule 9, item 2, subparagraph 701A-10(3)(c)(i)]

1.156 The rollover adjustable value accounts for any second element of cost (such as improvements) and any decline in value that has been calculated by the head company.

1.157 Section 701A-10 does not continue to apply where, at the time the new asset holder acquired the internally generated asset, the assets rollover adjustable value is greater than or equal to the assets cost to the new asset holder [Schedule 9, item 2, paragraph 701A-10(3)(c)] . This reflects the intent of this provision, which is to defer deductions where the deductions for the decline in value of the asset would be greater than would otherwise be permitted by this section. The deductions allowed can never be greater than otherwise permitted where the assets rollover value exceeds the assets cost because as long as the control test is satisfied:

subsection 40-65(2) requires, where a depreciating asset was acquired from an associate, the new asset holder to use the same method of working out the decline in value as the associate; and
subsection 40-95(4) requires, where a depreciating asset was acquired from an associate, the new asset holder to use the same effective life as the associate.

Calculating the decline in value for the internally generated asset

1.158 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(3) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value. [Schedule 9, item 2, paragraph 701A-10(4)(a)]

Example 1.16: New Asset Holder working out decline in value Using the facts in example 1.14, Yay Co acquired an internally generated asset for $180,000 on 30 June 2004. At that time, the control test was satisfied and the assets rollover adjustable value ($40,000 = $50,000 terminating value to the continuing majority-owned entity less $10,000 decline in value calculated by Glam) was less than Yays cost of the asset ($180,000).Therefore, at 30 June 2005, Yay Co calculates its deduction for the assets decline in value as being $10,000. This is because Yay must retain the same effective life determination (noting that at acquisition, 4 years of effective life remained) and the same method for calculating the decline in value (being prime cost).

Calculating the balancing adjustment for the internally generated asset

1.159 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment event occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its actual cost to the new asset holder (even though this section prevents some or all of that decline from being deductible).

1.160 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value); and
the deductions that would have been worked out using the internally generated assets actual cost.

[Schedule 9, item 2, paragraph 701A-10(4)(b)]

Where a new entity acquires membership interests in the leaving entity

1.161 A new entity will acquire membership interests in the leaving entity immediately after that entity leaves the consolidated group. This is because it is that new entitys acquisition of those membership interest which results in subsection 701-1(1) ceasing to apply.

1.162 Section 701A-10 will continue to apply where:

an entity (which is referred to as the new asset holder) started holding the internally generated asset because it ceased to be a subsidiary member of the consolidated group;
the head company no longer holds all the membership interests in the new asset holder, and so, some or all of those membership interests have been acquired by a third entity (the buyer of the new asset holder);
at the time of acquisition:

-
either the head company or the buyer of the new asset holder controls (for value shifting purposes) the other; or
-
another entity controls (for value shifting purposes) both the head company and the buyer of the new asset holder; and

the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(5)]

1.163 The assets rollover adjustable value is the internally generated assets adjustable value just before that entity ceases to be a subsidiary member of the consolidated group. The adjustable value which forms the assets rollover adjustable value is based on the assumption that the head company had acquired the asset for an amount equal to the continuing majority-owned entitys terminating value for the asset. This amount accounts for any second element of cost (such as improvements) and any decline in value that has been calculated by the head company. [Schedule 9, item 2, subparagraph 701A-10(5)(c)(i)]

1.164 In this instance, the internally generated assets cost to the new asset holder is its adjustable value worked out on the basis that the decline in value was calculated using its actual tax cost setting amount as determined when the continuing majority owned entity became a subsidiary member of the consolidated group. [Schedule 9, item 2, subparagraph 701A-10(5)(c)(ii)]

Calculating the decline in value for the internally generated asset

1.165 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(5) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value. [Schedule 9, item 2, paragraph 701A-10(6)(a)]

Calculating the balancing adjustment for the internally generated asset

1.166 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its cost to the new asset holder (see paragraph 1.164).

1.167 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value); and
the deductions that would have been worked out using the internally generated assets cost (as per paragraph 1.164).

[Schedule 9, item 2, paragraph 701A-10(6)(b)]

Later acquisitions of the internally generated asset

1.168 Section 701A-10 will also continue to apply to the holder of the internally generated asset regardless of how many times the asset has been disposed of to other entities provided:

the control test continues to be satisfied; and
the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(7)]

1.169 For the purposes of subsection 701A-10(7), the new asset holder is the current asset holder because it acquired the internally generated asset from an entity that was the new asset holder under:

subsection 701A-10(3) - where the original new asset holder acquired the internally generated asset from the head company;
subsection 701A-10(5) - where the original new asset holder held the internally generated asset as a consequence of ceasing to be a subsidiary member of a consolidated group; or
subsection 701A-10(7) - because of a previous application of that subsection.

[Schedule 9, item 2, paragraph 701A-10(7)(a)]

1.170 The control test will continue to be satisfied where:

an entity whose control (for value shifting purposes) has resulted in the control test being satisfied for each previous instance it has had to be applied for the purposes of section 701A-10; and
at the time the internally generated asset was acquired, that same entity:

-
was a party to the acquisition and controls (for value shifting purposes) or was controlled (for value shifting purposes) by the other party; or
-
was not a party to each acquisition but, at the time of the acquisition, controls (for value shifting purposes) the parties to the acquisition.

[Schedule 9, item 2, paragraphs 701A-10(7)(b) and (c)]

1.171 The assets rollover adjustable value is the internally generated assets adjustable value just before the acquisition of the internally generated asset. The adjustable value which forms the assets rollover adjustable value is based on the assumption that every previous new asset holder had acquired the asset for its rollover adjustable value, as worked out under subsection 701A-10(3) (refer paragraph 1.155), subsection 701A-10(5) (refer paragraph 1.163), or subsection 701A-10(7) just before that acquisition took place. [Schedule 9, item 2, subparagraph 701A-10(7)(d)(i)]

Calculating the decline in value for the internally generated asset

1.172 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(7) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value just before that acquisition. [Schedule 9, item 2, paragraph 701A-10(8)(a)]

Calculating the balancing adjustment for the internally generated asset

1.173 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its cost to the new asset holder.

1.174 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value just before that acquisition); and
the deductions that would have been worked out using the internally generated assets cost.

[Schedule 9, item 2, paragraph 701A-10(8)(b)]

Transitional provisions in relation to pre-CGT membership interests

1.175 A transitional provision is inserted into the IT(TP) Act 1997 to allow the group to claim the remaining CGT event L1 capital loss in certain circumstances.

1.176 The rationale for this transitional provision is to address the situation where the subsidiary member is disposed of before the 5 year period for claiming the loss has expired. In this circumstance the remaining CGT event L1 capital loss would not be available to offset the capital gain that could be made on disposal of the subsidiary.

1.177 The transitional provision does not apply to entities acquired after 30 June 2002 because consolidated groups will be aware of the pre-CGT membership interest provisions (i.e. sections 705-57, 705-163 and 705-240).

1.178 The transitional provision will apply where:

an entity that became a member of a consolidated group was subject to the pre-CGT membership rules contained in sections 705-57, 705-163 or 705-240 and was wholly-owned by the group at 30 June 2002;
that subsidiary member ceases to be a subsidiary of the group before the end of the 5 year period after the L1 CGT event happens; and
that subsidiary member leaves the group with all of the assets, other than excepted assets, it held immediately before joining the group.

[Schedule 3, item 8, subsection 701-12(1)]

1.179 If the transitional provision does apply, then the head company is entitled to apply the amount of the unrecouped CGT event L1 capital loss regardless of whether the 5 year period for claiming that capital loss has expired. [Schedule 3, item 8, subsection 701-12(3)]

What is an excepted asset?

1.180 In order to be an excepted asset, the asset must have been both:

a minor asset having regard to the size and nature of the business carried on by the head company as a consequence of the single entity rule treating the assets of the subsidiary entity to be assets of the head company; and
be disposed of in the ordinary course of that business.

[Schedule 3, item 8, subsection 701-12(2)]

1.181 Regard must be had to the nature and size of the business when determining whether an asset is a minor asset. What may be minor asset in relation to one business may not be a minor asset in relation to another business.

Consequential amendments

Consequential amendments as a result of inserting Subdivision 705-C

1.182 The inclusion of modifications in Subdivision 705-C to the core rules which apply where a consolidated group is acquired by another consolidated group has resulted in the following consequential amendments to provisions included in the May Consolidation Act and the June Consolidation Bill.

1.183 The consequential amendments are:

the second sentence of subsection 701-15(1) which refers to Subdivision 705-C is removed [Schedule 4, item 1] ; and
the second sentence of subsection 711-5(1) which refers to Subdivision 705-C is removed [Schedule 4, item 5] .

Consequential amendments as a result of the cost setting rules for trusts

1.184 The rules being added to deal with trusts that join or leave a consolidated group require a small number of changes to the existing consolidation provisions.

Informational amendments

1.185 Most of these simply add notes to existing provisions to draw attention to the changes made by the new trust provisions. [Schedule 5, items 8, 10, 11 and 14, notes to subsections 705-65(1), 705-90(1), 705-90(7) of the ITAA 1997; note to subsection 701-30(2) of the IT(TP) Act 1997]

Consequential amendments to step 3

1.186 The provision that works out step 3 of the ACA is not just altered if the joining entity is a trust but wholly replaced by a new provision. That requires minor changes to a number of provisions.

1.187 Section 705-60 lists all the steps involved in working out the ACA for an entity that joins a consolidated group and refers to the provisions that work each step out. An amendment adds a reference to the new provision that will work step 3 out for trusts. [Schedule 5, item 7, item 3 of the table in section 705-60]

1.188 The provision that usually works out step 3 is amended to make clear that it does not apply if the joining entity is a trust (other than a corporate unit trust or a public trading trust). [Schedule 5, item 9, subsection 705-90(1)]

1.189 Section 705-105 refers to the provision that calculates step 3. An amendment adds a reference to the new provision that calculates step 3 for trusts. [Schedule 5, item 12, section 705-105]

Consequential amendments as a result of inserting CGT event L1

1.190 The note after section 100-15 (overview of steps 1 and 2 of calculating a capital gain or capital loss) is up-dated to reflect that the concepts of cost base and capital proceeds are not relevant for CGT event L1. [Schedule 3, item 3]

1.191 The finding tables in sections 102-30 and 104-5 and the rules in relation to choice in section 103-25 of the ITAA 1997 have been amended to highlight to the reader the special rules relevant to CGT event L1. [Schedule 3, items 4, 5 and 7]

Chapter 2 - Interposed shelf head company

Outline of chapter

2.1 This chapter discusses modifications to the consolidation rules in the May Consolidation Act and the June Consolidation Bill dealing with membership. It also discusses changes that have been made to provisions in the ITAA 1997 as a consequence of these modifications.

Context of reform

2.2 In response to submissions received during consultation, this bill contains changes that amend the membership rules for consolidated groups (other than MEC groups) to ensure that, in limited circumstances, a consolidated group will not cease to exist even though the head company of the group is replaced by a new shelf head company. These changes will help to reduce unnecessary compliance costs for taxpayers, including those who wish to implement a Wallis Report recommendation that Australian banks should be able to interpose a non-operating holding company between the bank and its shareholders. These changes will also aid in protecting the integrity of the consolidation regime.

2.3 This bill also proposes changes to existing CGT rollover relief provisions that currently provide rollover relief for certain shareholders involved in a share exchange. These changes are necessary to maintain the integrity of the consolidation regime and were developed in consultation with external advisors.

Summary of new law

Interposed shelf head company

2.4 This bill amends the membership rules contained in the May Consolidation Act and the June Consolidation Bill to allow a consolidated group to continue to exist in limited circumstances where a company that is eligible to be a head company is interposed between the former head company of a consolidated group and its shareholders.

2.5 Related amendments included in this bill are made to existing CGT rollover relief provisions (in Subdivision 124-G of the ITAA 1997) to:

prevent gains and losses from being realised by shareholders on the disposal, cancellation or redemption of their shares in the former head company of a consolidated group where those shares are exchanged for shares in a replacement head company; and
modify the requirements for rollover relief in certain circumstances.

Comparison of key features of new law and current law
New law Current law
In certain circumstances, where a company is interposed between the head company (the former head company) of a consolidated group and its shareholders, the consolidated group will continue in existence with the former head company as a subsidiary member and the interposed company as the new head company of the group. A consolidated group will cease to exist where the head company of a consolidated group becomes a subsidiary member of a group that is consolidated or eligible to be consolidated.
Shareholders will be required to defer their revenue or capital gains or losses on the disposal, cancellation or redemption of their shares in the former head company of a consolidated group where those shares are exchanged for shares in a replacement head company and certain conditions are met. One of those conditions is that the replacement head company makes a choice for the consolidated group to continue in existence. This choice is equivalent in substance to a choice that section 124-385 of the ITAA 1997 apply.

Shareholders may choose to defer capital gains or losses on the disposal, cancellation or redemption of their shares in one company where those shares are exchanged for replacement shares in another company (the interposed company) and certain conditions are met. One of those conditions is that the interposed company makes a choice for certain consequences set out in section 124-385 of the ITAA 1997 to apply.

There is no relief from income tax on revenue gains realised on a share exchange. Shareholders are unable to defer a revenue loss realised on a share exchange.

Detailed explanation of new law

Interposed shelf head company

2.6 Generally, a consolidated group will cease to exist where the head company of the group no longer satisfies the conditions for being a head company. An exception to this rule now operates to ensure that a consolidated group will not cease to exist in limited circumstances despite an entity ceasing to be the head company of the group.

2.7 These changes will help to reduce unnecessary compliance costs. For example, by preserving a consolidated group in certain cases where nothing of substance has changed within the group, the group will be relieved of the burden of applying the consolidation cost setting rules (and obtaining the necessary market valuations). The changes will also aid in protecting the integrity of the consolidation regime. For example, the changes effectively prevent the cost bases of a groups assets from being reallocated between those assets where nothing of substance has changed within the group. Other integrity benefits of these changes are discussed in paragraphs 2.30 and 2.35.

In what circumstances will the deconsolidation exception apply?

2.8 A consolidated group will continue to exist if:

An entity (the original company) ceases to be a head company of a consolidated group because, through a share exchange, another company (the interposed company) is interposed between the original company and its shareholders and that company becomes the owner of all of the shares in the original company; and
the interposed company makes an irrevocable choice that the consolidated group is to continue in existence.

[Schedule 2, item 10, section 703-65 and subsection 703-70(1)]

What are the conditions for making the choice for the group to continue in existence?

2.9 An interposed company can make an irrevocable choice that a consolidated group is to continue in existence at and after the time (the completion time) when, broadly, the last of the shareholders of the original company has disposed of its shares in the original company to the interposed company or had its shares redeemed or cancelled (as part of the share exchange) if:

immediately before the completion time, the original company is the head company of a consolidated group; and
immediately after the completion time, the interposed company is the head company of a consolidatable group consisting only of itself and the members of the group immediately before the completion time.

[Schedule 2, item 4, subsections 124-380(5) and (7)]

2.10 It is important that following the completion time the interposed company satisfies the conditions for being a head company. The single entity rule operates to treat subsidiary members of a consolidated group as parts of the head company. If the interposed company makes a choice that the consolidated group is to continue in existence, this requirement will ensure that the group continues to be taxed like an ordinary Australian resident company.

2.11 Before the interposed company can make a choice that the consolidated group is to continue in existence, the share exchange which results in the interposed company being interposed between the original company and its shareholders must also be in accordance with the conditions set out in Subdivision 124-G of the ITAA 1997. For example, the interposed company needs to be a shelf company. Also, the entities described as the interposed company and the original company in paragraph 2.8 must come within the existing meanings of those terms given by Subdivision 124-G. Broadly, the term original company means the existing resident company in which the shareholders originally held shares before the share exchange. The term interposed company broadly means a resident company that acquires all of the shares in a company whose shares are held by the original shareholders.

2.12 A choice for the consolidated group to continue in existence must be made by the interposed company within 2 months after the completion time, or within such further time as the Commissioner allows. [Schedule 2, item 4, subsection 124-380(7)]

2.13 Under subsections 103-25(1) and (2) of the ITAA 1997, a choice made under the CGT provisions contained in the ITAA 1997 must generally be made by the day a taxpayer lodges its income tax return for the income year in which the relevant CGT event happened and the manner in which a taxpayer prepares its income tax return is sufficient evidence of the making of such a choice. Amendments are made to paragraph 103-25(1)(a) to ensure that the choice by the interposed company for the consolidated group to continue in existence is an exception to this rule. [Schedule 2, item 1, paragraph 103-25(3)(a)]

2.14 Once made, a choice by the interposed company to preserve the consolidated group results in consequences for:

the consolidated group (see paragraphs 2.15 to 2.25) [Schedule 2, item 10, section 703-65] ;
the original company when it ceases to be a subsidiary member of the group (see paragraphs 2.26 to 2.28) [Schedule 2, item 10, section 703-65] ; and
the shareholders of the original company (see paragraphs 2.29 to 2.42).

What are the consequences of the choice for the consolidated group?

2.15 If the interposed company makes a choice for the consolidated group to continue in existence, the interposed company will become the head company of the consolidated group at the completion time and the original company will cease to be the head company and immediately become a subsidiary member of the group at that time. [Schedule 2, item 10, subsection 703-70(2)]

2.16 Additionally, everything that happened in relation to the original company before the completion time will be taken to have happened instead in relation to the interposed company, just as if, at all times before the completion time:

the interposed company had been the original company; and
the original company had been the interposed company.

[Schedule 2, item 10, paragraphs 703-75(1)(a),(c) and (d)]

For brevity, this rule will be referred to in the explanatory memorandum as the substitution rule.

2.17 The substitution rule also ensures that things that happened to the original company prior to the completion time because of the single entity rule, the entry history rule, the transfer of history rule (see paragraph 3.118 in Chapter 3) or a previous application of the substitution rule will be taken to have happened to the interposed company [Schedule 2, item 10, subsection 703-75(2)]. The single entity rule and the entry history rule were contained in the May Consolidation Act. The single entity rule treats subsidiary members of a consolidated group (or MEC group) as part of the head company of the group and allows such groups to be treated as single entities for income tax purposes. The entry history rule allows the head company to inherit the income tax history of subsidiary members once they become subsidiary members of the group.

2.18 The substitution rule ensures that any income tax history of the interposed company that relates to periods prior to the completion time is effectively ignored. [Schedule 2, item 10, paragraph 703-75(1)(b)]

2.19 The substitution rule will apply for the following purposes:

for the head company core purposes in relation to an income year ending after the completion time. The head company core purposes were contained in the May Consolidation Act. They relate to the purposes of a head company working out its income tax liability or loss for any period during which it is the head company of a consolidated group (or MEC group) or any later income year; and
for the purposes of determining the respective balances of the franking accounts of the original company and the interposed company at and after the completion time.

[Schedule 2, item 10, paragraphs 703-75(3)(a) and (c)]

2.20 The substitution rule also applies for the entity core purposes in relation to an income year ending after the completion time [Schedule 2, item 10, paragraph 703-75(3)(b)] . However, this will be subject to the exit history rule and any provision which the exit history rule is subject to [Schedule 2, item 10, subsection 703-75(4)] . The exit history rule was contained in the May Consolidation Act. It allows an entity to inherit certain income tax history on ceasing to be a subsidiary member of a consolidated group (or MEC group) .

2.21 In general, for the income year that ends after the completion time, the head company of the consolidated group will be the interposed company. That is, generally, in respect of the income year that includes the completion time, the interposed company will be the head company of the consolidated group up until the completion time because of the substitution rule and afterwards because of the rule in paragraph 2.15.

2.22 Also, all of the tax attributes (e.g. losses and franking credits) of the original company will instead become those of the interposed company. This will include, for example, tax attributes generated by the consolidated group and tax attributes transferred to the original company from subsidiary members at the joining time or the group formation time.

2.23 Consolidation provisions that ordinarily apply when an entity becomes a subsidiary member of a consolidated group (hereafter referred to as the joining rules) will not apply when the original company becomes a subsidiary member of the group at the completion time (subject to any specific exceptions to this rule) [Schedule 2, item 10, subsection 703-70(3)] . This rule aims to prevent unintended consequences such as double counting of tax attributes that may otherwise occur. In the absence of such a rule it may be arguable, for example that losses of the original company are transferred to the interposed company under the joining rules. The transfer of the losses of the original company under the joining rules would be in addition to the effective transfer of those losses that would occur under the substitution rule.

2.24 The rule in paragraph 2.23 does not affect the application of the single entity rule. [Schedule 2, item 10, subsection 703-70(4)]

2.25 The substitution rule in conjunction with the rule in paragraph 2.23 that prevents the joining rules from applying when the original company becomes a subsidiary member of the consolidated group will also ensure that the consolidated groups existing asset cost bases will be retained following the change in the head company of the group.

What are the consequences for the original company if it ceases to be a subsidiary member of the consolidated group following the completion time?

2.26 As mentioned in paragraph 2.15, if the interposed company makes a choice for the consolidated group to continue in existence, the original company will become a subsidiary member of the group at the completion time. If the original company ceases to be a subsidiary member of the group following that time, any provision that would ordinarily apply to an entity when it ceases to be a subsidiary member will also apply to the original company.

2.27 However, the following modifications will apply when the original company ceases to be a subsidiary member of the consolidated group:

section 701-30 is modified so that in applying that section to the original company for the income year that includes the completion time, any non-membership period that starts before the completion time is to be ignored [Schedule 2, item 10, section 703-80] . This modification is necessary to avoid unintended tax consequences, such as double taxation that may otherwise arise (as a consequence of the substitution rule). Section 701-30 was contained in the May Consolidation Act and it, broadly, provides a method for working out an entitys tax position for a period when it is not a subsidiary member of any consolidated group. Its application can also affect the entitys tax position in later income years;and
the substitution rule will apply subject to the exit history rule and any exceptions to the exit history rule (see paragraph 2.20) [Schedule 2, item 10, subsection 703-75(4)] . This will ensure that when the original company ceases to be a subsidiary member of the consolidated group it will take with it only the income tax history that relates to the assets, liabilities and businesses that leave with the company.

2.28 One implication of the substitution rule operating in conjunction with the modification to section 701-30 (see paragraph 2.27) is that the only tax payable by the original company for the income year that includes the completion time arises because of the application of section 701-30 to non-membership periods in the income year that end after the completion time. Under the substitution rule, the interposed company inherits the original companys tax position for the part of the income year that ends before the completion time, with the consequences that the original companys taxable income, income tax payable, and losses of any sort for that part are each nil.

What are the consequences for a shareholder of the original company when a choice is made for the group to continue in existence?

2.29 There are consequences for a shareholder of the original company when the interposed company makes a choice for the consolidated group to continue in existence (see paragraphs 2.32 to 2.37). There are additional consequences where the shares in the original company are trading stock (see paragraphs 2.38 to 2.40) or revenue assets (see paragraph 2.41 to 2.42) of the shareholder immediately before the time that the share exchange takes place.

2.30 The effect of these implications (discussed in paragraphs 2.32 to 2.42) is to defer tax recognition of gains or losses on the disposal, cancellation or redemption of shares in the original company until the replacement shares in the interposed company are disposed of. These rules are aimed at preventing unintended consequences, in particular loss or gain duplication.

2.31 Compulsory deferral of losses or gains (on the disposal, cancellation or redemption of shares in the original company) is appropriate given that the rules that give rise to those outcomes will only be invoked in circumstances where nothing of substance would have changed for the shareholders of the original company as a consequence of the share exchange.

Consequences for shareholders of the original company

2.32 Where the interposed company makes a choice for the consolidated group to continue in existence, the shareholders of the original company will be taken to have chosen to obtain rollover relief on the disposal, cancellation or redemption of their shares in the original company which are exchanged for replacement shares in the interposed company if:

immediately before the completion time, the original company is the head company of a consolidated group; and
immediately after the completion time the interposed company is the head company of the group.

[Schedule 2, item 2, subsection 124-360(2), and item 3, subsection 124-370(1A)]

2.33 The share exchange which results in the interposed company being interposed between the original company and its shareholders must have also been in accordance with the conditions set out in Subdivision 124-G of the ITAA 1997 for the rule in paragraph 2.32 to apply.

2.34 Under the existing rules in Subdivision 124-G, shareholders may choose to defer capital gains or losses on the disposal, cancellation or redemption of their shares in the original company where those shares are exchanged for replacement shares in the interposed company provided that:

the interposed company makes an election that the consequences set out in section 124-385 of the ITAA 1997 apply; and
the share exchange is in accordance with the conditions set out in Subdivision 124-G.

2.35 As discussed, the existing rules in Subdivision 124-G are modified in the circumstances set out in paragraphs 2.32 and 2.33 so that rollover will now be compulsory in those circumstances. This is necessary to prevent gain or loss duplication.

2.36 Another difference between the existing rules in Subdivision 124-G and the rules in paragraphs 2.32 and 2.33 is that in respect of the latter rules, rollover is dependant on the interposed company making an election that the consolidated group continue in existence (rather than a choice that the consequences set out in section 124-385 apply). The consequences set out in section 124-385 are irrelevant in a consolidation context given that within a consolidated group intra-group membership interests are not recognised. Broadly, section 124-385 determines the number, if any, of the interposed companys shares in the original company that are pre-CGT assets and sets the interposed companys cost base for its newly acquired shares in the original company that are not pre-CGT assets. The consequences set out in section 124-385 are equivalent in substance to a choice that the consolidated group continue in existence.

2.37 As discussed, there are also consequences for shareholders of the original company if they are taken to have obtained the rollover under the rule in paragraph 2.32 and immediately before the time when their shares in the original company were disposed of, cancelled or redeemed some or all of those shares were their trading stock or revenue assets. [Schedule 2, item 7, subsection 124-390(1)]

Additional consequences for shareholders of the original company where those shares are shareholders trading stock

2.38 A shareholder of the original company is required to include an amount in its assessable income in respect of the disposal, redemption or cancellation of each of its shares (if any) in the original company that were its trading stock immediately before the time of the disposal, redemption or cancellation of those shares. The amount to be included in assessable income is equal to the amount set out in Table 2.1.

Table 2.1: The amount to be included in assessable income of a shareholder of the original company for disposal, redemption or cancellation of those shares that were its trading stock
If the trading stock is ... The amount to be included in assessable income is ...
Trading stock that was on hand at the start of the income year that includes the completion time. Its value as trading stock at the start of the income year that includes the completion time plus any amounts by which its cost has increased since the start of that income year.
Other trading stock that was acquired by the shareholder during the income year that includes the completion time. The cost of the trading stock at the time that it is disposed of, redeemed or cancelled.

[Schedule 2, item 7, subsection 124-390(2)]

2.39 A shareholder of the original company whose shares in the original company were its trading stock immediately before the time of the disposal, redemption or cancellation (of those shares) will be taken to have paid an amount for each of its replacement shares in the interposed company equal to the amount worked out under the following formula:

total amounts included in assessable income of the shareholder of the original company for its shares in the original company (worked out using Table 2.1) / number of the replacement shares issued in the interposed company to the shareholder for those shares that were shareholder's trading stock

[Schedule 2, item 7, subsection 124-390(3)]

2.40 The amount worked out by applying the formula in paragraph 2.39 becomes the shareholders cost of each of its replacement shares in the interposed company.

Additional consequences for shareholders of the original company where those shares are shareholders revenue assets

2.41 Similarly, a shareholder of the original company is required to include an amount in its assessable income in respect of the disposal, redemption or cancellation of each of its shares (if any) in the original company that were its revenue assets immediately before the time of the disposal, redemption or cancellation of those shares. For each share, the amount to be included in assessable income is broadly equal to the cost of that share immediately before the completion time. [Schedule 2, item 7, subsection 124-390(4)]

2.42 A shareholder of the original company whose shares in the original company were its trading stock immediately before the time of the disposal, redemption or cancellation of those shares will be taken to have paid an amount for each of its replacement shares in the interposed company. The amount will be equal to the result obtained by applying the following formula:

[Schedule 2, item 7, subsection 124-390(5)]

Application and transitional provisions

2.43 These amendments will take effect on 1 July 2002, along with other aspects of the consolidation measures.

Consequential amendments

2.44 There are various consequential amendments to Subdivision 124-G of the ITAA 1997 in relation to the measure discussed in this chapter.

2.45 The consequential amendments will update references to certain provisions currently contained in Subdivision 124-G. They will also ensure that the existing requirements for rollover under that Subdivision on an exchange of shares in the original company for shares in the interposed company are retained where the following conditions do not apply:

immediately before the completion time, the original company is the head company of a consolidated group; and
immediately after the completion time, the interposed company is the head company of a consolidatable group consisting of itself and the members of the group immediately before the completion time.

2.46 For example, one of the existing requirements for rollover under Subdivision 124-G is that the interposed company makes a choice, generally within 2 months after the completion time, that section 124-385 of the ITAA 1997 apply. Consequential amendments will ensure that this requirement remains in the circumstances set out in paragraph 2.45 (although this election is now irrevocable), along with the consequences set out in section 124-385 for the interposed company once the interposed company makes that election. [Schedule 2, item 4, subsections 124-380(6) and (7); item 5, and item 6, subsection 124-385(1A)]

2.47 Further, consequential amendments will update paragraph 103-25(3)(a) of the ITAA 1997 to continue to ensure that a choice made by the interposed company that section 124-385 apply is an exception to the general rule in subsections 103-25(1) and (2) of the ITAA 1997 regarding the timing of and method of making a choice under the CGT provisions in the ITAA 1997 (see paragraph 2.13). [Schedule 2, item 1, paragraph 103-25(3)(a)]

2.48 Shareholders of the original company will continue to be provided with a choice to obtain rollover under Subdivision 124-G where the pre-conditions for rollover are satisfied and the circumstances set out in paragraph 2.45 apply.

2.49 Aside from the above, consequential amendments are made to Division 703 (contained in the May Consolidation Act and the June Consolidation Bill). Amendments are made to subsection 703-60(3) to repeal the link note at the end of that section [Schedule 2, item 9, subsection 703-60(3)] . Further, consequential amendments are made to subsection 703-5(2) to add a note to explain that a consolidated group does not cease to exist in some cases where a shelf company is interposed between the head company and its former shareholders. [Schedule 2, item 8, subsection 703-5(2)]

Chapter 3 - MEC groups

Outline of chapter

3.1 This chapter explains rules that ensure the cost setting rules contained in the May Consolidation Act and the June Consolidation Bill apply in an appropriate manner to MEC groups.

3.2 The cost setting rules covered in this chapter are:

a single entity joining a MEC group (Division 701 and Subdivision 705-A of the May Consolidation Act);
the formation of a MEC group (Subdivision 705-B of the June Consolidation Bill), including the transitional cost setting rules contained in the amendments to the IT(TP) Act 1997 which were contained in the June Consolidation Bill; and
one or more entities leaving a MEC group (Divisions 701 and 711 of the May Consolidation Act).

3.3 This chapter also explains rules:

that reset the cost of membership interests in eligible tier-1 companies that are not held by other members of the MEC group (the pooling rules);
that ensure that the annual rate of use of a groups existing losses is adjusted as a result of a new eligible tier-1 company joining the group; and
that ensure the tax position of a MEC group does not change where a different company is appointed as the head company of the group.

3.4 The amendments explained in this chapter are contained in Schedules 6, 8 and 10 to this bill.

Context of reform

3.5 In general, the rules in Part 3-90 are to apply to a MEC group and its members in the same manner in which they apply to a consolidated group and its members. This general application rule will be contained in subsequent legislation. However, the general application rule will be subject to a number of specific modifications, such as those discussed in this Chapter, which take into account the special characteristics of a MEC group.

Cost setting rules

3.6 The treatment of assets of entities joining a MEC group is intended to mirror the treatment of assets of entities joining a consolidated group, the rules for which were contained in the May Consolidation Act and the June Consolidation Bill. Some modifications are required to those rules however to reflect the different nature of a MEC group. Unlike a consolidated group, a MEC group does not have a single Australian resident head company. Rather, a MEC group has 2 or more eligible tier-1 companies that are collectively akin to a head company of a consolidated group. The modifications contained in this chapter ensure that eligible tier-1 companies are treated in the same manner as the head company of a consolidated group from a cost setting perspective.

Pooling rules

3.7 The cost setting rules that apply when an entity joins or leaves a MEC group allow for assets to be transferred between members of the group without requiring cost base adjustments to address value shifting. The cost setting rules however are limited in their operation to membership interests held within the group. Without further measures, much of the benefits of forming a MEC group would disappear as entities who hold membership interests in eligible tier-1 companies would still be required to make value shifting adjustments when assets are transferred between members of the group. The pooling rules for eligible tier-1 companies in this chapter are designed to facilitate the tax free transfer of assets within a MEC group by removing the need to make value shifting adjustments at the eligible tier-1 company level.

Available fractions for MEC groups

3.8 A groups use of losses transferred to it by members on joining the group is restricted by the available fraction calculated for the losses. The available fraction is a proxy for determining the proportion of the groups income or gains generated by the joining loss entity.

3.9 In order to retain the integrity of an available fraction, it is essential that it be adjusted when capital is introduced into the group from outside. In that case, the groups income generating capacity is increased which reduces the proportion of the groups income that the original loss entity can be regarded as generating.

3.10 The inclusion of a new eligible tier-1 company in a group essentially amounts to an injection of capital into the group. That is, the new tier-1 company joins the group because of its relationship with the groups top company - the group has not paid cash or assets in order to acquire it. Therefore, a group will be required to adjust its available fractions when a new eligible tier-1 company joins.

Change in head company

3.11 Where the head company of a MEC group becomes ineligible to continue as the head company of the group, rules apply to allow the remaining eligible tier-1 companies to appoint a replacement head company. Whilst the MEC group will have a new head company as the taxpayer for the group, the tax position of the group should not be affected by the departure or change in membership status of the previous head company.

Summary of new law

Cost setting rules

3.12 The rules that deal with the cost of assets of subsidiary entities that join or leave a consolidated group (contained in Divisions 701, 705 and 711 of the May Consolidation Act) will generally have equivalent application to MEC groups. However, some modifications are required to ensure that those rules work appropriately in the MEC group context.

3.13 Broadly, the cost setting rules dealing with entities joining a group are modified so that each eligible tier-1 company is treated as if it were a part of the head company of the group, rather than a separate entity. This ensures, for example, that provisions in the cost setting rules that operate if the head company of the group holds membership interests in another entity will operate if one or more eligible tier-1 companies of the MEC group holds membership interests in the other entity. It also ensures that, when an eligible tier-1 company joins a MEC group, the cost of the assets of that company is not reset. This is because the rules that reset the cost of assets only apply when an entity joins a group as a subsidiary member.

3.14 Where an eligible tier-1 company leaves a MEC group, the rules in Divisions 701 and 711 that deal with entities leaving a group generally apply to reset the cost of membership interests in the leaving eligible tier-1 company that are held by other members of the MEC group. The cost of membership interests in the leaving eligible tier-1 company held by entities outside the MEC group is determined under special pooling rules (see paragraphs 3.50 to 3.71). No modifications to the leaving rules are required where a subsidiary that is not an eligible tier-1 company leaves the MEC group.

3.15 Certain modifications are also made to the transitional cost setting rules that were included in the June Consolidation Bill.

Pooling rules

3.16 The cost base of all membership interests in eligible tier-1 companies of a MEC group that are held by entities that are not members of the group are to be pooled just before the time either, or both, of the following events (for ease called trigger events) happen in relation to one or more eligible tier-1 companies in the group:

the company ceases to be a member of the group;
a CGT event happens in relation to one or more membership interests in the company.

3.17 Pooling the cost bases of those membership interests is required to allow the cost base of the interests to be reset based on an allocation from the pool immediately before the trigger event. The resetting of the cost base from the pool facilitates the free transfer of assets within the group as it removes the need to make value shifting adjustments to the membership interests each time there is a transfer of value between MEC group members.

3.18 The method adopted for allocating a part of the total cost base pool to each membership interest in each eligible tier-1 company differs depending on whether or not a trigger event happens in relation to the eligible tier-1 company. For those companies in relation to which a trigger event happens, the percentage allocation from the pool for each membership interest will equal the market value of the membership interest as a proportion of the market value of the group. For the remaining eligible tier-1 companies, the reset cost base is determined by allocating the remainder of the pool equally across all the membership interests in each of those companies.

3.19 Similar rules also apply to reset, just before the time of a trigger event, the reduced cost base of the membership interests in eligible tier-1 companies as well as the cost of those membership interests which are held on revenue account.

Available fractions for MEC groups

3.20 A groups existing available fractions are adjusted if the group expands because a new eligible tier-1 company joins the group. (An available fraction is calculated for a bundle of losses transferred to a group from an entity on joining the group. It is used to limit the annual rate at which transferred losses can be recouped by a group.)

3.21 Also, any losses generated by the group that were held by the groups head company when the new eligible tier-1 company joined will be treated as transferred losses. An available fraction will be calculated for them. It will be used to limit their annual rate of use.

Change in head company

3.22 When the head company of a MEC group is replaced by a new head company, its income tax history will be transferred to the new head company of the group.

Comparison of key features of new law and current law
New law Current law

A MEC groups cost of acquiring an entity (other than an eligible tier-1 company) is treated as the groups cost for the assets of that entity.

A MEC groups cost for the net assets of a group entity, at the time the group first disposes of membership interests in the entity, sets the groups cost for its membership interests in that entity.

Income tax consequences on disposal of an asset by a wholly-owned subsidiary are calculated by reference to the cost of the asset to the subsidiary. No regard is given to the groups cost of acquiring the entity including where the asset was acquired before the subsidiary came to be wholly-owned by the group.

Acquisition or disposal of an entity by a holding company is dealt with only as an acquisition or disposal of the membership interests in the entity.

The cost base of all membership interests in eligible tier-1 companies of a MEC group that are held by entities that are not members of the group are to be pooled just before the time either, or both, of the following events happen:

an eligible tier-1 company ceases to be a member of the group;
a CGT event happens in relation to one or more membership interests in an eligible tier-1 company.

The cost base of the membership interests will be reset immediately before the time of the event based on an allocation from the pool.

A separate cost base is maintained for each membership interest based on the original purchase price of the interests with value shifting adjustments being made to the cost base to take account of value shifts within the wholly-owned group.
A groups available fractions for its transferred losses are adjusted whenever an eligible tier-1 company joins the group. A groups available fractions are only adjusted if a new loss entity joins the group.
An available fraction will be calculated for a groups own losses when an eligible tier-1 company joins the group. Group losses only receive an available fraction when they are transferred to the head company of another group.
When a head company of a MEC group is replaced by a new head company, its income tax history will be transferred to the new head company of the group. No equivalent.

Detailed explanation of new law

Cost setting rules

An entity joining an existing MEC group

Joining cost setting rules generally apply

3.23 The cost setting rules for ordinary consolidated groups (i.e. non-MEC consolidated groups), contained in Division 701 and Subdivision 705-A of the May Consolidation Act, govern the treatment of an entitys assets when it joins an existing consolidated group. Broadly, the effect of these rules (i.e. joining rules) is that a consolidated groups cost of acquiring a subsidiary entity is treated as the cost to the group of acquiring the assets and liabilities of that entity.

3.24 The joining rules for ordinary consolidated groups generally have equivalent application to MEC groups. However, those rules are modified by a general modifying rule so that they take account of the special characteristics of a MEC group. [Schedule 8, item 8, sections 719-155 and 719-160]

General modifying rule

3.25 The general modifying rule operates to treat each eligible tier-1 company of the MEC group as if it were a part of the head company of the group, rather than a separate entity. This treatment also extends to an eligible tier-1 company when it joins a MEC group. [Schedule 8, item 8, subsection 719-160(2)]

3.26 The rationale for the general modifying rule is that eligible tier-1 companies, representing the top level of the MEC group structure, are collectively equivalent to the head company of an ordinary consolidated group. This is the case even though, nominally, only one of the eligible tier-1 companies of a MEC group becomes the head company with the remaining eligible tier-1 companies called subsidiaries. The modifying rule is required because, unlike an ordinary consolidated group, the head company of a MEC group will not hold (directly or indirectly) all the membership interests in the subsidiary members of the group.

3.27 There are a number of important effects of the general modifying rule.

3.28 The rule ensures that provisions in the cost setting rules that operate if the head company of the group holds membership interests in another entity will operate if one or more eligible tier-1 companies of the MEC group holds membership interests in that other entity. [Schedule 8, item 8, subsection 719-160(2), note 1(a)]

3.29 A second effect of the modifying rule is that provisions in the cost setting rules that operate if the head company owns or controls another entity will operate if one or more eligible tier-1 companies own or control that other entity. [Schedule 8, item 8, subsection 719-160(2), note 1(b)]

3.30 A further effect of the general modifying rule is that references in the cost setting rules to an entity interposed between the head company and another entity will apply to an entity interposed between an eligible tier-1 company and the other entity. [Schedule 8, item 8, subsection 719-160(2), note 1(c)]

Example 3.1: Effect of the general modifying rule

Example of the effect of the general modifying rule

Assume there is an existing MEC group comprising A Co, B Co, C Co (all eligible tier -1 companies) and D Co. E Co is the entity joining the MEC group. A Co is the head company of the MEC group for the income year in which E Co joins the group.Without the general modifying rule applying to the joining rules, the membership interests in E Co would not be taken into account when applying those rules because A Co, the head company of the MEC group, does not hold any direct or indirect membership interests in the joining entity. Further, A Co would not directly exercise any control or ownership over the joining entity. Also, the joining rules would not treat D Co as an entity interposed between the head company and the joining entity. The general modifying rule ensures the correct treatment in each of these cases by treating B Co and C Co as part of the head company, A Co, for the purposes of the joining rules.

No cost resetting for assets of an eligible tier -1 company

3.31 Another important effect of the general modifying rule is that, when an eligible tier-1 company joins a MEC group, the cost of the assets of that joining eligible tier-1 company is not reset. This is because the joining rules only apply when an entity joins a group as a subsidiary member. The general modifying rule treats a joining eligible tier-1 company as a part of the head company of the MEC group, rather than as a subsidiary member. [Schedule 8, item 8, subsection 719-160(2), note 2]

3.32 Therefore, when an eligible tier-1 company joins an existing MEC group, the eligible tier-1 company will retain the existing tax cost of its assets. This treatment is akin to the treatment of the head company of a consolidated group. It ensures neutrality between electing that the eligible tier-1 company join a MEC group and electing that the company become the head company of a consolidated group. In the latter case, there would also be no resetting of the cost of the companys assets.

3.33 This treatment means that where a member of the MEC group holds membership interests in a joining eligible tier-1 company, the cost of those membership interests will effectively be disregarded, as there will not be any resetting of the cost of the assets of that eligible tier-1 company (i.e. the cost of the membership interests will not be aligned with the cost of the companys assets). Groups in this situation have the option of transferring those membership interests in the eligible tier-1 company held outside the group to a member of the MEC group so that the company joins the group as a subsidiary member rather than as an eligible tier-1 company. In this event the cost of the assets of the joining company could be reset.

3.34 Further consideration will be given to ensuring that the MEC group membership rules provide sufficient time for such a transfer to occur before the relevant company is treated as being a member of the MEC group. Consideration will also be given to ensuring that such transfers are treated appropriately under the joining rules (which, for example, ignore the effects of certain asset rollovers in some circumstances).

Trading stock of a joining eligible tier-1 company

3.35 Subsection 701-35(4) of the May Consolidation Act does not apply in relation to the trading stock of an eligible tier-1 company when it joins an existing MEC group. As the cost of an eligible tier-1 companys assets (including its trading stock) is not reset when it joins a MEC group, there is no need to set a tax neutral amount for the trading stock for the companys income year that effectively ends at the time it joins the group. [Schedule 8, item 8, section 719-165]

Pre-CGT factors for assets of a MEC group

3.36 The application of the general modifying rule to the joining rules means that pre-CGT factors are only worked out for assets held by subsidiaries of a MEC group other than eligible tier-1 companies.

Example 3.2: Eligible tier-1 company joining an existing MEC group

Further example of the effect of the general modifying rule

Assume that non-resident company X Co owns 100% of the membership interests in each of resident companies A Co and B Co. X Co also owns 50% of the membership interests in resident company C Co. A MEC group is initially formed on 1 July 2003 comprising A Co and B Co (both eligible tier-1 companies), with A Co the provisional head company of the group.B Co subsequently acquires the remaining 50% of the membership interests in C Co. A Co, the provisional head company of the MEC group at the time of the acquisition, chooses for C Co to join the MEC group. C Co is an eligible tier-1 company of the MEC group.For the purposes of the joining rules, the MEC joining entity, C Co (an eligible tier-1 company) is treated as part of the head company, A Co. This means that the assets held by C Co do not have their cost reset under the joining rules. The cost of the membership interests B Co holds in C Co at the MEC joining time is disregarded.

Formation of a MEC Group

3.37 Subdivision 705-B of the June Consolidation Bill contains the cost setting rules for the formation of an ordinary consolidated group (the formation rules). Under those rules, each entity that becomes a subsidiary member of a consolidated group at the formation time is generally treated in the same way as an entity joining an existing consolidated group.

3.38 The formation rules for ordinary consolidated groups generally have equivalent application to MEC groups. However, the general modifying rule, discussed at paragraphs 3.25 to 3.36, also applies to the formation rules. [Schedule 8, item 8, paragraph 719-160(3)(c)]

Example 3.3: Formation of a MEC group

Diagrammatic example of the formation of a MEC group

Assume that non-resident company X Co owns 100% of the membership interests in resident companies A Co and B Co. A Co and B Co each own 50% of the membership interests in C Co.On 1 July 2005, A Co and B Co choose to form a MEC group comprising A Co, B Co and C Co. A Co and B Co are eligible tier-1 companies of the MEC group. A Co is the head company of the group for the income year in which the group is formed.For the purposes of the formation rules, B Co is treated as part of the head company, A Co. This means that the assets of A Co and B Co do not have their cost reset under the cost setting rules. In addition, the assets of C Co will have their cost reset under the formation rules as if a single head company held all the membership interests in C Co.

Other joining cases

3.39 Subsequent legislation will include any modifications necessary to ensure appropriate application to MEC groups in cases where:

one consolidated group is acquired by another consolidated group;
entities linked through membership interests join a consolidated group as a result of one of them joining; and
an entity joins an existing consolidated group where the entity is held by the group through one or more interposed entities outside the group.

An entity leaving a MEC group

3.40 Divisions 701 and 711 of the May Consolidation Act contain rules (leaving rules) that apply to reset the cost of the group-owned membership interests in a subsidiary member that leaves an ordinary consolidated group. Those leaving rules generally have equivalent application to an entity leaving a MEC group, subject to certain modifications. The modifications ensure that the rules take into account the special characteristics of a MEC group. [Schedule 8, item 8, sections 719-500 and 719-505 and subsection 719-510(1)]

3.41 The general modifying rule that applies when an entity joins a MEC group does not apply when an entity leaves a MEC group.

3.42 Where an entity that is not an eligible tier-1 company leaves a MEC group, the leaving rules apply without modification.

3.43 Where an eligible tier-1 company that is wholly-owned by entities outside the MEC group (e.g. by a non-resident entity or entities) leaves a MEC group, the leaving rules will effectively have no application. In these cases, the cost of the membership interests in the leaving eligible tier-1 company is set by special pooling rules in Subdivision 719-K of this bill (see paragraphs 3.50 to 3.71).

3.44 When an eligible tier-1 company that is partly owned by members of the MEC group leaves the group, a cost for each membership interest in the company held by other members of that MEC group is determined in broadly the same way as a cost for membership interests in a leaving subsidiary is determined under the leaving rules.

3.45 However, the leaving rules are modified to ensure they operate appropriately where the leaving entity is an eligible tier-1 company. A modification is necessary because, unlike when a subsidiary member leaves an ordinary consolidated group, all of the membership interests in a leaving eligible tier-1 company will not be held by members of the MEC group. This is because, by definition, some of the membership interests in an eligible tier-1 company must be held by entities outside the MEC group (e.g. non-resident entities).

3.46 The leaving rules are modified so that where an eligible tier-1 company leaves a MEC group, the ACA worked out in accordance with Division 711 of the May Consolidation Act is allocated to both:

membership interests, in one or more classes, in the leaving entity that are held by entities that remain members of the MEC group after the eligible tier-1 company leaves the group; and
membership interests, in one or more classes, in the leaving entity that are pooled interests in the leaving eligible tier-1 company. [Schedule 8, item 8, subsection 719-510(2)]

3.47 A pooled interest in an eligible tier-1 company of a MEC group is broadly a membership interest that is held by an entity that is not a member of the MEC group (see paragraphs 3.55 to 3.57). [Schedule 8, item 8, section 719-560] .

3.48 It is necessary to allocate the ACA for a leaving eligible tier-1 company to all membership interests in the company, including the pooled membership interests, in order to correctly apportion the ACA to those interests that members of the MEC group hold in the eligible tier-1 company. If the ACA for the leaving eligible tier-1 company was only allocated across the membership interests that members of the group held at the leaving time, the cost of those interests would be reset at an incorrect, and disproportionately high, amount.

3.49 However, it is important to note that the allocation of part of the leaving entitys ACA to the pooled interests in the leaving eligible tier-1 company is only necessary in order to work out the cost for the membership interests in that leaving entity that are held by members of the MEC group. This process does not set the cost for the pooled interests. The cost of pooled interests in a leaving eligible tier-1 company is set by the pooling rules discussed in paragraphs 3.50 to 3.71. [Schedule 8, item 8, note to subsection 719-510(2)]

Example 3.4: Eligible tier-1 company that is partly owned by group members leaves a MEC group

Diagrammatic representation of an eligible tier-1 company that is partly owned by group members, leaving a MEC group

X Co, a non-resident company, owns all 100 membership interests in resident company A Co and 50 of the 100 membership interests in resident company B Co. A Co owns the other 50 membership interests in B Co. There is only one class of membership interests in B Co. A MEC group comprising A Co and B Co was formed on 1 July 2003.On 1 July 2005, X Co sells its membership interests in B Co to an unrelated party causing B Co to leave the MEC group.To determine the tax cost setting amount for A Cos membership interests in B Co, first work out the groups allocable cost amount for B Co in accordance with section 711-20. Assume that this amount is $100. Then divide that amount by the total number of membership interests in B Co (including those held by X Co).

$100 / 100 membership interests = $1 / membership interest

The tax cost setting amount for each of A Cos 50 membership interests in B Co is $1.The cost of X Cos membership interests in B Co is set by the pooling rules - see Example 3.7.

Pooling rules

Overview

3.50 One of the policy objectives of the consolidation regime is to allow the tax free transfer of assets within a consolidated group without requiring cost base adjustments to address value shifting. Broadly, this is achieved through the operation of the cost setting rules that apply when an entity joins or leaves a consolidated group or MEC group.

3.51 The cost setting rules however are limited in their operation to membership interests held by the head company of the group as a result of the operation of the single entity rule. Without further measures, much of the benefits of forming a MEC group would disappear as entities who hold membership interests in eligible tier-1 companies would still be required to make value shifting adjustments when assets are transferred between members of the group.

3.52 The pooling rules are designed to facilitate the tax free transfer of assets within a MEC group by removing the need to make value shifting adjustments at the eligible tier-1 company level. The pooling rules achieve this by pooling the cost base of all membership interests in eligible tier-1 companies just before certain events happen and resetting the cost base of those membership interests based on an allocation from the pool.

When do the pooling rules apply?

3.53 The pooling rules apply when one of the following events (for ease called the trigger events) happen in relation to one or more eligible tier-1 companies who are members of the MEC group:

the company ceases to be a member of the group; or
a CGT event happens in relation to one or more membership interests in the company.

[Schedule 8, item 8, subsection 719-555(1)]

3.54 The time at which a trigger event happens is referred to as the trigger time. An eligible tier-1 company in relation to which a trigger event happens is referred to as a trigger company. Not all the eligible tier-1 companies in the group need be trigger companies at the time of a trigger event. For instance, if the foreign parent company disposed of only one of the eligible tier-1 companies in a MEC group, only that company would be a trigger company. If, on the other hand the foreign parent disposed of all of the eligible tier-1 companies in the MEC group, each of those companies would qualify as trigger companies. [Schedule 8, item 8, subsection 719-555(1)]

Which membership interests do the pooling rules apply to?

3.55 The pooling rules apply to those membership interests that are referred to as pooled interests. A pooled interest is a membership interest that an entity, not being a member of the MEC group, holds in an eligible tier-1 company of a MEC group. However, it does not include:

the 1% employee share scheme exception to the wholly-owned requirements for eligible tier-1 companies found in subsection 719-30(2); or
a membership interest that is held by an entity only as a nominee of one or more other entities each of which is a member of the group.

[Schedule 8, item 8, section 719-560; Schedule 8, item 10, subsection 995-1(1)]

3.56A membership interest is defined in section 960-135 of the May Consolidation Act. Briefly, it means each interest or set of interests or each right or set of rights in relation to an entity by virtue of which an entity is a member. For example, a unitholder of a trust is a member of a public trading trust. However, it does not include debt interests (see section 960-130 of the May Consolidation Act).

3.57 The 1% employee share scheme interest has been excluded from the definition of the term pooled interest as it would not be possible for the holder of such an interest to obtain the necessary market valuation figures needed to apply the pooling rules. A membership interest that is held by an entity as a nominee of one or more members of the MEC group is also excluded from the definition of a pooled interest as the cost base of such interests would be reset under the cost setting rules contained in Division 711 of the May Consolidation Act. [Schedule 8, item 8, subsection 719-560(2)]

Example 3.5 The pooling rules are focussing on the external interests (i.e. X Companys interests - where the stars are on the diagram below) in Companies A, B and C (all eligible tier-1 companies) that, together with Company D, constitute the MEC group. The pooling rules will be triggered, for example, when Company X sells Company C so it is no longer a member of the MEC group. The pooling rules have no application to Company Bs interest in its subsidiary, Company D.

Diagram representing pooling rules

Pooling rules not to apply if market value of the group is nil

3.58 The pooling rules will not apply to reset the cost of pooled interests if the market value of the pooled interests as a whole is nil just before the trigger time. The pooling rules will not apply because it is not possible to allocate a cost from the pool based on market value where the market value of those interests as a whole is nil. The existing cost base or reduced cost base of the pooled interests will be retained in these circumstances. [Schedule 8, item 8, paragraph 719-555(1)(c)]

How do the pooling rules operate?

3.59 The pooling rules operate by pooling the cost base of all pooled interests in eligible tier-1 companies just before the trigger time. The cost of the membership interests is then reset based on an allocation from the pool. The cost of the pooled interests is reset just before the trigger time because the original cost base of the pooled interests in the MEC group may no longer be appropriate. Reasons for this include the fact that assets held at the time the eligible tier-1 company was acquired may now be held by other members of the group. Alternatively, assets held by other members of the group may now be held by the exiting eligible tier-1 company.

3.60 The amount allocated from the pool for each membership interest is referred to as the cost setting amount. The calculation of the cost setting amounts is discussed in paragraphs 3.62 to 3.69. The cost setting amount represents:

if Parts 3.1 or 3.3 apply in relation to the pooled interest - the cost base or reduced cost base of the interest just before the trigger time; and
if a provision of the ITAA 1936 or the ITAA 1997 applies other than Parts 3.1 and 3.3 - the cost of the interest just before the trigger time.

[Schedule 8, item 8, section 719-565]

3.61 An example of where the cost setting amount would be used to set a cost in the above mentioned second scenario would be where the membership interests are held on revenue account but not as trading stock.

How is the cost setting amount worked out?

3.62 The method to be adopted for working out the cost setting amount for each pooled interest differs depending on whether or not the interest is held in a trigger company at the trigger time. Each pooled interest for which a cost setting amount is worked out is referred to as a reset interest. [Schedule 8, item 8, subsection 719-555(2)]

Reset interests held in trigger companies

3.63 A cost setting amount is worked out for each reset interest held in each trigger company just before the trigger time. Broadly, the cost setting amount for each reset interest will equal the percentage of the pool that equals the market value of the reset interest as a proportion of the market value of the group. The cost setting amount is worked out under the formula:

(Market value of the reset interest / Market value of the group) * Pooled cost amount

Where:

Market value of the reset interest is the market value (just before the trigger time) of all reset interests in the trigger company (in the same class as the interest) divided by the number of reset interests in that company in that class;

Market value of the group is either:

if each eligible tier-1 company of the group, just before the trigger time, is a trigger company - the sum of the market value (just before the trigger time) of all reset interests in each eligible tier-1 company of the MEC group; or
the market value of the reset interests as a whole (including the market value of synergies arising from the combination of those interests) just before the trigger time.

[Schedule 8, item 8, subsections 719-555(2) and 719-570(1)]

Pooled cost amount is the sum of the cost bases of all reset interests just before the trigger time. [Schedule 8, item 8, subsection 719-570(1)]

3.64 The meaning to be given to the term market value of the group in the formula differs depending on whether or not all the eligible tier-1 companies that were members of the group are trigger companies. In cases where this is so, the market value of the group will simply equal the sum of the market value of all reset interests in each eligible tier-1 company just before the trigger time. Adopting this amount as the denominator ensures the sum of the numerators in the formula will equal the denominator, thereby ensuring the total pooled cost amount is allocated across the reset interests.

3.65 In situations where not all the eligible tier-1 companies are trigger companies, the market value of the group is to be worked out taking into account the market value of the reset interests as a whole including any synergies arising from the combination of those interests. The market value of the group in this situation is therefore simply not the sum of the market values of each of the eligible tier-1 companies.

3.66 The market value of the reset interest is to be worked out on a class by class basis. This ensures the cost setting amount calculated for the reset interest takes into account market valuation variances between different classes of membership interests in the company.

Example 3.6

Diagrammatic example of how the market value of a reset interest could be calculated

Companies A and B are the two eligible tier-1 companies of a MEC group. Company X holds 100 C class shares in Company A and it sells 40 of these shares to Company B (the trigger time) for $2 per share. Just before the trigger time the market value of all C Class shares in Company A (the trigger company) must be divided by the total number of C class shares in Company A. Therefore, the market value of the reset interest will be $200 100 = $2.

3.67 Where the cost setting amount constitutes the reduced cost base of a reset interest in a trigger company, the cost setting amount is calculated in the same manner as outlined in paragraph 3.63 except that references in that paragraph to cost base are to be replaced by references to reduced cost base. [Schedule 8, item 8, subsection 719-570(3)]

Reset interests held in other eligible tier-1 companies

3.68 A cost setting amount is also worked out for each reset interest in each eligible tier-1 company that is a member of the MEC group but which is not a trigger company at the trigger time. Broadly, the cost setting amount for each reset interest will equal the balance of the pool not allocated to reset interests in trigger companies divided by the number of reset interests in those eligible tier-1 companies. The cost setting amount for these interests is worked out under the formula:

(Pooled cost amount - Amount allocated to trigger company interests) / Number of non-trigger company interests

Where:

Pooled cost amount has the same meaning as in paragraph 3.63;

Amount allocated to trigger company interests is the sum of all the cost setting amounts worked out for the reset interests held in the trigger companies; and

Number of non-trigger company interests is the number of reset interests held in eligible tier-1 companies that are not trigger companies. [Schedule 8, item 8, subsection 719-570(2)]

3.69 Where the cost setting amount constitutes the reduced cost base of a reset interest in an eligible tier-1 company other than a trigger company, the cost setting amount is calculated in the same manner as outlined in paragraphs 3.68 except that references in that paragraph to cost base are to be replaced by references to reduced cost base. [Schedule 8, item 8, subsection 719-570(3)]

Example 3.7

Example of caluculating cost setting amounts

X Company has three wholly-owned Australian subsidiaries, Companies A, B and C. One hundred shares in each of these 3 companies have been issued. However, Company X only owns 50 of those shares in Company B with Company A owning the other 50. Companies A, B and C are all eligible tier-1 companies and comprise a MEC group. At the time of joining the MEC group the cost base of the membership interests in Companies A and C is both $100 and the cost base of the membership interests in Company B held by Company X is $50. Scenario 1 On 1 July 2003, Company X disposes of its membership interests in Company C to a company that is not a member of the same wholly-owned group. This causes Company C (the trigger company) to cease being a member of the MEC group. To work out the income tax consequences for Company X, it is necessary to reset the cost base of the pooled interests in Company C as well as the pooled interests in the remaining eligible tier-1 companies of the group.If just before the trigger time (i.e. just before Company C is sold) the market value of Company C is $290 and the market value of the reset interests as a whole is $850, the cost setting amount for each reset interest in Company C will be worked out under the formula:

(Market value of the reset interest / Market value of the group) * Pooled cost amount

The market value of the reset interest:

$290 / 100 = $2.90

The pooled cost amount:

($100 * 2) + $50 = $250

Therefore the cost setting amount for each reset interest in Company C will be:

($2.90 / $850) * $250 = $0.85

Therefore, for the purposes of applying Parts 3-1 and 3-3, the new cost base for each reset interest in Company C will be $0.85. As 100 shares are being sold the total cost base for all membership interests in Company C:

$0.85 * 100 shares = $85.

From this Company X can work out any capital gain or loss it made from selling all of the membership interests in Company C. (In this example, a gain of $205, being the difference between $290 and $85.)The cost setting amount for each reset interest that is held in the remaining eligible tier-1 companies of the MEC group will be worked out under the formula:

(Pooled cost amount - Amount allocated to trigger company interests) / Number of non-trigger company interests
($250 - ($0.85 * 100 shares in Company C)) / 150 shares in Companies A and B = $1.10

The new cost base for the remaining interests Company X has in Companies A and B is $1.10 per pooled interest. Scenario 2 Assume Company X subsequently sells its interests in Company B for $75. The market value of the reset interests as a whole at this time is $400. The partial sale of Company B will cause that company (the trigger company) to cease being a member of the MEC group. To work out the income tax consequences for Company X, and to ensure Company A has an appropriate cost base for its membership interests in Company B, it is necessary to reset the cost base of the membership interests in Company B.However, only the membership interests in Company B held by Company X will qualify as pooled interests. Accordingly, a cost setting amount will not be calculated under the pooling rules for the membership interests held in Company B by Company A. Rather, a cost for those membership interests will be set under the internal cost setting rules discussed in paragraphs 3.40 to 3.49.Under the pooling rules, the cost setting amount for each reset interest in Company B, held by Company X, will be worked out under the formula:

(Market value of the reset interest / Market value of the group) * Pooled cost amount

The market value of the reset interest:

$75 / 50 = $1.50

The pooled cost amount:

$1.10 * 150 shares = $165

Therefore the cost setting amount for each reset interest in Company B will be:

($1.50 / $400) * $165 = $0.62

From this Company X can work out any capital gain or loss it made from selling all of the membership interests it held in Company B. (In this example, a gain of $44, being the difference between $75 and $31.)The cost setting amount for each reset interest that is held in the remaining eligible tier-1 company of the MEC group will be worked out under the formula:

(Pooled cost amount - Amount allocated to trigger company interests) / Number of non-trigger company interests
($165 - $0.62 * 50 shares in Company B) / 100 shares in Company A = $1.34

The new cost base for the remaining interests Company X has in Company A is $1.34 per pooled interest.

What happens when a trigger time occurs more than once to a trigger company?

3.70 If a trigger time happens to a trigger company on more than one occasion, this Subdivision applies successively at each trigger time.

Provisions that adjust cost base and reduced cost base of membership interests

3.71 Under the ITAA 1936 and the ITAA 1997, various provisions apply to adjust the cost base and the reduced cost base of membership interests. Amendments consequential to the pooling rules will be made to those provisions in subsequent legislation to ensure they apply to cost bases and reduced cost bases that have been reset under these measures in a manner that is consistent with the current operation of the law.

Available fractions for MEC groups

3.72 Generally, available fractions for MEC groups will be calculated and adjusted in the same way as they are for ordinary consolidated groups.

3.73 However, a groups existing available fractions will be adjusted if the group expands because a new eligible tier-1 company joins the group. Also, an available fraction must be calculated for any group losses held by the groups head company when the new eligible tier-1 company joined. Essentially, the inclusion of a new eligible tier-1 company is treated as a merger between the existing group and the new eligible tier-1 company. [Schedule 8, item 8, Subdivision 719-F]

Why are available fractions calculated or adjusted when a new eligible tier-1 company joins?

3.74 All losses transferred to the head company of a consolidated group from a joining loss entity form a single loss bundle for which an available fraction is calculated. The available fraction is basically the proportion that the loss entitys market value at the joining time bears to the value of the whole group at that time.

3.75 A groups annual use of its transferred losses is limited by their available fraction. That is, they may only be offset against a fraction of the groups income and gains. Essentially the available fraction is a proxy for determining the proportion (i.e. fraction) of the groups income or gains generated by the loss entity. The inclusion of a new eligible tier-1 company increases the groups income generating capacity which reduces the proportion of the groups income that the original loss entities can now be regarded as generating.

3.76 The increase in value or income generating capacity occurs because the group has not paid cash or assets (or increased its liabilities) in order to acquire the additional eligible tier-1 company. That is, there has been no exchange of one type of group assets for another (which would generally leave the groups value unchanged). The inclusion in the group of the additional eligible tier-1 company (and its wholly-owned subsidiaries) occurs purely because of the companys relationship with the groups top company.

3.77 Therefore, the inclusion of a new eligible tier-1 company in a group effectively introduces capital into the group from outside the group. However, it is not covered by the existing rule requiring a groups available fractions to be adjusted if there is an injection of capital into the group. That is because the existing rule is triggered by an injection of capital into a member of the group. That has not happened here. Rather, the eligible tier-1 company is included in the group purely because of its relationship with the groups top company. Nevertheless, the effect is the same. For that reason, a groups existing available fractions will be adjusted whenever a new eligible tier-1 company joins.

3.78 If the group has group losses when the new eligible tier-1 company joins it, the losses will also be given an available fraction as though they were transferred losses of the expanded group. This is consistent with the treatment of these cases as a merger of 2 groups of entities. Assigning group losses an available fraction broadly ensures they can only be offset against the portion of the groups income that can be said to have been generated by the entities that contributed to the making of the loss.

The new eligible tier-1 company is already a consolidated group

3.79 New eligible tier-1 companies and their subsidiaries may, prior to their acquisition by the group, have themselves been an ordinary group or a MEC group. In that case, available fractions for losses held by them will be adjusted in the normal manner. That is, using the rules in section 707-320 of the May Consolidation Act that adjust available fractions for losses that are transferred on a second or subsequent occasion.

When are available fractions calculated or adjusted?

3.80 The calculation and adjustment rules described in paragraphs 3.86 to 3.104 apply if:

a MEC group expands to include a new eligible tier-1 company; or
an ordinary consolidated group converts to a MEC group.

[Schedule 8, item 8, subsections 719-300(1), (2) and (3)]

Expansion of a MEC group

3.81 A MEC group can expand after formation to include a new eligible tier-1 company of the top company. The new eligible tier-1 company will become a member of the group if the groups provisional head company notifies the Commissioner. (See subsection 719-5(4) of the May Consolidation Act.) The expanded group will also include wholly-owned subsidiaries of the new eligible tier-1 company.

Example 3.8

Example of a MEC group expanding

A MEC group forms comprising eligible tier-1 companies T1 and T2 and their subsidiaries A and B. Subsequently, Top Co acquires another company T3 which also meets the requirements to be an eligible tier-1 company. The existing MEC group expands to include T3 and its subsidiary C.

Conversion of an ordinary group to a MEC group

3.82 An ordinary consolidated group can convert to a MEC group if the head company of the group is also an eligible tier-1 company of the top company, another company becomes an eligible tier-1 company of the top company and the original head company notifies the Commissioner that a MEC group is to come into existence. (See section 719-40 of the May Consolidation Act.) The converted group will include the ordinary group plus the additional eligible tier-1 company and its wholly-owned subsidiaries.

The rules do not apply if the new eligible tier-1 company was already a member of the group

3.83 The new calculation and adjustment rules do not apply if the new eligible tier-1 company had, immediately before becoming an eligible tier-1 company, been a member of the MEC or consolidated group. That is, they do not apply if, for example, membership interests in a member company held by an eligible tier-1 company are transferred (rolled-up) to the groups top company resulting in the member company becoming a new eligible tier-1 company of the group. [Schedule 8, item 8, subsections 719-300(4), (5) and (6)]

3.84 The calculation and adjustment rules discussed in paragraphs 3.86 to 3.104 are not appropriate in a roll-up case. They are based on a merger of 2 groups of entities whereas the roll-up scenario simply involves a reorganisation of a groups existing entities.

3.85 Nonetheless, the roll-up of interests will enhance the groups income generating capacity if, for example, the top company paid the group cash or assets in exchange for the interests. But in that case it can be said that capital has been injected into the group and therefore the groups available fractions would be adjusted under item 4 of the table in subsection 707-320(2) of the May Consolidation Act.

Rule 1: Calculating an available fraction for group losses

3.86 Any group losses held by a groups ongoing head company when a new eligible tier-1 company joins are treated as though they were transferred losses of the expanded group. This ensures they form a loss bundle for which an available fraction is calculated. The losses are not actually tested and transferred. Rather they are treated as if they had passed the transfer tests and were transferred to the head company under Subdivision 707-A of the May Consolidation Act at the time the new eligible tier-1 company joined. [Schedule 8, item 8, subsections 719-305(1) and (2)]

3.87 This deemed transfer is for the purpose of applying Subdivision 707-C of the May Consolidation Act. That is, Subdivision 707-C will apply in determining how much of the losses can be used for an income year (in the same way that Subdivision already applies in determining the maximum annual usage of a transferred loss). [Schedule 8, item 8, subsections 719-305(1) and (2)]

3.88 However, these rules only apply to (and therefore available fractions are only calculated for) group losses made in an income year that is earlier than the income year in which the new eligible tier-1 company joined the group. This matches what occurs when a group forms part way through the head companys income year. In that case, the head company transfers to itself any losses made by it in income years prior to the formation year, but is not required to calculate a separate taxable income or loss for the period from the start of the formation year to the formation time.

3.89 The available fraction is calculated under subsection 707-320(1) of the May Consolidation Act using this fraction:

Modified market value of the real loss-maker at the initial transfer time / Transferees adjusted market value at the initial transfer time

Numerator: real loss-makers modified market value

3.90 The head company, in its capacity as the head company of the original group, is the real loss-maker referred to in the numerator - it is taken to have made the group loss by virtue of the single entity rule.

3.91 Section 707-325 of the May Consolidation Act sets out how a real loss-makers modified market value is worked out. But that section only applies to work out the modified market value of an entity that becomes a member of a consolidated group. In the expansion case, the ongoing head company continues as a member of the MEC group - it does not become a member of a new group. Therefore, in working out an available fraction for the group loss bundle, it is assumed that the ongoing head company did become a member of a group at the time the new tier-1 company joined. [Schedule 8, item 8, paragraph 719-305(3)(a)]

3.92 Also, section 707-325 requires a real loss-maker to work out its modified market value as a separate entity. Section 707-330 ensures that when the real loss-maker was the head company of a group (the old group) and is transferring its group losses to another group (the new group) the modified market value of the whole of the old group is used in working out an available fraction for the losses.

3.93 However, that section only applies when the ex-head company of the old group becomes a subsidiary member of a new group. It therefore cannot apply when all that happens is a new eligible tier-1 company joins the head companys group. Therefore, equivalent rules will apply in working out the modified market value of a head company of the original group as a result of a new eligible tier-1 company joining. That is, the head company works out its modified market value as if:

each subsidiary member of the original group at the time the eligible tier-1 company joined were a part of the head company [Schedule 8, item 8, paragraph 719-305(3)(b)] ; and
the single entity rule also applies to the period the original group was in existence before the eligible tier-1 company joined [Schedule 8, item 8, paragraph 719-305(3)(c)]:

-
this ensures that capital injected into (or non-arms length transactions involving) subsidiary members of the original group before the new tier-1 company joins are taken into account in working out the head companys modified market value.

Denominator: transferees adjusted market value

3.94 The head company of the new group is also the transferee referred to in the denominator - the group losses are taken to have been transferred to that entity. The single entity rule ensures that in working out the head companys adjusted market value, all of the other group members, including the new eligible tier-1 company, are treated as a part of the head company.

Transferred group losses retain their original date of occurrence

3.95 The transferred group losses retain their original date of incurrence. That is, the group losses continue to be made by the head company for the income year in which the head company actually made them (rather than the income year of the deemed transfer). This means that when they are tested to determine whether they can be used they are tested from the date they were actually made. [Schedule 8, item 8, subsection 719-305(4)]

Transferred group losses cannot access transitional concessions

3.96 In calculating an available fraction for group losses, access to the value and loss donor transitional concession is specifically denied. In the absence of this rule it could perhaps have been argued that the concession could apply in working out an available fraction for group losses in respect of a consolidated group that converted to a MEC group during the transitional period. [Schedule 10, item 2, section 719-305]

Rule 2: Adjusting existing available fractions

3.97 The ongoing head company adjusts its existing available fractions when a new eligible tier-1 company joins by multiplying each available fraction by:

Market value of the existing group just before the eligible tier-1 company joins / Market value of the new group just after the eligible tier-1 company joins

[Schedule 8, item 8, subsections 719-310(1) and (2)]

3.98 This adjustment is based on the one in item 1 of the table in subsection 707-320(2) of the May Consolidation Act. That item adjusts the available fractions of a group that is acquired by another group. That is, the inclusion of a new eligible tier-1 company is treated as a merger between the existing group and the new tier-1 company.

Application of item 3 of the table in subsection 707-320(2) is restricted

3.99 The adjustment set out in paragraph 3.97 applies regardless of whether the new eligible tier-1 company or any of its subsidiaries are loss entities. It therefore applies instead of the one in item 3 of the table in subsection 707-320(2) of the May Consolidation Act. [Schedule 8, item 8 , paragraph 719-310(3)(b)]

3.100 Item 3 adjusts an existing groups available fractions when a new loss entity joins the group as part of ensuring that a groups available fractions cannot total more than one. It does not provide the appropriate adjustment for a group when a new eligible tier-1 company joins - even if the new tier-1 company is a loss entity. That item only gives an appropriate outcome when there has been value exchanged for an incoming entity and the incoming entity is a loss entity.

3.101 This means that item 3 only applies to a MEC group if the new entity is a wholly-owned loss subsidiary of an existing eligible tier-1 company. In that case, the group will have exchanged value in order to acquire the entity and so item 3 provides the appropriate adjustment.

3.102 Also, item 3 does not apply if the head company is taken to have transferred group losses to itself as a result of an eligible tier-1 company joining. [Schedule 8, item 8, paragraph 719-310(3)(a)]

Rule 3: Capping available fractions if the group has both group losses and transferred losses

3.103 A group may have both group losses and transferred losses when the new eligible tier-1 company joins. In that case, the groups available fractions for its group and transferred losses, calculated and adjusted as set out in paragraphs 3.86 to 3.98 are capped so their total does not exceed what would otherwise have been the available fraction for the group losses. Each available fraction is multiplied by this fraction:

The available fraction for the group loss bundle / The sum of the available fraction for the group loss bundle and the (adjusted) available fractions for the existing transferred loss bundles

[Schedule 8, item 8, section 719-315]

3.104 This adjustment is based on the one in item 2 of the table in subsection 707-320(2) of the May Consolidation Act. That item caps the available fractions of a group that is acquired by another group.

Example 3.9

The capping of the available fractions of a group that is acquired by another group

The ongoing [T1, T2] groupT1 and T2 are eligible tier-1 companies of the top company. They choose to form a MEC group. That group comprises T1, T2, S1 and S2.On formation, S1 and S2 transfer losses to the group. Their available fractions are:
S1 0.246
S2 0.312
After formation, the group makes a tax loss.The joining [T3] groupSubsequently, the groups top company acquires T3 (an eligible tier-1 company) and S4. As a result, the MEC group expands to include T3 and S4.Prior to their acquisition, T3 and S4 had been a consolidated group. S4 had transferred losses to the consolidated group on its formation. Those losses are now transferred from T3 to the MEC group. The available fraction for this bundle prior to that transfer was 0.214. After formation of the T3 and S4 consolidated group, this group made a tax loss.The values when T3 and S4 join the MEC group are:

the market value (and modified market value) of the continuing MEC group comprising T1 and T2 and their subsidiaries is $5,000; and
the market value of the T3 and S4 group is $3,000.

Work out available fractions for the ongoing [T1, T2] group
Step 1: Calculate an available fraction for the group loss
Group loss $5,000 / $8,000 = 0.625
Step 2: Adjust the available fractions for the S1 and S2 bundles
S1 0.246 * ($5,000 / $8,000) = 0.154
S2 0.312 * ($5,000 / $8,000) = 0.195
Step 3: Cap the step 1 and 2 available fractions
Group loss 0.625 * (0.625 / 0.974) = 0.401
S1 0.154 * (0.625 / 0.974) = 0.099
S2 0.195 * (0.625 / 0.974) = 0.125
Note: 0.974 is the sum of the available fractions calculated or adjusted under steps 1 and 2 (i.e. 0.625 + 0.154 + 0.195). Work out available fractions for the joining [T3] group
Step 1: Calculate an available fraction for the group loss
Group loss $3,000 / $8,000 = 0.375
Step 2: Adjust the available fraction for the S4 bundle
S4 0.214 ($3,000 $8,000) = 0.080
Step 3: Cap the step 1 and 2 available fractions
Group loss 0.375 * (0.375 / 0.455) = 0.309
S4 0.080 * (0.375 / 0.455) = 0.066
Total available fractions for the expanded group
T1, T2 group loss 0.401
S1 0.099
S2 0.125
T3 group loss 0.309
S4 0.066
Total 1.000

Eligible tier-1 company joins part way through the income year

3.105 A groups use of its existing (group and transferred) losses will be apportioned if the new eligible tier-1 company joins the group part way through the groups income year.

3.106 For a groups transferred losses, the existing apportionment rule in section 707-335 of the May Consolidation Act applies. This rule ensures that where the numerical value of an available fraction changes during the income year, the new adjusted fraction only applies from the time of the event that triggered the adjustment. In this case, that would mean the adjusted available fraction applied from the time the new eligible tier-1 company joined.

3.107 A new principle will be added to section 707-335 to cover group losses that are treated as transferred losses. It will ensure that in the income year in which the new eligible tier-1 company joined, the groups use of the losses for the pre-joining period is unrestricted (in accordance with their status as group losses for that period) but their use is subject to their new available fraction for the post-joining period (in accordance with their status as transferred losses for that period). This will be achieved by treating the group losses as being in a bundle with an available fraction of one for the pre-joining period. [Schedule 6, item 3, paragraph 707-335(1)(a)) and item 4, paragraph 707-335(3)(e)]

3.108 This principle will also ensure a similar outcome when a head company transfers its own losses to itself on formation part way through its income year. That is, the groups use of the head companys own losses is only subject to their available fraction for the post-formation period. No restrictions apply to their use for the pre-formation period. This is discussed in more detail in Chapter 8.

3.109 The available fraction of one, that is assigned to the group loss bundle, is not adjusted if any of the adjustment events set out in the table in subsection 707-320(2) of the May Consolidation Act occur during the pre-joining period. This is consistent with the losses having group loss status for that period.

Losses retain their status as group losses for the pre-joining period

3.110 The amount of transferred group losses that can be used and which are attributable to the period for which the bundle had an available fraction of one (i.e. the pre-joining period) is taken not to have been a loss transferred under Subdivision 707-A. That is, that amount is a group loss and must therefore be deducted from the groups income and gains before applying the available fraction for other loss bundles. [Schedule 8, item 8, section 719-320]

3.111 Giving the group loss bundle an available fraction of one for the pre-joining period is simply a technique to ensure that use of the losses for that period is unrestricted. It is not intended to change the fact that in all other respects the losses used for that period retain their status as group losses.

New power to cancel losses

3.112 The head company of the expanded or converted MEC group may choose to cancel all the losses in:

its group loss bundle; and
any of its existing bundles.

[Schedule 8, item 8, subsection 719-325(1)]

3.113 A head company may achieve a better outcome under the capping rule 3 by cancelling some or all of its existing transferred loss bundles. Alternatively, it may avoid the application of rule 3 altogether by cancelling its group loss bundle. The choice to cancel a loss cannot be revoked. [Schedule 8, item 8, subsections 719-325(2), (5) and (7)]

3.114 Broadly, the effect of cancellation is that the cancelled losses can be used up until the new eligible tier-1 company joins but cannot be used thereafter. The apportionment rule in section 707-335 of the May Consolidation Act is applied on the assumption that:

the cancelled group losses are in a bundle with an available fraction of one during the pre-joining period [Schedule 8, item 8, paragraph 719-325(3)(a)]:

-
the cancelled transferred losses would already have been in a bundle with an available fraction for the pre-joining period; and

the cancelled group and transferred losses have an available fraction of zero for the post-joining period [Schedule 8, item 8, paragraph 719-325(3)(b)] .

3.115 Cancelled losses cannot be used by any entity for an income year following the income year in which the new tier-1 company joined. [Schedule 8, item 8, subsection 719-325(6)]

3.116 Also, the ability to transfer cancelled losses under Subdivision 707-A of the May Consolidation Act (or Division 170 of the ITAA 1997) is specifically denied. This closes off an argument that may otherwise arise that the unused portion of a cancelled loss could be transferred to a new group on the basis that the rules provide for it to be utilised for the income year in which the tier-1 company joined. [Schedule 8, item 8, subsection 719-325(4)]

Change in head company

3.117 The membership rules for MEC groups can accommodate changes to the identity of the head company of the group. A change to the head company of a MEC group will occur when a company (the old head company) that is the head company of the group at the end of an income year is different to the company (the new head company) that is the head company at the start of the next income year.

3.118 When one head company of a MEC group is replaced with another, everything that happened in relation to the old head company of a MEC group before the time that it ceased to be the head company (the transition time) is instead taken to have happened in relation to the new head company of the group, just as if the new head company had been the old head company at all times before the transition time [Schedule 8, item 8, section 719-85 and subsection 719-90(1)]. For brevity, this will be referred to as the transfer of history rule in this explanatory memorandum.

3.119 The transfer of history rule also ensures that things that happened to the old head company prior to the transition time because of the single entity rule, the entry history rule, the substitution rule (see paragraph 2.16 in Chapter 2) or a previous application of the transfer of history rule will be taken to have happened to the new head company [Schedule 8, item 8, subsection 719-90(2)] . The single entity rule and the entry history rule were contained in the May Consolidation Act. The single entity rule treats subsidiary members of a MEC group or a consolidated group as part of the head company of the group and allows such groups to be treated as single entities for income tax purposes. The entry history rule allows the head company to inherit the income tax history of subsidiary members once they become subsidiary members of the group.

3.120 The transfer of history rule applies for the purposes of calculating the new head companys income tax liability or tax loss for any income year that ends after the transition time. [Schedule 8, item 8, paragraph 719-90(3)(a)]

3.121 The transfer of history rule also applies for the entity core purposes for an income year that ends after the transition time [Schedule 8, item 8, paragraph 719-90(3)(b)] . However, this will be subject to the exit history rule and any provisions which the exit history rule is subject to [Schedule 8, item 8, subsection 719-90(4)] . The entity core purposes relate to the purposes of a subsidiary member working out its income tax liability or loss for any period during which it is a subsidiary member of a MEC group or consolidated group or any later income year. The exit history rule allows an entity to inherit certain income tax history on ceasing to be a subsidiary member of a MEC group or consolidated group. Both the entity core purposes and the exit history rule were contained in the May Consolidation Act.

3.122 One effect of the rule in paragraph 3.121 is that when the old head company ceases to be a subsidiary member of the MEC group, it will take with it only the income tax history that relates to the assets, liabilities and businesses that leave the group with the company.

3.123 The transfer of history rule does not mean that the new head company is given any new responsibility for income tax liabilities relating to periods prior to when it became the head company of the group.

3.124 One implication of the transfer of history rule is that all of the tax attributes of the old head company that are relevant to the head company core purposes (e.g. losses and foreign tax credits) will instead become those of the new head company once the old head company is replaced. This means that those tax attributes that have not affected taxable income or will not affect a later taxable income will not be inherited by the new head company by virtue of the transfer of history rule . For example, the franking credit balances in the old head companys franking account (if any) will not become those of the new head company under the transfer of history rule.

3.125 It is not appropriate that the transfer of history rule be extended to cover the transfer of franking account balances between head companies of a single MEC group. It is necessary for franking credits to be able to be accessed at any given time during an income year but this would not be possible if franking account balances were transferred between head companies of a single MEC group. This is because, unlike the provisional head company of a MEC group, the head company of a MEC group can generally only be determined at the end of any given income year. The transfer of franking account balances between provisional head companies of a MEC group will be regulated by other rules that will be introduced in subsequent legislation.

3.126 A change in the head company of a MEC group also has implications for consolidation provisions that ordinarily apply when an entity becomes a subsidiary member of a MEC group (hereafter called the joining rules) or ceases to be a subsidiary member of a MEC group. [Schedule 8, item 8, section 719-85]

3.127 The joining rules will not apply where an entity becomes a subsidiary member of a MEC group if immediately beforehand it ceases to be the head company of that group (subject to any specific exceptions) [Schedule 8, item 8, subsection 719-95] . A company will cease to be a head company of a MEC group and become a subsidiary member of that group where, for example, membership interests in the company that were previously held by a non-resident entity are transferred to another member of the MEC group. The rule aims to prevent unintended consequences such as double counting of tax attributes that may otherwise occur. In the absence of such a rule, it may be arguable, for example, that losses of the old head company would be transferred to the new head company under the joining rules. The transfer of those losses under the joining rules would be in addition to the transfer that would occur under the transfer of history rule.

3.128 The rule in paragraph 3.127 does not affect the application of the single entity rule. [Schedule 8, item 8, subsection 719-95(2)]

3.129 Consolidation provisions that ordinarily apply when an entity ceases to be a subsidiary member of a MEC group will not apply where immediately after cessation, the entity becomes the head company of the same MEC group (subject to any specific exceptions) [Schedule 8, item 8, subsection 719-95(3)] . The rule aims to prevent unintended consequences, such as the application of the exit history rule to the new head company when it ceases to be a subsidiary member of the MEC group. The exit history rule is clearly only intended to apply when an entity ceases to be a subsidiary member of a MEC group because it leaves the group.

Application and transitional provisions

3.130 The consolidation regime will apply from 1 July 2002.

Cost setting rules

3.131 The transitional cost setting rules introduced in the June Consolidation Bill (Divisions 701 and 702 of the IT(TP) Act 1997) require some modifications so that they apply appropriately in the MEC group context.

3.132 The general modifying rule, discussed in paragraphs 3.25 to 3.26, will generally apply to the transitional cost setting rules. The transitional cost setting rules principally modify the joining and formation rules. The general modifying rule needs to apply to those rules to ensure their appropriate operation in relation to MEC groups (see paragraphs 3.25 to 3.38). [Schedule 10, item 2, subsection 719-160(1)]

3.133 However, the general modifying rule does not apply to sections 701-5, 701-40 or 701-45 of the transitional cost setting rules. These provisions offer choices that need to be made by the actual head company of the MEC group (not by all of the eligible tier-1 companies). In addition, these provisions cover issues dealing with an entity leaving a group: the general modifying rule does not apply when an entity leaves a MEC group. [Schedule 10, item 2, subsection 719-160(2)]

3.134 Although the general modifying rule does not apply to section 701-45, paragraph 701-45(1)(b) is modified so that it also applies to pre-CGT assets held by entities that were eligible tier-1 companies of a transitional MEC group at the time the group was formed. [Schedule 10, item 2, section 719-165]

Available fractions for MEC groups

3.135 The value donor concession cannot be used in calculating an available fraction for a group loss as a result of a new eligible tier-1 company joining the group. [Schedule 10, item 2, section 719-305]

Consequential amendments

3.136 Consequential amendments have been made to subsection 995-1(1) of the ITAA 1997 to include references to new dictionary terms.

3.137 The definition of available fraction in subsection 995-1(1) of the ITAA 1997 will be expanded to include available fractions calculated under the rules discussed in paragraphs 3.97 and 3.103. [Schedule 8, item 9]

3.138 Consequential amendments have also been made to Division 719 of the May Consolidation Act to remove the link note at the end of subsection 719-80(2). [Schedule 8, item 7, subsection 719-80(2)]

Chapter 4 - Additional part-year rules

Outline of chapter

4.1 This chapter explains how amounts of income and deductions are divided between a head company and a subsidiary member that is only in the consolidated group for part of a year if the law attributes the income or deduction to a period rather than to a particular moment.

Context of reform

4.2 The existing provisions that split income and deductions between an entity that joins or leaves a consolidated group part-way through an income year and the groups head company only deal with amounts that are brought to account at a single moment (e.g. when they are derived or incurred). They do not deal with amounts that are brought to account over a period. The amendments address those period cases.

Summary of new law

4.3 The amendments apportion, between an entity and the head company of a consolidated group it joins or leaves in the year, the entitys assessable income and deductions that would normally be brought to account over several income years.

4.4 They do the same for the entitys immediately deductible capital expenditure and for its share of amounts from a partnership or trust in which it is a partner or beneficiary.

4.5 The apportionment divides the amounts between the entity and the groups head company according to how long in the year the entity was in the group.

4.6 The amendments also annualise amounts that an entity needs to count for its own part-year assessment to see if it has met the thresholds that trigger particular income tax provisions.

Comparison of key features of new law and current law
New law Current law
Amounts of an entitys assessable income and deductions that are spread over more than one income year are split between the entity and the head company of a consolidated group that it joins or leaves in the year. The split is based on how much of the year the entity spent in the group. No equivalent.
Amounts of capital expenditure that are fully deductible in a single income year are also split between the entity and the head company on the same basis. No equivalent.
An entitys share of a partnership loss, or of net income of a partnership or trust, is divided in a different way. In those cases, what is split between the entity and its head company are the underlying amounts of income and deductions that make up the net income or loss, rather than the net income or loss itself. Again, the split is based on how much of the year the entity spent in the group. No equivalent.
Sometimes, an entity has to compare an amount to a threshold to see if particular income tax provisions are triggered. An entity with only a partial income year (because it joined or left a consolidated group) must first gross-up that amount to an annual figure. No equivalent.

Detailed explanation of new law

4.7 The existing provisions in section 701-30 of the May Consolidation Act work out the assessable income and deductions of an entity for the part of a year before it joins, or after it leaves a consolidated group (a non-membership period) as if that period were an income year of the entity. So, if the entity received dividends, for example, it would only bring to account those dividends that it received in a non-membership period. Those received while it was in a consolidated group would be brought to account by the head company instead.

4.8 However, those existing provisions do not deal with amounts that the law brings to account over a period. For example, if an entity is deducting a prepaid amount over 2 years, the provisions do not deal with what happens if the entity joins a consolidated group in the second of those years. The amendments are designed to address such cases.

Apportionment rules

4.9 The main amendments divide such spread amounts between the entity that has joined or left a consolidated group and the groups head company. This is done for 4 particular cases:

assessable income brought to account over 2 or more years;
deductions spread over 2 or more years;
capital expenditure that is made deductible in a single year; and
shares of the net income or loss of a partnership or trust.

4.10 Each of those cases deals with an amount that belongs to a period rather than just to a moment within a period.

Spread assessable income

4.11 The assessable income rule applies if an entity joins or leaves a consolidated group in an income year and some part of an amount of assessable income that is spread over 2 or more income years would have been assessable in the year:

to the entity, if it had not been in the group in that year; and
to the head company of the group, if the entity had been in the group for the whole year.

[Schedule 1, item 3, subsections 716-15(1), (2) and (4)]

4.12 If the rule applies, the part of the amount that would have been assessable in the year is divided between the entity and the head company. The entity would include this fraction of it in its assessable income:

days in both the entitys non-membership period and the spreading period / days in both the income year and the spreading period

[Schedule 1, item 3, subsection 716-15(5)]

4.13 The head company would include this fraction in its assessable income:

days in both the income year and the spreading period and on which the entity was in the group / days in both the income year and the spreading period

[Schedule 1, item 3, subsection 716-15(3)]

4.14 The spreading period is the period used to work out how the full amount is spread over the 2 or more income years [Schedule 1, item 3, subsection 716-15(6)] . For example, a taxpayer who elects (under section 385-105 of the ITAA 1997) to spread over 5 years the tax profit on disposal of diseased cattle, would have a spreading period from receipt of the proceeds of disposal until the end of the fourth later year.

4.15 Together, the entity and the head company would return as assessable income the whole part of the spread amount that falls into the income year.

Example 4.1: Spread insurance receipts Fresian Ltd operates a cattle stud. In year 1, it loses some calves to attacks by wild dogs and, on 1 December, derives a right to a $30,000 insurance receipt. It elects (under section 385-130 of the ITAA 1997) to return only 20% ($6,000) of that in year 1, and a further 20% in each of the next 4 years.On 1 May of year 1, Fresian joins the Charolet consolidated group. Because the insurance receipt is being returned as assessable income over more than one income year, the spreading rules will apply to split the $6,000 between Fresian and Charolet.The part of the spreading period in year 1 is the 212 days from the derivation of the insurance receipt until the end of the year. Fresians non-membership period is the 304 days from the start of the year until 30 April. The period that is common to both is the 151 days from 1 December until 30 April. So, Fresian will include $4,273.58 in its assessable income for year 1:

$6,000 * (151 / 212) + $4,273.58

Fresian will have spent 61 days of year 1 in the Charolet group and all of that would have fallen into the spreading period. Therefore, Charolet will include $1,726.42 in its assessable income for year 1:

$6,000 * (61 / 212) = $1,726.42

Between them, they will include the whole:

$4,273.58 + $1,726.42 = $6,000

Spread deductions

4.16 The spread deductions rule works in much the same way as the income rule. It applies if an entity joins or leaves a consolidated group in an income year and some part of a deductible amount that is spread over 2 or more income years would have been deductible in the year:

to the entity, if it had not been in the group in that year; and
to the head company of the group, if the entity had been in the group for the whole year.

[Schedule 1, item 3, subsections 716-25(1), (3) and (5)]

4.17 The part of the deductible amount that falls into the income year would be divided between the entity and the head company using exactly the same fractions that were used in the income case [Schedule 1, item 3, subsections 716-25(4) and (6)] . Together, the entity and the head company would claim the whole part of the deductible amount that falls into that income year.

4.18 The spreading period is the period used to work out how the full amount is spread over the 2 or more income years. [Schedule 1, item 3, subsection 716-25(7)]

Example 4.2: Prepayments Continuing the previous example, Fresian incurred $5,000 on 1 January in year 1 for regular cattle market analyses for 2 years. The prepayments rules would allow only $1,240 of that to be deducted in year 1. Because the prepayment is being deducted over more than one income year, the spreading rules will apply to split that $1,240 deduction between Fresian and Charolet.In this case, the part of the spreading period that falls into year 1 runs from 1 January until the end of the year (181 days). 120 days are in both the spreading period and Fresians non-membership period. So, Fresian will deduct $3,314.92 in year 1:

$5,000 * (120 / 181) = $3,314.92

Charolet will deduct $1,685.08:

$5,000 * (61 / 181) = $1,685.08

Between them, they will deduct the full:

$3,314.92 + $1,685.08 = $5,000

Exception for depreciation

4.19 Deductions for depreciation are not covered by the spreading rule for deductions. It would not be appropriate to calculate a single deductible amount for depreciation to spread evenly across the year because the tax cost of depreciating assets is reset when an entity joins a consolidated group. The resetting means that the daily depreciation before the joining time can be different to that afterwards. [Schedule 1, item 3, subsection 716-25(2)]

4.20 Since depreciation is excluded from the spreading rule for deductions, the head company and the joining (or leaving) entity will instead each work out their own depreciation deduction for the part of the year that the asset is theirs.

One-year capital expenditure

4.21 Capital expenditure is not normally deductible unless a particular provision makes it so. The provisions that do that (e.g. depreciation) usually allow deductions to be claimed over a period that approximates the consumption of benefits from the expenditure (e.g. depreciation is claimed over an assets effective life as its value declines).

4.22 However, a few provisions allow an amount of capital expenditure to be fully deducted in a single income year, even though the expenditures benefits will be consumed over a longer period (e.g. expenditure on a landcare operation on primary production land - see Subdivision 40-G of the ITAA 1997). These provisions serve particular policy objectives (usually to encourage certain activities). Even though such expenditure might be incurred or paid at a single moment, the deduction represents the consumption of benefits over a longer period, so it is appropriate that it be attributed evenly to the year into which that period is compressed.

4.23 The rule for one-year capital expenditure works in much the same way as the spread deductions rule. It applies if an entity joins or leaves a consolidated group in an income year and the whole of an amount of capital expenditure would have been deductible in the year:

to the entity, if it had not been in the group in that year; and
to the head company of the group, if the entity had been in the group for the whole year.

[Schedule 1, item 3, subsections 716-70(1), (2) and (4)]

4.24 The deduction for the capital expenditure would be divided between the entity and the head company using essentially the same fractions that were used in the income case. [Schedule 1, item 3, subsections 716-70(3) and (5)]

4.25 In this case, the spreading period used in applying those fractions is the period from the time that an entity would become entitled to deduct the amount until the end of that income year. [Schedule 1, item 3, subsection 716-70(6)]

4.26 Together, the entity and the head company would deduct the full amount of the deductible capital expenditure.

Partnership and trust amounts

4.27 The amendments deal specifically with cases where a partner in a partnership, or a beneficiary in a trust, is a subsidiary member of a consolidated group for only part of a year. They do not deal with cases where the partnership or trust itself joins or leaves a consolidated group. In those cases, the part-year rules would apply to the partnership or trust in the same way that they apply to any other entity that joins or leaves a consolidated group. [Schedule 1, item 3, section 716-75]

4.28 A share of the net income of a trust, or the net income or loss of a partnership, will usually attach to a partner or beneficiary at a single moment (usually the end of the year). However, like the one-year capital expenditure case, that amount is really attributable to the entire year rather than to that single moment, so should be apportioned between the partner or beneficiary and the head company.

4.29 That apportionment could have been done on a simple daily basis but that would not necessarily be appropriate. For example, a partnership might deduct an amount for interest paid when the partner was outside the consolidated group. A daily apportionment would distribute some of the benefit of that interest expense to the head company, even though it was incurred before the partner joined the consolidated group.

4.30 To deal with such issues, the amendments attribute the partners or beneficiarys shares of the underlying partnership or trust income and deductions:

for each non-membership period - to the partner or beneficiary; and
for each period when the partner or beneficiary was in a consolidated group - to the groups head company.

4.31 Working out of the result for particular periods like this, by referring to the underlying partnership or trust amounts, is intentionally like the way partnership cases are dealt with in the current-year loss rules in Division 165 of the ITAA 1997 (for partners that are companies) and Division 268 of Schedule 2F to the ITAA 1936 (for partners that are trusts).

Details of the mechanism - the partner or beneficiary

4.32 The rules dividing partnership and trust amounts only apply if, in the absence of consolidation, an entity would have included a share of the net income of a partnership or trust in its assessable income for an income year, or deducted a share of the net loss of a partnership. [Schedule 1, item 3, section 716-75]

4.33 If that entity was in a consolidated group for only part of the year, it will return as assessable income its share of:

the partnerships or trusts assessable income that is reasonably attributable to a non-membership period of the entity; and
the non-membership periods percentage (worked out on a daily basis) of any assessable income of the partnership or trust that cant reasonably be attributed to a particular period in the year.

[Schedule 1, item 3, subsections 716-85(1) and (3) and section 716-100]

4.34 The entitys share of the assessable income (and deductions) of a partnership or trust is a percentage that equals:

its percentage interest in the partnerships net income or loss; or
the percentage of the trusts income to which it is presently entitled.

[Schedule 1, item 3, section 716-90]

Example 4.3: Subsidiarys share of trust income Lumosure Tiles Pty Ltd is a 50% beneficiary of a fixed trust. On 1 November in year 1, Lumosure is bought by the Hotel Bathrooms consolidated group and becomes a subsidiary member. The trust is not a member of the group.At the end of year 1, the trust works out its net income as $2.5 million, of which Lumosures share is $1.25 million. The trusts net income is made up this way:

  Assessable income Deductions Totals
1 Jul to 31 Oct (123 days) 600,000 (125,000) 475,000
1 Nov to 30 Jun (242 days) 2,170,000 (185,000) 1,985,000
Unattributable amounts 60,000 (20,000) 40,000
1 Jul to 30 Jun (365 days) 2,830,000 (330,000) 2,500,000
Since Lumosure is presently entitled to a share of the trusts net income, it would have included that share in its assessable income if it had never joined the group. Therefore, the provisions will apply to split the underlying amounts between Lumosure and Hotel Bathrooms.Lumosures non-membership period runs from 1 July to 31 October. It will therefore return its 50% share ($300,000) of the trusts assessable income for that period. It will also return a proportion of its share of the $60,000 assessable income that is not attributable to a particular part of the year. That proportion is worked out on a daily basis:

50% * $60,000 * (123 / 365) = $10,109.59

Lumosure will therefore return $310,109.59 as assessable income from the trust for year 1.

4.35 The entity will also deduct its share of:

the partnerships or trusts deductions that are reasonably attributable to a non-membership period of the entity; and
the non-membership periods percentage (worked out on a daily basis) of those deductions of the partnership or trust that can not reasonably be attributed to any particular period in the year.

[Schedule 1, item 3, subsections 716-85(2) and (3) and section 716-100]

Example 4.4: Subsidiarys share of trust deductions Continuing the previous example, Lumosure will deduct its 50% share ($62,500) of the trusts deductions attributable to its non-membership period. It will also deduct a proportion of its share of the $20,000 trust deductions that are not attributable to a particular period in the year. It uses the same apportionment method as it used for assessable income:

%50 * $20,000 * (123 / 365) = $3,369.86

Lumosure will therefore deduct $65,869.86 in relation to the trust for year 1.

4.36 Only income and deductions that would have gone into working out the partnerships or trusts net income or partnership loss if the entity had never been in a consolidated group can be apportioned between the entity and the head company. A reason why amounts might not be counted is that the current year loss rules can prevent part-year losses being deducted if there is a sufficient change of ownership during a year. [Schedule 1, item 3, section 716-95]

Details of the mechanism - the head company

4.37 If the rules apply to apportion part of a partnership or trust amount to a subsidiary that is a partner or beneficiary, they will also apply to apportion the rest of it to the head company of the entitys consolidated group.

4.38 If the entity was in a consolidated group for only part of the year, the head company will bring to account as assessable income the entitys share of:

the partnerships or trusts assessable income that is reasonably attributable to a period when the entity (but not the partnership or trust) was in the consolidated group; and
such a periods percentage (worked out on a daily basis) of any assessable income of the partnership or trust that can not reasonably be attributed to a particular period in the year.

[Schedule 1, item 3, paragraph 716-80(1)(a), subsection 716-80(2) and section 716-100]

Example 4.5: Head companys share of trust income Continuing the previous example, Hotel Bathrooms will return Lumosures share of the assessable income of the trust for the period when Lumosure was in the group (from 1 November to 30 June). That comes to $1,085,000 (50% of $2,170,000). It will also return a proportion of Lumosures share of the $60,000 assessable income that is not attributable to a particular part of the year. That proportion is worked out on a daily basis:

%50 * $60,000 * (242 / 365) = $19,890.41

Hotel Bathrooms will therefore return $1,104,890.41 as assessable income from the trust. Together with Lumosures $310,109.59 a total of $1,415,000 will have been returned. This is exactly equal to Lumosures 50% share of the trusts assessable income for year 1.

4.39 The head company will also deduct the entitys share of:

the partnerships or trusts deductions that are reasonably attributable to a period when the entity (but not the partnership or trust) was in the consolidated group; and
such a periods percentage (worked out on a daily basis) of those deductions of the partnership or trust that can not reasonably be attributed to any particular period in the year.

[Schedule 1, item 3, paragraph 716-80(1)(b), subsection 716-80(2) and section 716-100]

Example 4.6: Head companys share of trust deductions Completing the previous example, Hotel Bathrooms will deduct Lumosures share of the trusts deductions for the period from 1 November to 30 June. That comes to $92,500 (50% of $185,000). It will also return a proportion of Lumosures share of the $20,000 deductions that are not attributable to a particular part of the year. That proportion is worked out on a daily basis:

%50 * $20,000 * (242 / 365) = $6,630.14

Hotel Bathrooms will therefore deduct $99,130.14 in respect of the trust. Together with Lumosures $65,869.86 a total of $165,000 will have been deducted. This is exactly equal to Lumosures 50% share of the trusts $330,000 deductions for year 1.

Relationship between apportionment rules and the current year loss rules

4.40 The existing current year loss rules in Division 165 of the ITAA 1997 apply to companies that experience a 50% change in their ownership or control during an income year. There are similar rules for trusts in Schedule 2F to the ITAA 1936.

4.41 Those current year loss rules separate a year into periods, divided at points where such changes in control occur. Generally, a loss from one of those periods cant be used by the entity to offset income either in other periods or in later years. Those rules cover much the same ground as the apportionment rules in the amendments, so the interaction between them needs to be understood. There are 2 cases; first where the end of a period under the current year loss rules does not coincide with the entity joining a consolidated group and secondly when it does.

End of current year loss period does not coincide with joining time

4.42 The current year loss rules might apply without the apportionment rules in cases where there is a partial acquisition of an entity. For example, an entity might change its ownership or control by more than 50% but not be wholly-owned by a consolidated group. Alternatively, the entity might be acquired by a group of entities that has not yet formed a consolidated group. If the entity joins a consolidated group later in the same year, both the current year loss rules and the apportionment rules could apply in the year to the joining entitys income and deductions.

4.43 In such cases, the apportionment rules in the amendments would apply to distribute amounts between the head company and the joining company. However, the joining entity would apply the current year loss rules to divide its non-membership period into sub-periods and to distribute its income and deduction amounts between them.

End of current year loss period coincides with joining time

4.44 If the current year loss rules and the apportionment rules could both apply at the same point (e.g. if a consolidated group buys 100% of a company at a single moment in the year), there would be potential conflicts between them. However, there are two reasons why that cant occur.

4.45 First, the apportionment rules would be expected to prevail because they are aimed at a specific situation and the current year loss rules are more general (applying to all changes of ownership, not just those arising because of consolidation). With interpretation, one would usually prefer the specific to the general.

4.46 Secondly, and more significantly, the provisions actually dont admit cases where both can relevantly apply at once. This is best illustrated by thinking about the simple case where a group buys a company halfway through the year (although the reasoning applies equally to more complex cases). The companys non-membership period to that point is treated as an income year for the purposes of working out its taxable income (see subsection 701-30(3) of the May Consolidation Act). The current year loss rules wont apply in this case because the only relevant change in the companys ownership or control is at the end of the deemed year when it joins the group (see section 165-35 of the ITAA 1997). The current year loss rules could apply if there is some other change during the deemed year, as discussed in paragraphs 4.42 and 4.43.

4.47 Even if the current year loss rules could apply to this case, a loss made in the companys non-membership period could not be transferred to the head company. Losses can only be transferred if they are made in an income year that ends before the company joins a consolidated group (see paragraph 707-115(1)(b) and subsection 707-405(1) of the May Consolidation Act) and this non-membership period is a deemed income year that ends at the joining time. It follows that, even if the two sets of rules could apply at the same time, they would have no relevant effect.

Different income years

4.48 Joining or leaving a consolidated group does not affect an entitys income year. So, it is possible for an entity with one income year to join (or leave) a consolidated group that, because of a SAP, has a different income year.

4.49 Such cases can affect the apportionment rules. Rather than extensively detailing how they are to be dealt with, the amendments use a general principles approach. They require amounts to be apportioned between periods in the most appropriate way, having regard to the other apportionment rules and to the objects of the consolidation provisions. In particular, they require apportionment in a way that recognises each item only once for each purpose (e.g. the same amount should not be assessed twice or deducted twice). [Schedule 1, item 3, section 716-800]

Threshold rules

4.50 The income tax law contains a number of provisions that permit, or deny, particular treatments on the basis of whether some threshold is met. For example, a company can only claim a deduction for 125% of some R&D expenditure if its aggregate R&D amount for the year is more than $20,000 (e.g. see subsection 73B(14) of the ITAA 1936). Entities that only have partial years because of joining or leaving a consolidated group would obviously find it harder to meet such thresholds.

4.51 The amendments address that problem by annualising the amounts for those partial years. They do that by multiplying the amount from the start of the year to the end of the non-membership period by:

365 / days in that period

[Schedule 1, item 3, section 716-850]

4.52 The amount being annualised may include amounts that arose before the non-membership period but are attributed to the entity by the entry and exit history rules. Counting those amounts as well as the amounts arising in the particular non-membership period reduces the chances that the annualising will distort the result. Indeed, if the non-membership period lasts to the end of the income year, this approach would result in the actual amounts for the year, rather than an annualised figure, being compared to the threshold.

Example 4.7: Qualifying for the 125% R&D deduction Sturmovik Products Ltd incurs the following non-contracted R&D expenditure over an income year:

4,000 3,000 7,000 8,000
91 days 91 days 92 days 91 days
The unshaded parts are non-membership periods. The shaded parts are periods when Sturmovik is in a consolidated group - the amounts from those periods are attributed to Sturmovik by the exit history rule.Sturmovik can only claim a 125% deduction for the $3,000 it spent in its first non-membership period if it meets the $20,000 threshold set by subsection 73B(14) of the ITAA 1936. It would annualise the $7,000 for the year to date ($3,000 actual + $4,000 attributed) by multiplying it by 365/182, giving it $14,038. Since that is less than the threshold, it can only claim a 100% deduction for the $3,000.In its second non-membership period, Sturmovik would annualise its $22,000 for the year to date ($8,000 actual + $14,000 attributed from earlier periods) by 365/365, leaving it with $22,000. As that is above the threshold, it can claim the 125% deduction for the $8,000 expended.

Consequential amendments

4.53 The existing rules work out an entitys taxable income for the part of a year before it joins, or after it leaves, a consolidated group, as if each such part-year were a separate income year. Those rules are amended to make it clear that amounts that go into working out the taxable income must either be exclusively allocated to only one such part-year or apportioned between several part-years (which is the aspect added by the amendments). [Schedule 1, item 1, paragraph 701-30(3)(c)]

4.54 An existing note to the rules for the part-year cases is amended to also cover the effect of the amendments. [Schedule 1, item 2, note to subsection 701-30(3)]

4.55 The dictionary of defined terms to the ITAA 1997 is amended to include a definition of spreading period . The amendment refers readers to the specific provisions in the apportionment rules that define that expression. [Schedule 1, item 4, section 995-1, definition of spreading period]

Chapter 5 - Removal of grouping provisions

Outline of chapter

5.1 This chapter explains the amendments to various taxation Acts following the introduction of the new consolidation measures that have been made in order to reflect the changes to Subdivision 126-B of the ITAA 1997 (about capital gains and losses). These concessions are to be progressively removed in accordance with the introduction of the consolidation regime, as foreshadowed in previous exposure drafts and legislation.

5.2 This chapter also explains modifications to the loss transfer provisions in Subdivisions 170-A and 170-B of the ITAA 1997. The modifications are in addition to those contained in Schedule 3 to the May Consolidation Act. As a result of the introduction of the consolidation regime, those Subdivisions now only apply to a transfer of tax losses or net capital losses if one of the companies is an Australian branch of a foreign bank.

5.3 This bill contains amendments to phase out various other grouping provisions as follows:

the phasing out of the thin capitalisation grouping rules are explained in Chapter 6;
the foreign tax credit rules for phasing out group transfers are explained in Chapter 9; and
the removal of the inter-corporate dividend rebate rules are explained in Chapter 10.

Context of reform

5.4 This bill contains consequential amendments to the removal of former Subdivision 126-B and Division 170 of the ITAA 1997 as contained in the May Consolidation Act. Subdivision 126-B, which deals with CGT rollover relief for asset transfers between members of the same wholly-owned company group, has been removed and replaced by a more limited form of rollover relief between members of a wholly-owned company group.

5.5 The May Consolidation Act limits loss transfers under Division 170 to loss transfers involving an Australian branch of a foreign bank.

5.6 It is necessary to modify Division 170 so it works appropriately in a consolidation environment. In particular to ensure that:

a loss that has been transferred to the head company of a consolidated group under Subdivision 707-A continues to be transferable to a foreign bank branch;
a loss, made by a branch before the company to which it could have been transferred joined a consolidated group, is transferable to the group; and
the amount transferred by the branch to the group approximates the amount that could have been transferred by the branch to companies in the group had they not become members of the group.

Summary of new law

New Subdivision 126-B

5.7 Consequential amendments have been made to various taxation Acts in order to reflect the changes that have been made to Subdivision 126-B of the ITAA 1997 following the introduction of the new consolidation measures.

Retention of loss transfers for foreign bank branches

Transfer: group to branch

5.8 A head company of a consolidated or MEC group can transfer a loss to an Australian branch of a foreign bank.

5.9 Rules are needed to facilitate the transfer if the loss is one that was originally made by a member of the group and transferred to the head company of the group under Subdivision 707-A when that member joined. Broadly, the transfer can occur if the branch and each loss owner (i.e. the original loss-maker and each head company to which the loss is transferred) are members of the same wholly-owned group for the period of that ownership.

Transfer: branch to group

5.10 An Australian branch of a foreign bank can transfer a loss to the head company of a consolidated or MEC group.

5.11 Rules are needed to facilitate the transfer if the loss is one that was made by the branch before a company (the first link company) to which it could otherwise have transferred the loss joined the group. These are referred to in this explanatory memorandum as pre-joining branch losses. Broadly, the transfer can occur if the branch could have transferred its pre-joining branch loss to:

the first link company at the time the company joined the group (assuming it had not joined the group); and
every other company in the chain:

-
this is each company to which the branch loss could have been transferred under Subdivision 707-A (assuming the first link company had made the branch loss for the income year in which the branch made it).

5.12 The amount of a pre-joining branch loss that can be transferred by a branch to the head company of a consolidated or MEC group approximates the amount that could have been transferred to the company that joins the group had it not joined the group.

Comparison of key features of new law and current law
New law Current law
Various taxing Acts have been updated to reflect changes to Subdivision 126-B of the ITAA 1997. Subdivision 126-B has been replaced by a more modified form of CGT rollover relief for asset transfers between members of the same wholly-owned group.
Broadly, a loss is transferable under Division 170 between the head company of a consolidated group (or a MEC group) and a foreign bank branch if the conditions for transfer are satisfied in respect of the branch and another company up until the time the company joined the group. Thereafter the conditions must be satisfied by the branch and the groups head company. (These rules only apply if the branch is otherwise unable to satisfy the Division 170 conditions in respect of the head company). A loss is transferable under Division 170 between a company and a foreign bank branch if the conditions for transfer are satisfied in respect of the branch and the company.
The maximum amount of a foreign bank branch loss that may be transferred to the head company of a consolidated group (or a MEC group) is approximately the amount that could have been transferred to members of the group in the absence of consolidation. The maximum amount of a foreign bank branch loss that may be transferred is the amount the transferee company may use for the deduction year.

Detailed explanation of new law

Consequential amendments to introduction of new Subdivision 126-B

5.13 As part of the introduction of the consolidation regime, certain grouping provisions applying to wholly-owned groups have been removed and replaced in some cases with limited concessions. The May Consolidation Act contained amendments to this effect dealing with Division 170 and Subdivision 126-B of the ITAA 1997.

5.14 Subdivision 126-B now provides CGT rollover relief for asset disposals which occur between members of the same wholly-owned company group, provided that either the originating company or the recipient company is a non-resident.

5.15 To reflect this alteration, consequential amendments have been made to several provisions in various taxation Acts. The Acts affected are the:

Income Tax Assessment Act 1997;
Income Tax Assessment Act 1936;
Financial Corporations (Transfer of Assets and Liabilities) Act 1993; and
Wool Services Privatisation Act 2000.

[Schedule 18, items 1 to 16]

5.16 The majority of the consequential amendments reflect the fact that rollover relief is now applicable only to certain wholly-owned groups. [Schedule 18, items 1, 2 and 8 to 16]

5.17 Further, rollover relief under certain R&D provisions in relation to asset transfers between wholly-owned groups and which were contingent on rollover relief being available under the former Subdivision 126-B, will no longer apply. In effect, corresponding rollover relief under the R&D provisions will only be available where rollover relief has been allowed under the previous version of Subdivision 126-B. This means that this related R&D rollover relief will cease to apply after the former Subdivision 126-B ceases operation. Given that R&D concessions apply only to Australian companies, it is not appropriate to retain rollover relief in any form for transfers of assets involving non-residents. [Schedule 18, items 3 to 7]

Retention of loss transfers for foreign bank branches

5.18 Division 170 of the ITAA 1997 will be modified to ensure it operates appropriately in respect of loss transfers between an Australian branch of a foreign bank and the head company of a consolidated group. [Schedule 12, items 1 to 28]

5.19 A reference in this explanation to a consolidated group includes a MEC group (unless otherwise specified).

Background

5.20 Broadly, Division 170, as amended by Schedule 3 to the May Consolidation Act, limits the ability of companies to transfer losses under that Division to transfers between:

an Australian branch (as defined by Part IIIB of the ITAA 1936) of a foreign bank; and
the foreign banks resident wholly-owned company subsidiaries provided they are not members of a consolidatable group - that is, a subsidiary may be a single entity or the head company of a consolidated group, but if it is a single entity it cannot be a member of a consolidatable group.

5.21 Division 170 will generally continue to operate as it does currently (i.e. without modification) in respect of such transfers. That is, a loss can be transferred if the transferor (the loss company) and the transferee (the income company) meet the conditions in Division 170. A reference in this explanation to an income company in respect of a tax loss includes a gain company in respect of a net capital loss.

5.22 The conditions in Division 170 can be broadly categorised as:

the relationship test:

-
the loss company and the income company must be in existence and members of the same wholly-owned group during the loss year, the deduction year (i.e. the transfer year) and any intervening income year; and

the utilisation test:

-
the loss company must not have been prevented from deducting or applying the loss in the deduction year (had it not transferred it); and
-
the income company must also not have been prevented from deducting or applying it for that income year (assuming it had made the loss instead of the loss company and had made it for the income year in which the loss company made it).

5.23 A reference in this explanation to a deduction year in respect of a tax loss includes an application year in respect of a net capital loss. Likewise, a reference to deducting a tax loss includes applying a net capital loss.

5.24 However, the Division 170 conditions will be modified in respect of the transfer of losses made by a company or a foreign bank branch (a branch) before the company joined a consolidated group. The particular modifications depend in part on whether the transfer is from a group to a branch or from a branch to a group. Broadly, they ensure that:

the relationship test works appropriately to ensure that the wholly-owned group relationship exists between group members and the branch;
the utilisation tests (i.e. the COT and the SBT in Division 165 of the ITAA 1997) work appropriately in testing whether losses can be transferred from a branch to a group; and
the amount that can be transferred from a branch to a group reflects the amount that could have been transferred had the group not consolidated.

Transfer from a group to a branch

5.25 Losses transferred from a consolidated group to a branch may be either:

losses generated by the group (group losses); or
losses transferred, or taken to have been transferred, to the head company of the group under Subdivision 707-A (Subdivision 707-A losses):

-
Subdivision 707-A was introduced by the May Consolidation Act to allow losses of entities joining a consolidated group to be transferred to the head company of the group if certain conditions are met: see Chapter 6 of the explanatory memorandum relating to the May Consolidation Act and Chapter 3 of this explanatory memorandum for further details.

5.26 Division 170 will generally operate as it does currently in relation to the transfer of group losses. However, modifications are required for the transfer of Subdivision 707-A losses. The modifications address the fact that a Subdivision 707-A loss will generally have had two or more owners during the period from the start of the loss year until the end of the transfer year. The owners are the original loss company and each head company to which the loss is transferred under Subdivision 707-A.

5.27 However, those modifications are not intended to change the fact that Division 170 only allows the transfer of losses between companies. Therefore, Subdivision 707-A losses can only be transferred to a branch if the entity that originally made the loss was a company. In the absence of this rule it may be argued that the modifications allow a loss transferred by a trust to the head company of a consolidated group under Subdivision 707-A to be transferred to a branch under Division 170. [Schedule 12, item 4, subsections 170-32(1) and (2) and item 16, subsections 170-132(1) and (2)]

Transfer group to branch: relationship test

5.28 Broadly, each loss owner, while it owned the loss, will be required to have been in existence and a member of the same wholly-owned group as the branch. That is:

the original loss company must be a member of the same wholly-owned group as the branch during the loss year while both are in existence and until the loss is transferred to the head company of the consolidated group; and
the head company and the branch must maintain the same wholly-owned group relationship from the time the loss was transferred to the group until the end of the income year in which the loss was transferred to the branch (the deduction year) or while they are both in existence during that year.

[Schedule 12, item 4, subsections 170-32(1) to (3) and item 16, subsections 170-132(1) to (3)]

5.29 A Subdivision 707-A loss may pass through more than one consolidated group before being transferred to a branch. If the loss is transferred under Subdivision 707-A from one head company (the old head company) to another head company (new head company) because the old head company becomes a subsidiary member of the new head companys group, the old head company must be in existence and a member of the same wholly-owned group as the branch from the time of the Subdivision 707-A transfer to it until the loss is transferred to the new head company. Thereafter, the new head company must retain the appropriate relationship with the branch. [Schedule 12, item 4, subsections 170-32(4) and (5) and item 16, subsections 170-132(4) and (5)]

5.30 There is no requirement that the original loss-maker, or any later owner of the loss, be a member of the consolidated group at the time the group transfers the loss to the branch. This matches the rules for utilisation of Subdivision 707-A losses. That is, for those losses, there is no requirement that the original loss-maker that transferred the loss to the group be a member of the group when the group seeks to recoup the loss.

Transfer group to branch: utilisation test

5.31 No modifications are required to the utilisation test as it applies to the head company. The head company will be taken to have made the Subdivision 707-A loss in the income year in which it was transferred to it. That date of incurrence is used as the basis for testing its ability to use the loss (rather than the income year in which it was actually made). Nonetheless the correct outcome is achieved. This is because a Subdivision 707-A loss will already have satisfied modified versions of the company loss utilisation tests in order to have been transferred from the original loss-maker to the head company.

5.32 However, a modification is required to the utilisation test as it applies to the branch. The modification ensures that the branch tests its ability to utilise the loss on the assumption that it made the loss for the original loss year. In the absence of this modification the branch would have tested on the basis of the (refreshed) income year for which the head company is taken to have made the Subdivision 707-A loss. [Schedule 12, item 1, subsection 170-15(3) and item 13, subsection 170-115(3)]

Transfer group to branch: order

5.33 A head company transferring losses to a branch must do so in this order:

group losses;
COT concessional losses:

-
these are Subdivision 707-A losses that a group uses in accordance with the transitional concession in section 707-350 of the transitional provisions in the May Consolidation Act; and

other Subdivision 707-A losses:

-
these are Subdivision 707-A losses that a group uses in accordance with the available fraction method.

[Schedule 12, item 11, subsections 170-55(3) to (5); item 21, subsections 170-155(2) to (4); item 24, section 170-55; item 27, section 170-155]

Transfer group to branch: pre-Part IIIB losses

5.34 The rules allowing the Division 170 transfer of a Subdivision 707-A loss (by testing the branchs relationship with each loss owner) do not change the fact that a loss cannot be transferred under Division 170 to a branch if the original loss-maker made the loss for an income year starting before 1 July 1994.

5.35 A Subdivision 707-A loss is refreshed in the hands of each new loss owner in that it is taken to have been made by the new loss owner in the income year in which it was transferred to it, rather than the date it was actually made by the original loss-maker. This refreshing will not have the effect of bringing pre-Part IIIB losses within Part IIIB. That is because the relationship test must be satisfied from the original loss year. Part of that test requires the branch to have been in existence during the loss year. A foreign bank branch is unable to satisfy the in existence aspect of the relationship test for pre-Part IIIB losses.

5.36 Pre-Part IIIB losses can only be transferred under the Financial Corporations (Transfer of Assets and Liabilities) Act 1993. Rules will be introduced in a later bill to ensure those rules continue to operate appropriately in a consolidation environment.

Transfer from a branch to a group

5.37 Division 170 will also be modified in respect of the transfer of certain losses from a branch to the head company of a consolidated group. More specifically, the rules will allow pre-joining branch losses to be transferred to a group. A pre-joining branch loss is a loss made by the branch relating to a period before the relevant company joined the group. In this context, the relevant company is a company to which the branch could have transferred the loss had the company not joined the group.

5.38 Essentially Division 170 is modified to allow the branch to track its relationship with the original company through a consolidated group of which that company becomes a member. Also, it can track its relationship further through a chain of consolidated groups if the original head company became a subsidiary member of another consolidated group and so on. The company with which the branch had the original relationship during its loss year is called the first link company. The branch can then transfer the loss to the group if it could have transferred it to the first link company and to each successive company in the chain.

5.39 In the absence of these tracking rules a branch may not be able to transfer a pre-joining branch loss because the identity of the company to which it could originally have transferred the loss has been subsumed as a result of that company becoming a subsidiary member of a consolidated group.

5.40 Therefore, a branch that is unable to satisfy the conditions in Division 170 for a loss transfer to the head company of a consolidated group will nonetheless be taken to have satisfied them if it meets the conditions in respect of each company in the chain. [Schedule 12, item 4, subsection 170-33(1) and item 16, subsection 170-133(1)]

Transfer branch to group: identifying a chain of companies

5.41 The primary tests for establishing a chain of companies are:

first, identify any company that became a subsidiary member of a consolidated group after the start of the branch loss year [Schedule 12, item 4, paragraph 170-33(2)(a) and item 16, paragraph 170-133(2)(a)] ;
second, assume that company made the branch loss for the income year in which the branch made it [Schedule 12, item 4, paragraph 170-33(2)(c) and item 16, paragraph 170-133(2)(c)] ; and
third, determine whether, on the basis of that assumption, the loss would have been incurred by the head company to which the branch is seeking to transfer the loss because of one or more transfers of the loss under Subdivision 707-A [Schedule 12, item 4, paragraph 170-33(2)(c) and item 16, paragraph 170-133(2)(c)] .

5.42 If the head company would have incurred the loss on the basis of that assumption, there is a chain of companies in respect of the loss. The company referred to in the first dot point above is the first link company (subject to it also satisfying the tests discussed in paragraphs 5.46 and 5.47). The first link company may be a single entity or the ex-head company of a consolidated group.

5.43 Every other company to which the first link company could have transferred the loss on the basis of the assumption in the second dot point is part of the chain. The head company of the group to which the branch is seeking to transfer its pre-joining loss is the last company in the chain - it is the entity that Division 170 calls the income company. Any company in the chain that comes between the first link company and the income company is referred to in this explanatory memorandum as an intervening link company.

5.44 The next step is to determine whether the branch could have transferred its pre-joining loss to the first link company and to every other company in the chain. It does this using the modified relationship and utilisation tests discussed in paragraphs 5.50 to 5.52. Broadly, the branch and the first link company must satisfy the relevant tests until that company joins the group. Thereafter, the tests must be satisfied in respect of the branch and each successive company in the chain.

5.45 A branch may be able to establish more than one chain (ending at the same income company) in respect of a single loss. It is important that a branch establish each possible chain for the loss. This is because the assumption that the branch loss is made by the first link company in the chain ensures the loss is notionally included in a loss bundle. These loss bundles are used as the basis for determining the amount of the loss that can be transferred. This is discussed in more detail in paragraphs 5.62 to 5.75.

Transfer branch to group: first link company

5.46 The branch must have been able to transfer its pre-joining loss to the first link company under Subdivision 170-A or 170-B when the first link company joined a consolidated group. The following assumptions are made in determining whether the branch could have transferred the loss to the first link company at that time:

the deduction year is the trial year:

-
the trial year generally starts 12 months before and ends immediately after an entity joins a consolidated group. See Chapter 6 of the explanatory memorandum relating to the May Consolidation Act for a more detailed explanation of the trial year concept;

the trial year did not start before the loss year:

-
this ensures that using the 12 month trial year period does not have the effect of extending the test time back before the start of the loss year if the loss year and the deduction year overlap;

the link company did not become a subsidiary member of that group at that time but continued as a separate entity:

-
this enables the first link company to be tested on the basis that it is a single entity rather than a part of the groups head company; and

the link company had enough assessable income or capital gains for the trial year:

-
this effectively overrides the fact that losses may only be transferred under Division 170 to the extent that the transferee has income or gains against which the loss can be offset (but only for the purpose of testing the first link company).

[Schedule 12, item 4, paragraph 170-33(2)(b) and item 16, paragraph 170-133(2)(b)]

5.47 The test is whether the branch could have transferred its pre-joining loss to the first link company for the trial year on the basis of the other assumptions listed in the previous paragraph. Framing the test in this way ensures that it will only be met if both the relationship and the utilisation tests are satisfied. Also, the assumption that the first link company is taken to have made the loss (set out in the second dot point of paragraph 5.41) ensures that the first link company tests its ability to use the loss for the trial year by reference to the general loss rules as modified by Subdivision 707-A.

5.48 The first link company does not have to be a member of the group to which the branch transfers its pre-joining loss. That is, the branch loss is still transferable to the group even if the first link company has left the group. However, because the loss is still transferable to the group it is not also transferable to the first link company that has exited. This flows naturally from the single entity rule. That is, as a result of the single entity rule the link company will not be regarded as having been in existence as a separate entity while it was a subsidiary member of the group - rather it is treated as a part of the head company.

Transfer branch to group: intervening link companies

5.49 The branch must also satisfy the Division 170 conditions in respect of each link company between the first link company and the income company. There may be one or more intervening link companies. [Schedule 12, item 4, subsection 170-33(4) and item 16, subsection 170-133(4)]

5.50 The branch will satisfy the relationship test in respect of an intervening link company if the branch and each intervening link company were in existence and members of the same wholly-owned group for the period:

starting when the loss would have been transferred to the intervening link company under Subdivision 707-A; and
ending when the loss would have been transferred under Subdivision 707-A by that intervening link company to the next company in the chain.

[Schedule 12, item 4, subsection 170-33(3) and item 16, subsection 170-133(3)]

5.51 This modification builds on the requirement that the pre-joining branch loss must have been able to have been transferred under Subdivision 707-A from the first link company, through the intervening link companies, to the income company. The relationship test period matches the notional period of loss ownership for each intervening link company.

5.52 On that same basis, the utilisation test will have been satisfied by each intervening link company. That is, the utilisation test will have been satisfied because an entity will only be identified as an intervening link company if the branch loss could notionally have been transferred to it under Subdivision 707-A.

5.53 Again, there is no requirement that an intervening link company be a member of the group when the branch transfers its pre-joining loss to the group.

Transfer branch to group: income company (chain)

5.54 The last company in the chain is the head company of the group to which the branch seeks to transfer its pre-joining loss.

5.55 The relationship test will be met if the branch and the income company are in existence and members of the same wholly-owned group for the period consisting of the income companys notional loss ownership period, being the period:

starting when the loss would have been transferred to the income company under Subdivision 707-A; and
ending at the end of the income year in which the loss is sought to be transferred (i.e. the deduction year).

[Schedule 12, item 4, subsection 170-33(5) and item 16, subsection 170-133(5)]

5.56 The income company tests its ability to utilise the loss on the assumption that it incurred the branch loss for the income year in which it would notionally have been transferred to it under Subdivision 707-A. [Schedule 12, item 1, subsection 170-15(4); item 9, subsections 170-42(3) and (4); item 13, subsection 170-115(4); item 19, subsections 170-142(3) and (4)]

5.57 The branch tests its ability to use its pre-joining loss on the basis of its actual loss year. No modification is needed to ensure that.

Transfer branch to group: income company (no chain)

5.58 There are 2 further cases in which modifications are required even though there is no chain of companies as set out in paragraphs 5.41 to 5.45. They are:

the income company became the head company of a consolidated group after the start of the branch loss year [Schedule 12, item 9, paragraph 170-42(1)(a) and item 19, paragraph 170-142(1)(a)] ; and
the income company is the head company of a MEC group but some time after the end of the branch loss year and before the end of the deduction year a new eligible tier-1 company joined the group [Schedule 12, item 9, paragraph 170-42(1)(b) and item 19, paragraph 170-142(1)(b)]:

-
this includes the case where the MEC group formed as a result of converting from an ordinary group.

5.59 No modification is needed to the relationship test because in these cases there has effectively been no change in the identity of the group company to which the branch could have transferred the loss.

5.60 However, the utilisation test is applied to the income company on the assumption that it made the branch loss for the income year in which the branch made the loss. [Schedule 12, item 9, subsection 170-42(2) and item 19, subsection 170-142(2)]

5.61 This assumption is also relevant in determining the amount of the pre-joining branch loss that can be transferred. This is discussed in paragraphs 5.62 to 5.75.

Transfer branch to group: amount is limited

5.62 The last modification limits the amount of a pre-joining branch loss that can be transferred to the head company of a consolidated group. This modification replaces the limit in subsections 170-45(2) and (3) of the ITAA 1997, though for pre-joining branch losses only. This modification is intended to ensure that the amount transferred to the consolidated group reflects the amount that could have been transferred had the group not consolidated.

5.63 In the absence of this modification, the branch could transfer so much of its pre-joining losses as could be offset against the head companys income and gains. This would, as a result of the single entity rule, include the income and gains attributable to all group members, regardless of whether the branch could otherwise have transferred its losses to those members.

5.64 The limit builds on the assumptions discussed in paragraphs 5.41 and 5.42 that treat the branch pre-joining loss as having been made by the income company. This allows an available fraction to be calculated for the loss and to be used in limiting the amount of the loss that can be used - in the same way that the annual usage of Subdivision 707-A losses is limited by their available fraction.

5.65 In the case of a chain of companies the pre-joining branch loss is taken to have been made by the income company if it could have been transferred to the income company under Subdivision 707-A on the assumption that it was made by the first link company. Where there is no chain, the assumption is simply that the income company made the loss.

5.66 One implication of these assumptions is that the branch loss is notionally included in a loss bundle. If the first link company actually transfers its own losses to the income company (or an intervening link company) then the branch loss will be notionally included within that existing bundle. If the first link company does not transfer any actual losses, then a notional loss bundle will be created to house the branch loss. The same implications can be drawn where there is no chain. That is, the branch loss will be included in a loss bundle taken to have been transferred from the income company to itself in its capacity as head company.

5.67 There is one other circumstance in which a pre-joining branch loss is included in a loss bundle. That is where the income company is the head company of a MEC group but, sometime after the end of the branch loss year and before the end of the deduction year, a new eligible tier-1 company joined the group. Any group losses held by the head company at that time are taken to have been transferred by the head company to itself and are given an available fraction: see the discussion in Chapter 3.

5.68 The branch loss is also included in a loss bundle at that time on the assumption that group losses are also transferred at that time. This ensures that the amount of the branch loss that can be transferred is limited to an available fraction worked out in respect of the original group members and not the new eligible tier-1. If a branch loss is also a pre-joining loss in respect of the new eligible tier-1, a separate bundle and fraction will be created for the loss in respect of the tier-1.

5.69 The same branch loss may be included in more than one loss bundle if, for example, there is more than one chain of companies in respect of the loss. However, the method for calculating the limit (discussed in paragraph 5.75) ensures that the branch cannot transfer in total more than the actual amount of the loss.

5.70 An available fraction is calculated for each of the actual or notional loss bundles containing the branch loss. This is provided for by the rules contained in Subdivision 707-C of the May Consolidation Act and the special rules contained in this bill about available fractions for MEC groups.

5.71 That available fraction will be adjusted if any of the adjustment events listed in the table in subsection 707-320(2) of the May Consolidation Act occur (e.g. on each notional transfer of the loss from the first link company to the income company or if capital is injected into a member of a group during a period it is taken to be an owner of the loss). In this way the available fraction, whether it is notional or actual, will keep pace with the groups other available fractions so that together they cannot total more than one.

5.72 However, if a loss bundle containing a branch loss would otherwise be entitled to use an increased available fraction as a result of applying the value donor transitional concession in Schedule 3 to the May Consolidation Act, that increased available fraction cannot be used in determining the limit. That is, the available fraction worked out without regard to the value donor concession must be used in determining the amount of pre-joining losses a branch can transfer to the head company of a consolidated group. [Schedule 12, item 24, section 170-45 and item 27, section 170-145]

5.73 Any head company in the chain may cancel the notional transfer of a branch loss in respect of a particular loss bundle. It may choose to do this, for example, to avoid making available fraction adjustments in respect of that loss bundle (though that could only be achieved if the bundle contained no actual losses). But if the branch loss (or more correctly its notional transfer) is cancelled, then the branch is not entitled to transfer any amount to the income company in respect of its loss bundle. This cancellation facility matches that which exists for actual Subdivision 707-A transferred losses. [Schedule 12, item 23, subsection 707-315(5)]

5.74 As discussed in paragraph 5.69, a branch loss may be included in more than one loss bundle. Cancelling it in respect of one bundle does not mean it is cancelled in respect of other loss bundles or that the branch itself cannot use the loss. [Schedule 12, item 23, subsection 707-315(6)]

Transfer branch to group: amount is limited - method statement

5.75 The amount of pre-joining tax losses or net capital losses transferred by the branch cannot exceed the amount worked out like this:

identify each (notional and actual) loss bundle that is assumed to include the pre-joining branch losses:

-
the same pre-joining branch loss may be included in more than one loss bundle;

for each loss bundle, work out the maximum amount of the pre-joining branch losses that can be used by applying the rules for Subdivision 707-A losses contained in section 707-310 of the May Consolidation Act assuming that:

-
the branch losses can only be deducted after other actual Subdivision 707-A losses of the same sort in the loss bundle are deducted; and
-
if there are 2 or more pre-joining branch losses of the same sort in the loss bundle they are to be deducted in the order in which the branch incurred them; and

total the results for each loss of a particular sort in all relevant loss bundles:

-
this total becomes the total amount of the branch losses of that sort that can be transferred to the income company.

[Schedule 12, item 10, subsection 170-45(4) and item 20, subsection 170-145(7)]

5.76 See Example 5.1 and 5.2 for further information on how the limit is calculated.

Example 5.1 A group consolidates on 1 July 2002. There are two subsidiary company members A and B that have been members of the same wholly-owned group as an Australian branch of a foreign bank since 1 July 1996. The head company (HC) is also a member of the same wholly-owned group as the branch but only from the 1998-1999 income year.The branch made losses for the 1996-1997 and 1997-1998 income years that it has not recouped (pre-joining losses). The total net capital losses are for those years $3,000 and tax losses $5,000.Subsidiary As net capital loss of $60 and tax losses of $800 were transferred to HC under Subdivision 707-A on joining the group. Subsidiary B had no losses at the time it joined the group.The loss bundle including losses transferred from A gets an available fraction of 0.2. The branchs losses for which the conditions in section 170-33 (or 170-133) are satisfied are treated as if A made them and they are therefore transferred to HC and hypothetically included in the same loss bundle as other losses transferred from A under Subdivision 707-A.The branchs losses are also similarly hypothetically included in loss bundle B. The loss bundle gets an available fraction of 0.15.For the 2002-2003 income year HC has a capital gain of $1,000 (no capital losses) and other assessable income of $6,000 (no deductions).Loss bundle A income and gains against which transferred losses (including hypothetically included branch losses) may be utilised:

capital gains 0.2 * $1,000 = $200

Maximum Subdivision 170-B transfer from the branch in respect of loss bundle A is $200 - $60 (actual bundle capital loss that must be applied first) = $140The branch may transfer $140 pre-joining net capital losses hypothetically included in the loss bundle. The notional net capital gain is

$200 - ($60 + $140) = $0

Other income against which tax losses in the loss bundle may be utilised is:

0.2 * $6,000 = $1,200

Maximum tax loss transfer from the branch in respect of loss bundle A is $1,200 - $800 (actual loss bundle tax loss that must be deducted first) = $400The branch may transfer $400 pre-joining tax losses hypothetically included in loss bundle A.
Assessable income ($) Deductions ($)
net capital gain 0
other assessable income 1,200 707-A tax losses 800
pre-joining branch tax losses 400
Total 1,200 Total 1,200
Notional taxable income for loss bundle A is $1,200 - $1,200 = $0Loss bundle B income and gains against which transferred losses (including hypothetically transferred branch losses) may be applied:

capital gains 0.15 * $1,000 = $150

Maximum Subdivision 170-B transfer of capital losses from the branch in respect of the loss bundle B is $150 - $0 (actual loss bundle capital loss that must be applied first) = $150The branch may transfer $150 pre-joining net capital losses hypothetically included in loss bundle B.Other income against which tax losses in the loss bundle may be utilised is

0.15 * $6,000 = $900

Maximum tax loss transfer from branch of losses hypothetically included in loss bundle A is $900 - $0 (actual loss bundle tax loss to be deducted first) = $900The branch may transfer $900 pre-joining tax losses hypothetically included in loss bundle B.
Assessable income ($) Deductions ($)
net capital gain 0 0
other assessable income 900 707-A tax losses 0
pre-joining tax losses transferred from branch 900
Total 900 Total 900
Notional taxable income for loss bundle B is $900 - $900 = $0Therefore, the following loss amounts can be utilised by the head company:
Actual loss bundle losses
Net capital losses $60
Tax losses $800
Transfer from branch
Net capital losses $140 + $150 = $290
Tax losses $400 + $900 = $1,300
Work out the HCs taxable income by first working out HC net capital gain
Gains ($) Net capital losses ($)
Capital gain 1,000 from bundles 60
pre-joining transferred from branch 290
Total 1,000 Total 350
HCs net capital gain is $1,000 - $350 = $650HCs taxable income
Assessable income ($) Deductions ($)
Net capital gain 650
Other assessable income 6,000 actual loss bundle tax losses 800
pre-joining tax losses transferred from branch 1,300
Total 6,650 Total 2,100
Taxable income $6,650 - $2,100 = $4,550The branch and HC enter into an agreement that the branch transfers:

$290 pre-joining net capital losses; and
$1,300 pre-joining tax losses,

to the HC for the income year.

Example 5.2 The facts are the same as in Example 5.1 but the income year is 2003-2004. The group made a net capital loss of $200 and a tax loss of $2,999 for the 2002-2003 income year. The branch also made a net capital loss of $500 and a tax loss of $900 for that income year.Loss bundle A income and gains against which transferred losses (including hypothetically included branch losses) may be utilised:

capital gains 0.2 ($1,000 - $200 group capital loss) = $160

Maximum Subdivision 170-B transfer from the branch of hypothetically included branch losses in loss bundle A is $160 - $60 (actual loss bundle capital loss to be applied first) = $100The branch may transfer a pre-joining net capital loss of $100 hypothetically included in that loss bundle. The notional net capital gain is $160 - (60 + $100) = $0Other income against which tax losses in the loss bundle may be utilised is 0.2 ($6,000 - $2,999 group loss) = $600Maximum tax loss transfer from branch of hypothetically included branch losses in loss bundle A is $600 - $600 (loss bundle tax loss) = $0The branch may not transfer any pre-joining tax losses in relation losses hypothetically included in loss bundle A as there is no income left for that loss bundle against which the loss may be deducted.
Assessable income ($) Deductions ($)
Net capital gain 0
Other assessable income 600 loss bundle A tax losses 600
pre-joining tax losses transferred from branch 0
Total 600 Total 600
Notional taxable income for loss bundle A is $600 - $600 = $0Loss bundle B income and gains against which transferred losses (including notional losses) may be applied:

capital gains 0.15 * ($1,000 - $200 group capital loss) = $120

Maximum Subdivision 170-B transfer of capital losses from the branch of hypothetically included branch losses in loss bundle B is $120 - $0 (actual loss bundle capital loss to be applied first) = $120.The branch may transfer $120 pre-joining net capital losses hypothetically included in loss bundle B.The notional net capital gain is $120 - $120 = $0Other income against which tax losses in the loss bundle may be utilised is 0.15 ($6,000 - $2,999 group loss) = $450. There are no actual loss bundle losses.The branch may transfer $450 pre-joining tax losses hypothetically included in loss bundle B.
Assessable income ($) Deductions ($)
Net capital gain 0
Other assessable income 450 loss bundle B tax losses 0
pre-joining tax losses transferred from branch 450
Total 450 Total 450
Notional taxable income for loss bundle B is $450 - $450 = $0Therefore, the following loss maximum amounts can be utilised by the head company:
Groups prior year losses
Net capital losses $200
Tax losses $2,999
Loss bundle losses
Net capital losses $60
Tax losses $600
Transfer from branch in respect of the loss bundles
Net capital losses $100 + 120 = $220
Tax losses $450
Work out the HCs taxable income by first working out HC notional net capital gain
Gains ($) Net capital losses ($)
Capital gain 1,000 Group (prior year) 200
from loss bundles 60
pre-joining transferred from branch 220
Total 1,000 Total 480
HCs notional net capital gain is $1,000 - $480 = $520The branch also has a net capital loss of $500 that it can transfer to the group (loss made at the time the consolidated group is in existence). That loss is transferred to the group. The groups net capital gain is $520 - $500 = $20HCs notional taxable income
Assessable income ($) Deductions ($)
Net capital gain 20 group prior year tax loss 2,999
Other assessable income 6,000 loss bundle tax losses 600
pre-joining losses transferred from branch 450
Total 6,020 Total 4,049
Notional taxable income $6,020 - $4,049 = $1,971The branch has a prior year tax loss of $900 that it can transfer to the group (loss made at the time the consolidated group is in existence). That loss is transferred to the group. The groups taxable income is $1,971 - $900 = $1,071.The branch and the HC enter into an agreement that the branch transfers:

$220 pre-joining net capital losses;
$450 pre-joining tax losses;
$500 post-joining net capital losses; and
$900 post-joining tax losses,

to the HC for the income year.

Application and transitional provisions

Retention of loss transfers for foreign bank branches

5.77 The amendments made by this bill to Division 170, and to the transitional provisions in Schedule 3 to the May Consolidation Act, apply to deduction or application years ending after 1 July 2002. [Schedule 12, items 12, 22, 25 and 28]

5.78 The 2 amendments to the transitional provisions in Schedule 3 to the May Consolidation Act are:

in transferring losses under Division 170 from the head company of a consolidated group to a foreign bank branch, the head company must transfer its concessional losses after its group losses but before its other Subdivision 707-A transferred losses [Schedule 12, item 24, section 170-55 and item 27, section 170-155] ; and
in transferring losses under Division 170 from a foreign bank branch to the head company of a consolidated group, the maximum amount that can be transferred is set by reference to an available fraction worked out without regard to the value donor transitional concession [Schedule 12, item 24, section 170-45 and item 27, section 170-145] .

Consequential amendments

5.79 Minor consequential amendments have been made to certain headings and notes in Division 170 to reflect the introduction of the consolidation regime and the fact that Division 170 now only applies to loss transfers involving an Australian branch of a foreign bank. [Schedule 12, items 2, 3, 5, 6, 7, 8, 14, 15, 17, 18 and 26]

Chapter 6 - Consolidation and thin capitalisation

Outline of chapter

6.1 This chapter explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997. With the consolidation regime largely replacing all existing grouping provisions in the ITAA 1936 and ITAA 1997, including Subdivision 820-F of the thin capitalisation provisions, the amendments ensure that the thin capitalisation regime continues to operate as intended. Legislative references are to the ITAA 1997 unless otherwise stated.

6.2 This chapter also explains that, with some important exceptions, the existing grouping provisions in Subdivision 820-F will continue to operate until the end of the 2002-2003 income year for entities that consolidate. Where entities do not consolidate the existing grouping rules will cease to operate from 1 July 2003.

Context of reform

6.3 Division 820 introduced a new thin capitalisation regime consistent with recommendations of A Tax System Redesigned. The objective of the regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. Following the introduction of the consolidation regime, a number of amendments are required to ensure that the thin capitalisation rules continue to operate as intended for a consolidated or MEC group and to phase out the existing grouping rules in the thin capitalisation regime.

Summary of new law

6.4 The main features outlined in this chapter are:

How the thin capitalisation rules apply to consolidated groups and MEC groups.

The nature of the members that comprise the consolidated group or MEC group will determine which thin capitalisation rules will apply to the head company of the group for the relevant period. More than one set of rules may apply to the head company in any given income year.

There are also rules showing how to calculate the equity capital of a group where that is necessary.

How the rules apply to include a foreign bank branch as part of the head company or a single resident company for thin capitalisation purposes. The rules set out the circumstances in which a foreign bank branch can be included as part of the consolidated group or single resident company for thin capitalisation purposes. It also sets out how assets and liabilities of the branch are taken into account when applying the thin capitalisation rules and how any debt deduction disallowed is to be apportioned.
Comparison of key features of new law and current law
New law Current law

The provisions determine which thin capitalisation rules will apply to the head company of a consolidated group or MEC group which is a single taxpayer.

The provisions also permit a foreign bank branch to be included as part of a head company or single resident company for thin capitalisation purposes and in these cases the rules largely mirror those in the existing law.

Subdivision 820-F sets out the conditions that must be met before entities can form a resident TC group for thin capitalisation purposes. The resident TC group is a notional group formed for the purpose of determining the maximum allowable debt deduction of the group as if it were a single entity with the combined characteristics of its individual members. Any debt deduction denied is apportioned between the entities that comprise the group.
Entities that comprise the consolidated group or MEC group are determined by the consolidation regime. This can change from period to period within an income year. The formation of a resident TC group is based on entities having the same income year end.

Detailed explanation of new law

6.5 The introduction of the consolidation regime means that all other grouping provisions within the ITAA 1936 and ITAA 1997 will be largely repealed or phased out. Entities will generally have to form a consolidated group or MEC group in order to access benefits that were previously available under the various grouping provisions.

6.6 Thin capitalisation, however, contains an exception to this in that it will allow an Australian branch of a foreign bank to be part of a groups head company or part of a single resident company for the purpose of determining their thin capitalisation position.

6.7 This chapter describes:

the application of the thin capitalisation rules to a head company of a consolidated group or MEC group (see paragraphs 6.9 to 6.33) [Schedule 13, item 3, section 820-579] ;
the application of the thin capitalisation rules where a foreign bank branch becomes part of the head company or a single resident company (see paragraphs 6.34 to 6.66) [Schedule 13, item 3, section 820-595] ; and
when the resident TC grouping rules cease to operate (see paragraphs 6.67 to 6.85) [Schedule 13, item 2, sections 820-455 to 820-458].

6.8 The thin capitalisation rules will generally apply to the head company of a consolidated group or MEC group or to a single company as a consequence of the head company or single company being classified as either:

an outward investing entity (non-ADI);
an inward investing entity (non-ADI);
an outward investing entity (ADI); or
an inward investing entity (ADI).

When do the thin capitalisation rules apply to consolidated groups and MEC groups?

6.9 The thin capitalisation rules will apply to any head company that is classified according to the preceding paragraph where that head company does not meet the requirements of either the limit for debt deductions or the Australian assets threshold test. These de minimis tests are set out in sections 820-35 and 820-37, respectively.

6.10 The rules will also apply to consolidated groups or to MEC groups that have either commenced or ceased their existence during the income year. The determination of the thin capitalisation position of the head company for the income year needs to take account of such changes in relationships among entities to be equitable. In these cases, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following parts of the income year (e.g. if the classification described in paragraph 6.8 changes during the year):

a period throughout which a company is the head company of that group;
a period throughout which that company is the head company of a different consolidated group or MEC group; or
a period throughout which that company is not a member of any consolidated group or MEC group.

[Schedule 13, item 3, section 820-581]

Example 6.1 Austco Ltd is not a member of a consolidated group for the first 6 months of an income year, but then becomes the head company of a consolidated group which continues in existence for the rest of the income year.For those first 6 months Austco is an outward investor (general) under section 820-85. For the rest of the income year Austco is an outward investor (general) under subsection 820-583(2).This section ensures that section 820-120 (about part-year periods) applies to Austco instead of section 820-85, so that Subdivision 820-B has 2 separate applications to Austco: one for the first 6 months and the other for the rest of the income year. Under the second application, account is taken of the subsidiary members that are taken to be part of Austco as head company of the consolidated group.

When do the outward investing entity (non-ADI) rules apply to a head company?

6.11 The head company of a consolidated group or MEC group is an outward investing entity (non-ADI) for a period that is all or part of an income year if it is either:

an outward investor (general) for that period; or
an outward investor (financial) for that period.

[Schedule 13, item 3, subsection 820-583(1)]

When is a head company an outward investor (general)?

6.12 The head company is an outward investor (general) if it would be classified as such for a period that is all or part of an income year. This occurs where the head company meets the requirements of being an outward investing entity set out in Subdivision 820-B and no other member of its group is a financial entity or an ADI during that period [Schedule 13, item 3, subsection 820-583(2)] . This is the case even if a member within the group is a foreign-controlled Australian entity, because the thin capitalisation rules for outward investing entities take priority over the thin capitalisation rules for inward investing entities. The head company will be an outward investing entity if it is so in its own right or if because of the single entity rule it is so because one of the subsidiary members of the group is.

6.13 Being an outward investor (general) means that the head company would apply the rules set out in Subdivision 820-B to determine its thin capitalisation position. It should be noted that section 820-100 would not apply to the head company in this instance as that section only applies to outward investing entities that are financial entities.

When is a head company an outward investor (financial)?

6.14 The head company is an outward investor (financial), for a period that is all or part of an income year, if:

it meets the requirements for an outward investing entity set out in Subdivision 820-B for that period;
throughout the period, there is at least one member of the group that is a financial entity; and
no member of the group is an ADI during that period.

[Schedule 13, item 3, subsection 820-583(3)]

6.15 Being an outward investor (financial) means that the head company would apply the rules set out in Subdivision 820-B to determine its thin capitalisation position. It should be noted that section 820-95 would not apply to the head company in this instance as that section only applies where the taxpayer is treated as outward investor (general).

6.16 For the head company, as an outward investor (financial), this also means that the special rules about on-lent amounts and zero-capital amounts would apply to all such assets held by the group, whether held legally by the actual financial entities in the group or by other group entities.

What if the consolidated group or MEC group includes an ADI?

6.17 Subdivision 820-B does not apply to a head company that would otherwise be an outward investor (non-ADI) for a period if one of the group members is an ADI for that period. In this instance, the head company would be treated as an outward investing entity (ADI) for that period (see paragraph 6.24).

When do the inward investing entity (non-ADI) rules apply to a head company?

6.18 The head company of a consolidated group or MEC group is an inward investing entity (non-ADI) for a period that is all or part of an income year if it is either:

an inward investment vehicle (general) for that period; or
an inward investment vehicle (financial) for that period.

[Schedule 13, item 3, subsection 820-583(4)]

When is a head company an inward investment vehicle (general)?

6.19 The head company is an inward investment vehicle (general), for a period that is all or part of an income year if:

it is a foreign-controlled Australian entity for that period; and
provided no other member of the group is a financial entity or an ADI at any time during that period.

This classification only holds where the head company could not be classified as an outward investing entity (non-ADI) during that period. [Schedule 13, item 3, subsection 820-583(5)]

6.20 Being an inward investment vehicle (general) means that the head company would apply the rules set out in Subdivision 820-C to determine its thin capitalisation position. It should be noted that section 820-200 would not apply to the head company in this instance as that section only applies to inward investment vehicles that are financial entities. Sections 820-205 and 820-210 also do not apply as those sections apply to foreign entities only.

When is a head company an inward investment vehicle (financial)?

6.21 The head company is an inward investment vehicle (financial) for a period that is all or part of an income year if:

it is a foreign-controlled Australian entity for that period;
at least one member of that group is a financial entity throughout the period; and
no other member of the group is an ADI during that period.

This classification only holds where the head company could not be classified as an outward investing entity (non-ADI) during that period. [Schedule 13, item 3, subsection 820-583(6)]

6.22 Where the head company is an inward investment vehicle (financial) the special rules about on-lent amounts and zero-capital amounts would apply to all such assets held by the group, whether held legally by the actual financial entities in the group or by other group entities.

What if the consolidated group or MEC group includes an ADI?

6.23 Subdivision 820-C does not apply to a head company that would otherwise be an inward investor (non-ADI) for a period if one of its members is an ADI for that period. In this instance, the head company would be treated as an ADI for that period and apply the relevant rules accordingly.

When do the outward investing entity (ADI) rules apply to a head company?

6.24 The head company of a consolidated group or MEC group is an outward investing entity (ADI) for a period that is all or part of an income year if either:

one member of the group is an outward investing entity (ADI) for that period; or
the group includes at least one outward investing entity (non-ADI) and another entity that is an ADI, for that period.

[Schedule 13, item 3, subsection 820-583(7)]

6.25 Being an outward investing entity (ADI) means that the head company would apply the rules set out in Subdivision 820-D to determine its thin capitalisation position.

6.26 If, however, the head company of a MEC group is not an outward investing entity (ADI) for the period, but the group includes at least one foreign-controlled Australian ADI and another member that is not a wholly-owned subsidiary of a foreign-controlled Australian ADI, then Subdivision 820-D will also apply to that group as if it were an outward investing entity (ADI) [Schedule 13, item 3, section 820-587] . An example of this would be a MEC group where a foreign bank has 2 wholly-owned Australian subsidiaries, one being a bank and the other not a bank, where the latter is not owned by the Australian bank and so does not come under APRA supervision.

6.27 As stated previously, the outward investing ADI rules apply to a consolidated group or MEC group where the head entity is an outward investing (ADI). However, a MEC group may include entities that are not supervised by APRA. To account for these cases, the outward investing ADI rules are modified to include in the definition of adjusted average equity capital the following item:

the (consolidated) paid-up share capital (other than debt interests), capital of other entities (other than debt interests), retained earnings, interest-free debt and general reserves of the entities that are not supervised by APRA.

This is then combined with the total value of the tier 1 capital (net of any debt capital that is part of that tier 1 capital) for entities in the group that are ADIs or wholly-owned subsidiaries of an ADI. This is the adjusted average equity capital for the MEC group. Where a consolidated group or MEC group consists solely of entities that are ADIs or wholly-owned subsidiaries of an ADI then the calculation of the adjusted average equity capital is based solely on the total value of tier 1 capital (net of debt capital that is part of that tier 1 capital). [Schedule 13, item 3, section 820-589] .

6.28 The information used by the head company in determining the value of adjusted average equity capital for the group is that which would be contained in a set of consolidated accounts prepared in accordance with accounting standards at the measurement time. [Schedule 13, item 3, subsection 820-589(3)]

6.29 For the purposes of determining the safe-harbour capital amount of the head company of a consolidated group or MEC group special rules apply where an ADI subsidiary of that group has issued debentures under section 128F. This occurs where the ADI subsidiary has on-lent the debentures to an Australian permanent establishment of the foreign bank that is not part of the same consolidated group or MEC group because of a choice made under Subdivision 820-FB [Schedule 13, item 3, subsection 820-591(1)] . For these cases, in determining the safe-harbour capital amount for the consolidated group or MEC group which includes the ADI subsidiary, the rule adjusts the risk-weighted assets of the group by not including any amount for the section 128F funds on-lent to the permanent establishment [Schedule 13, item 3, subsection 820-591(2)] . The rationale for the rule is to ensure that the same pool of section 128F funds is not counted twice for thin capitalisation purposes.

6.30 This rule may also have effect where the head company has included an Australian permanent establishment as part of its group in accordance with a choice made under section 820-597. This will occur where the debenture funds are lent to a permanent establishment of a group foreign bank that is not covered by the choice in section 820-597. [Schedule 13, item 3, subsection 820-591(3)]

6.31 The rule applies for 4 years to allow time for foreign banks to refinance their section 128F programs by issuing the debentures through their Australian branches [Schedule 13, item 3, subsection 820-591(4)] . The section will cease to have effect from the 2006-2007 income year of the head company.

When are the thin capitalisation rules not applied to the head company of a consolidated group?

6.32 In addition to de minimis cases, the thin capitalisation rules will not operate to disallow a debt deduction where the head company of the consolidated group, in its own right, is either:

a foreign-controlled Australian bank that does not qualify as an outward investing entity (ADI); or
a foreign-controlled Australian company which, if it were not for the consolidation rules, has an Australian bank as its only asset and has no debt capital (i.e. it is a pure bank holding company).

[Schedule 13, item 3, section 820-585]

6.33 The thin capitalisation rules do not apply in these situations because the capital adequacy requirements of APRA are considered sufficient for tax purposes.

Is a foreign bank branch able to be grouped with a head company or single Australian resident company for thin capitalisation purposes?

6.34 For thin capitalisation purposes, provided certain conditions are met a choice can be made so that the Australian bank branches of foreign banks (foreign bank branches) are able to be treated as part of either the head company of a consolidated group or MEC group or part of a single Australian resident company. This allows these branches to be grouped with subsidiaries of the foreign bank when determining the thin capitalisation positions of both the branches and the subsidiaries. The conditions to be met and how the thin capitalisation rules then apply in these cases are contained in Subdivision 820-FB.

When is a foreign bank branch able to be treated as part of a head company of a consolidated group or MEC group?

6.35 It is the head company that is able to make a choice to treat the foreign bank branch as part of itself for thin capitalisation purposes. It may do this for a period (called the grouping period) in which the foreign bank and the head company are members of the same wholly-owned group and in which the foreign bank carries on banking business in Australia through at least one Australian permanent establishment. It can make this choice provided certain other conditions are met.

6.36 The necessary conditions are that:

the grouping period began on or after 1 July 2002;
the period was all or part of an income year of the head company; and
the consolidation or MEC group was in existence throughout the period.

[Schedule 13, item 3, subsections 820-597(1) and (2)]

6.37 The grouping period where the foreign bank branch in Australia is considered to be part of the head company may be either all or part of the relevant income year of the head company. However, the head company is unable to choose a shorter grouping period in instances where the necessary conditions are met for longer periods during the head companys income year. [Schedule 13, item 3, subsection 820-597(3)]

6.38 In determining these periods it is not necessary that the head company and the foreign bank have income years that end on the same day. Where income years overlap it is necessary for separate calculations to be performed for each period that relates to different income years for the respective taxpayers. For example, if the head company has a standard income year but the foreign bank has an end-December SAP, separate calculations will have to be made for each half of each calendar year. [Schedule 13, item 3, section 820-607]

When is a foreign bank branch able to be treated as part of a single Australian resident company?

6.39 An Australian resident company is able to make a choice to treat the foreign bank branch as part of itself for thin capitalisation purposes in similar circumstances to a head company. The same requirements as for a head company must be met but in addition the resident company cannot be a dual resident company and it cannot be a member of a consolidatable group or of a potential MEC group. [Schedule 13, item 3, subsections 820-599(1) and (2)]

6.40 The extent of the grouping period is governed by similar rules as for head companies and in like fashion the income years of the single resident company and the foreign bank do not have to be the same. [Schedule 13, item 3, subsection 820-599(3) and section 820-607]

Is the choice made by the head company or single company binding?

6.41 Where either the head company of a consolidated or MEC group or the single company choose to treat the foreign bank branch as part of itself for thin capitalisation purposes then that decision binds both the taxpayer making the choice and the foreign bank for the grouping period in relation to that income year. The decision made to include the foreign bank branch cannot be revoked in relation to that period [Schedule 13, item 3, subsection 820-603(1)] . However, because the choice is only made for the income year (or part of it that is the grouping period), a new choice may be made each income year.

6.42 Where a choice is made to include the foreign bank branch as part of the head company or single company then it is the rules in Subdivision 820-FB that will be applicable. [Schedule 13, item 3, section 820-601]

What is the effect of a foreign bank branch being treated as part of a head company or single Australian resident company?

6.43 Where a foreign bank branch is treated as part of a head company or single Australian resident company for the grouping period, then for that period, and each test time in that period, it is not considered to be part of the foreign bank. For that period it is considered to be part of the head companys consolidated group or MEC group or part of a consolidated group which encompasses the single resident company and the foreign bank branch only. [Schedule 13, item 3, subsections 820-603(2) to (4)]

6.44 Where these requirements are met, the head company or single company is treated as if it had incurred all the debt deductions for that period, including those costs actually incurred by the foreign bank branch. [Schedule 13, item 3, subsection 820-603(7)]

6.45 The inclusion of the foreign bank branch as part of a head company or single resident company does not affect the requirements set out in Subdivision 820-L for the foreign bank to keep records in relation to its Australian permanent establishment(s). [Schedule 13, item 3, subsections 820-603(3) to (5)]

6.46 However, while not limiting what was stated in paragraphs 6.43 and 6.44, but for the purpose of disallowing any debt deduction under section 820-605, the foreign bank branch is also considered to be an entity for the purposes of applying the thin capitalisation rules. Therefore, each asset and liability of the foreign bank that is attributable to the foreign bank branch is considered to be an asset or liability of the foreign bank branch at the test time. They are not considered to be assets and liabilities of the foreign bank. Similarly, debt deductions incurred by the foreign bank that are attributable to the foreign bank branch are considered to be debt deductions of the foreign bank branch. [Schedule 13, item 3, subsection 820-603(5)]

What is the classification of a head company or single company when a foreign bank branch is included?

6.47 The appropriate thin capitalisation rules to apply to the head company or single resident company depend upon what classification is given to the head company or single company as a result of rules set out in Subdivision 820-FB. [Schedule 13, item 3, subsection 820-603(6)]

6.48 With one exception, where a head company or single company makes the choice to include the foreign bank branch as part of itself, the head company or single company will be classified as an outward investing entity (ADI). This includes a head company or single ADI that, prior to the inclusion of the foreign bank branch, would have been excluded from applying the thin capitalisation because it was considered that the capital adequacy rules of APRA were sufficient for tax purposes (see paragraphs 6.32 and 6.33). Also covered by this classification are head companies of MEC groups to which section 820-587 would have applied if not for the inclusion of the foreign bank branch (see paragraph 6.26). [Schedule 13, item 3, subsections 820-609(1) and (2)]

6.49 The one exception is where the head company or single company would have been either an inward investment vehicle (general) or inward investment vehicle (financial). In this instance, the inclusion of a foreign bank branch as part of the head company or single company will result in that company being classified as an inward investing entity (ADI) for the test period. [Schedule 13, item 3, subsections 820-609(1) and (3)]

6.50 Classification of the head company or single resident company as a result of section 820-609 takes precedence over any other classification resulting from this Division. [Schedule 13, item 3, subsection 820-609(4)]

What rules apply if the head company or single resident company is treated as an outward investing entity (ADI)?

6.51 Being classified as an outward investing entity (ADI) means that the head company or single resident company would apply the rules set out in Subdivision 820-D to determine its thin capitalisation position.

6.52 When a head company or single company makes the choice to include the foreign bank branch the definition of adjusted average equity capital (see paragraphs 6.27 and 6.28) set out in subsection 820-589(3) is adjusted further to include:

the equity capital of the foreign bank attributable to its Australian branch (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

Note that for a foreign bank branch it is paragraph 820-613(3)(c) that includes the amounts in the calculation of adjusted average equity capital. Amounts attributable to the foreign bank branch are not to be included as a result of either paragraph 820-613(3)(a) or (b).

[Schedule 13, item 3, subsections 820-613(1) to (3)]

6.53 The risk-weighted assets of the head company or single company also need to be modified to include the risk-weighted assets of the foreign bank that are attributable to its Australian branch (but not allocated to offshore banking activities of the foreign bank). [Schedule 13, item 3, subsection 820-613(4)]

What rules apply if the head company or single resident company is treated as an inward investing entity (ADI)?

6.54 Where the inclusion of the foreign bank branch results in the head company or single company being treated as an inward investing entity (ADI), then that head company or single resident company will apply the rules in Subdivision 820-E as if it were an inward investing entity (ADI) for the test period. [Schedule 13, item 3, subsection 820-615(1)]

6.55 The calculation of theaverage equity capital will now include the consolidated paid-up share capital (less amounts that are debt interests), capital of other entities (other than debt interests), retained earnings, general reserves and asset revaluation reserves of each member of the head companys group or of the single company itself. It will also include the equity capital of the foreign bank branch which is included as part of the head company or single resident company. [Schedule 13, item 3, subsection 820-615(2)]

6.56 The safe-harbour capital amount of the head company or single resident company for the grouping period is calculated by determining the risk-weighted assets of the head company or single resident company. For the foreign bank branch these are the risk-weighted assets attributable to the foreign bank branch (not including risk-weighted assets attributable to offshore banking activities) [Schedule 13, item 3, subsection 820-615(4)] . The total of the risk-weighted assets of the group formed by the choice is multiplied by 4% to determine the safe-harbour capital amount [Schedule 13, item 3, subsection 820-615(3)] .

6.57 Where a choice has been made to include a foreign bank branch as part of a single company, then for the purposes of determining the safe-harbour capital amount of that single company special rules may apply where it has issued debentures under section 128F. This occurs where the single company, being a wholly-owned subsidiary of a foreign bank and an ADI, has on-lent the debenture funds to an Australian permanent establishment of another foreign bank in the same wholly-owned group. Furthermore, that permanent establishment cannot be part of the single company because of a choice made under Subdivision 820-FB [Schedule 13, item 3, subsection 820-617(1)] . For these cases, the rule adjusts the risk-weighted assets of the single company by not including anything for the section 128F funds on-lent to the permanent establishment [Schedule 13, item 3, subsection 820-617(2)] . The rationale for the rule is to ensure that the same pool of section 128F funds is not counted twice for thin capitalisation purposes.

6.58 As was the case for the head company of a consolidation group or MEC group, this rule applies for 4 years to allow time for foreign banks to refinance their section 128F programs by issuing the debentures through their Australian branches [Schedule 13, item 3, subsection 820-617(3)] . The section will cease to have effect from the 2006-2007 income year of the single resident company.

What happens if the test period overlaps the grouping period applicable to foreign bank branches?

6.59 For an income year, when applying the thin capitalisation rules either the head company/single resident company or the foreign bank, as separate taxpayers, may have a test period that overlaps with the grouping period relevant to the head company/single resident company and the foreign bank branch. Where this occurs separate applications of the thin capitalisation rules are required for the relevant entity in respect of the following periods during that income year:

the period of the overlap;
the part (if any) of the test period for that entity that is before the overlap period; and
the part (if any) of the test period for that entity that is after the overlap period.

[Schedule 13, item 3, section 820-607]

Example 6.2 Austcos income year ends on 30 June 2003. Forbanks income year ends on 30 September 2003. Both Austco and Forbank are subject to the thin capitalisation rules for the 2002-2003 income year. From 1 July 2002, Austco treats the Australian bank branch of Forbank as part of its consolidated group for thin capitalisation purposes.The grouping period is Austcos income year being 1 July 2002 to 30 June 2003. Separate thin capitalisation calculations are necessary for the following periods as a result of the overlapping income years:

1 July 2002 to 30 September 2002;
1 October 2002 to 30 June 2003; and
1 July 2003 to 30 September 2003.

The first two calculations combined determine any disallowed deductions for Austco for the 2002-2003 income year, while the second two calculations do the same for Forbank.

How are the calculations done for the purposes of Subdivision 820-FB?

What is the value of the head companys or single resident companys assets and liabilities?

6.60 The value of the assets and liabilities to be used by the head company or single resident company when determining the value of a particular matter, at a particular time, for thin capitalisation purposes is to be calculated as if either:

the head company of the consolidated group or MEC group and the foreign bank branch; or
the single resident company together with the foreign bank branch,

were a single entity. This means that all intra-group transactions and balances are ignored.

6.61 The information to be used is that which would be contained in a set of consolidated accounts prepared in accordance with the accounting standards at the measurement time. [Schedule 13, item 3, paragraph 820-611(1)(a)]

6.62 The information required is only in relation to those entities that are considered to be part of either the head company or the single resident company at that measurement time (and so include the permanent establishments of the foreign bank). [Schedule 13, item 3, paragraph 820-611(1)(b)]

6.63 This information is also to be used for the purposes of determining the value of any matter mentioned in sections 820-613 to 820-617. [Schedule 13, item 3, subsection 820-611(2)]

How is a debt deduction disallowed to the foreign bank where its bank branch is part of the head company or single resident company?

6.64 Because a foreign bank branch is considered to be part of the head company or single company where the choice is made in accordance with Subdivision 820-FB, any disallowance is only in relation to debt deductions that are external to the head company or single resident company combined with the branch. This calculation does not affect any debt deduction claimed by either the foreign bank or the head company/single resident company to the extent that it was incurred or owed to the other, if the expense/cost was incurred during the grouping period. [Schedule 13, item 3, Notes 1 and 2 to section 820-605]

6.65 Any debt deduction partly or wholly disallowed to the head company or single resident company because of Subdivision 820-FB and Division 820, that would otherwise be a debt deduction of the foreign bank, is disallowed to the foreign bank to the same extent [Schedule 13, item 3, section 820-605] . The proportion of the debt deductions of the foreign bank which remain external to the head company or single resident company that are disallowed (if any) is the proportion calculated under Subdivision 820-D or 820-E, as appropriate. For example where a head company is classified as an outward investing entity (ADI) as a result of a choice under section 820-597, the fraction (capital shortfall/average debt) in section 820-325 would be the relevant proportion for the head company and for the foreign bank in relation to the external debt deductions of each.

6.66 It should be noted that if a debt deduction is disallowed to the foreign bank, what are otherwise the debt deductions of the head company or single company are not affected solely because of that. For example, if the foreign bank is denied debt deductions but all the head companys interest expenses are paid to the foreign banks branches, the head company would not be denied any deductions. If some or all of a debt deduction is to be denied it is denied to the entity which has incurred the cost and not to both entities. Nevertheless, because Division 820 disallows all debt deductions equally, in this situation the actual (external) debt costs of the head company/single company would be denied to the same extent.

Example 6.3

Diagram of an example of thin capitalisation

Head company, Austbank, has included AustPE as part of itself for thin capitalisation purposes. Assume a $10 million capital shortfall and average group debt of $100 million.The $6 million intra-group debt deductions are ignored for thin capitalisation purposes.The disallowance to both Austbank, as head company of the consolidated group, and to Forbank is based on what would have been disallowed to the group. That is:

Austbanks debt deductions disallowed are:

-
$8 million $10 million / $100 million = $800,000; and

Forbanks debt deductions disallowed are:

-
$2 million $10 million / $100 million = $200,000.

Removal of thin capitalisation grouping

6.67 With some important exceptions, the resident TC grouping rules in Subdivision 820-F will cease to operate from the time a group consolidates. Once a group consolidates, the thin capitalisation rules will apply to the head company of the consolidated group or MEC group.

Example 6.4 Entities with a SAP ending 31 December 2003 consolidate on 1 January 2004. The top entity can make the choice to form a resident TC group for the period 1 January 2003 to 31 December 2003. From 1 January 2004 to 31 December 2004 the TC rules will apply to the head company of the consolidated group or MEC group.

Cut-off day

6.68 The day on which the existing TC grouping rules will generally cease to operate is known as the cut-off day . The cut-off day will be the consolidation day (when the group is first formed) or 1 July 2003 depending on when, and if, members of the group form a consolidated group or MEC group. It is the cut-off day that is used as the basis for determining whether or not the top entity can continue to apply the TC grouping rules. Generally, the option to apply the TC grouping rules is not available beyond the cut-off day. The top entitys ability to choose to form a resident TC group is not affected at all if the income year ends before the cut-off day. [Schedule 13, item 2, paragraph 820-455(1)(b)]

6.69 The cut-off day is the consolidation day if:

the first day on which at least one of the potential TC group members becomes a member of a consolidated group or MEC group occurs on or before 1 July 2003; or
the consolidation day is before 1 July 2004 and that day is the first day of the first income year starting after 30 June 2003 for the head company of the consolidated group or MEC group.

For all other cases the cut-off day will be 1 July 2003.

[Schedule 13, item 2, subsection 820-455(1)]

6.70 If all entities in the potential resident TC group become part of a consolidated group or MEC group on the cut-off day, then a choice is no longer available for the top entity to form a resident TC group past that day.

6.71 The top entity cannot make a choice to use the TC grouping rules in an income year if:

the cut-off day is before 1 July 2003 and the income year starts on or after 1 July 2003; or
the cut off day is on or after 1 July 2003 and the income year starts on or after the cut-off day.

[Schedule 13, item 2, subsection 820-455(2)]

Where top entity may choose to form a resident TC group

The income year starts on or after a pre-1 July 2003 cut-off day but before 1 July 2003

6.72 If the cut-off day is before 1 July 2003 and the income year starts on or after the cut-off day but before 1 July 2003, the top entity may make a choice to use the TC grouping rules for those potential group members of the resident TC group that have not become members of any consolidated group or MEC group. The resident TC group cannot include any members of a consolidated or MEC group. The top entity is only able to make this choice for the period from the start of the income year until 30 June 2003. This will be treated as being the end of the income year for TC grouping purposes. Note that this section could apply to cases to which section 820-457 also applies (where the cut-off day occurs during an income year ending before 1 July 2003) in relation to the following income year. [Schedule 13, item 2, subsections 820-456(1) and (2)]

6.73For the potential group members that continue to use the resident TC grouping rules, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following periods:

the period from the start of the income year to 30 June 2003; and
the rest (if any) of the income year.

[Schedule 13, item 2, subsection 820-456(3)]

6.74 These periods reflect the fact that resident TC grouping in these circumstances is only available until 30 June 2003.

Example 6.5 Entities with income years ending on 30 September 2003 choose not to consolidate on 1 October 2003. The cut-off day is 1 July 2003. For the period 1 October 2002 until 30 June 2003, the top entity can make the choice to form a resident TC group for thin capitalisation purposes. From 1 July 2003 until 30 September 2003 the thin capitalisation rules will apply separately to each entity that was previously part of the resident TC group.

The income year includes but does not start on the cut-off day

6.75 The top entity may also continue to use the TC grouping rules where the income year includes but does not start on a cut-off day that is on or before 1 July 2003. (A cut-off day cannot be after 1 July 2003 unless it is the start of an income year.) In this situation the income year end is considered to be immediately before the cut-off day for the purposes of the TC grouping rules. [Schedule 13, item 2, subsections 820-457(1) and (2)]

6.76 This permits the TC grouping rules to continue to work as intended given the composition of the resident TC group is determined at the end of an income year. That is, the resident TC group would now be determined immediately before the cut-off day.

Example 6.6 Entities with an income year ending 30 June consolidate on 1 May 2003. From 1 July 2002 until 30 April 2003 the top entity can make the choice to group for TC purposes those entities that qualify on 30 April 2003. From 1 May 2003 until 30 June 2003 the TC rules apply to the head company of the consolidated group.

6.77 Where the cut-off day is before 1 July 2003 the top entity may continue to choose to group for TC purposes from the cut-off day until:

30 June 2003; or
the day when the income year would otherwise have ended, whichever is the earlier.

This applies only to the potential group members of the resident TC group that do not become members of any consolidated group or MEC group. [Schedule 13, item 2, subsection 820-457(3)]

6.78 For each of those potential group members of a resident TC group, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following periods:

the period from the beginning of the income year to immediately before the cut-off day; and
if the cut-off day is before 1 July 2003:

-
the period from the cut-off day to 30 June 2003; and separately
-
the rest (if any) of the income year; or

if the cut-off day is 1 July 2003 - the period from the cut-off day to the end of the income year.

[Schedule 13, item 2, subsection 820-457(4)]

Limitations on foreign bank including its permanent establishment in the resident TC group

6.79 Currently, the inclusion of the foreign bank branch as part of the resident TC group is based on a choice being made by the foreign bank. With the introduction of the consolidation regime, it is necessary to ensure that the continued availability of this choice for the foreign bank is the same as that which will apply for the top entity.

6.80 The foreign bank is, therefore, prevented from making a choice to include the foreign bank branch as part of a resident TC group in circumstances where the top entity would also have been prevented from making a choice if the foreign bank branch were considered to be a potential group member of the resident TC group. That is, if it was the top entity, rather the foreign bank, which had to make the choice under Subdivision 820-F to include the foreign bank branch as part of the resident TC group, would it be permitted to do so given the limitation imposed by subsection 820-455(2)? If the answer is no, then the foreign bank is also prevented from making a choice to include the foreign bank branch in a resident TC group. The cut-off day in subsection 820-455(1) could be determined by a choice made under Subdivision 820-FB because for the relevant grouping period the bank branch is considered to be part of a consolidated group.

6.81 In these circumstances a choice by the top entity, and therefore the foreign bank, could not be made to form a resident TC group that included the foreign bank branch if:

the relevant cut-off day is on or after 1 July 2003, and the income year starts on or after the cut-off day; or
the income year starts on or after 1 July 2003 where the cut-off day is before 1 July 2003.

[Schedule 13, item 2, subsection 820-458(1)]

6.82 Where, however, a choice to form a resident TC group is able to be made by the top entity and the foreign bank, then each Australian permanent establishment for which a choice has been made is treated as if it had been a member of the resident TC group. [Schedule 13, item 2, subsection 820-458(2)]

What if entities do not consolidate?

6.83 Where wholly-owned entities do not consolidate before 1 July 2004, the cut-off day is 1 July 2003. [Schedule 13, item 2, subsection 820-455(1), item 3 in the table]

6.84 The top entity may choose to group for thin capitalisation purposes from the beginning of the income year up until 30 June 2003. The thin capitalisation rules will apply to each entity individually from 1 July 2003 as the top entity is unable to make a choice to form a resident TC group for income years that commence on or after 1 July 2003.

6.85 Table 6.1 illustrates the operation of sections 820-455 to 820-457 for companies with different income year ends depending on if and from when they choose to consolidate. It ignores the existence of any potential resident TC group members which do not become members of a consolidated group or MEC group before 1 July 2003 when other potential members do (see paragraphs 6.72 to 6.78).

Table 6.1: Operation of cut-off rules
Consolidation day Cut-off day Item in table in 455(1) Cant form TC group in: What provision? Can form TC group in:
June balancer
1.7.2002 1.7.2002 1 2002-2003 and later IYs 456(2) and 455(2)(a) 2001-2002
2.7.2002 to 30.6.2003 Consolidation day 1 From consolidation day in 2002-2003 and later IYs 457(2) and (3), 455(2)(a) 2001-2002 and up to consolidation day in 2002-2003
1.7.2003 1.7.2003 1 or 2 2003-2004 and later IYs 455(2)(b) 2001-2002 and 2002-2003
After 1.7.2003 1.7.2003 3 2003-2004 and later IYs 455(2)(b) 2001-2002 and 2002-2003
Doesnt consolidate 1.7.2003 3 2003-2004 and later IYs 455(2)(b) 2001-2002 and 2002-2003
Early December balancer
1.7.2002 to 31.12.2002 Consolidation day 1 From consolidation day in 2002-2003 and later IYs 457(2) and (3), 456(2), 455(2)(a) Up to consolidation day in 2002-2003
1.1.2003 1.1.2003 1 2003-2004 and later IYs 456(2), 455(2)(a) 2002-2003
2.1.2003 to 30.6.2003 Consolidation day 1 From consolidation day in 2003-2004 and later IYs 457(2) and (3), 455(2)(a) 2002-2003 and up to consolidation day in 2003-2004
1.7.2003 to 31.12.2003 1.7.2003 1 or 3 From 1.7.2003 in 2003-2004 and later IYs 457(2), 455(2)(b) 2002-2003 and up to 30.6.2003 in 2003-2004
1.1.2004 1.1.2004 2 2004-2005 and later IYs 455(2)(b) 2002-2003 and 2003-2004
After 1.1.2004 1.7.2003 3 From 1.7.2003 in 2003-2004 and later IYs 457(2), 455(2)(b) 2002-2003 and up to 30.6.2003 in 2003-2004
Doesnt consolidate 1.7.2003 3 From 1.7.2003 in 2003-2004 and later IYs 457(2), 455(2)(b) 2002-2003 and up to 30.6.2003 in 2003-2004
Late September balancer
1.7.02 to 30.9.02 Consolidation day 1 From consolidation day in 2001-2002 and later IYs 457(2) and (3), 456(2), 455(2)(a) Up to consolidation day in 2001-2002
1.10.02 1.10.2002 1 2002-2003 and later IYs 456(2), 455(2)(a) 2001-2002
2.10.02 to 30.6.03 Consolidation day 1 From consolidation day in 2002-2003 and later IYs 457(2) and (3), 455(2)(a) 2001-2002 and up to consolidation day in 2002-2003
1.7.03 to 30.9.03 1.7.2003 1 or 3 From 1.7.2003 in 2002-2003 and later IYs 457(2), 455(2)(b) 2001-2002 and up to 30.6.2003 in 2002-2003
1.10.03 1.10.2003 2 2003-2004 and later IYs 455(2)(b) 2001-2002 and 2002-2003
After 1.10.03 1.7.2003 3 From 1.7.2003 in 2002-2003 and later IYs 457(2), 455(2)(b) 2001-2002 and up to 30.6.2003 in 2002-2003
Doesnt consolidate 1.7.2003 3 From 1.7.2003 in 2002-2003 and later IYs 457(2), 455(2)(b) 2001-2002 and up to 30.6.2003 in 2002-2003

Application and transitional provisions

6.86 In subsection 820-10(1) of the IT(TP) Act 1997 the reference to subsection (2) has been replaced with the words this section as a result of the introduction of a new subsection (1A) dealing with the application of Subdivisions 820-FA and 820-FB. [Schedule 13, item 15, subsection 820-10(1) of the IT(TP) Act 1997]

6.87 Subdivisions 820-FA and 820-FB of the ITAA 1997 apply on and after 1 July 2002. [Schedule 13, item 16, subsection 820-10(1A) of the IT(TP) Act 1997]

Consequential amendments

6.88 Changes to the map of Division 820 in section 820-10 are needed as a result of the inclusion of Subdivisions 820-FA and 820-FB into the ITAA 1997 and phasing out the existing TC grouping provisions contained in Subdivision 820-F. [Schedule 13, item 1, item 3 in the table in section 820-10]

6.89 Amendments to subsection 995-1(1) update dictionary items following the inclusion of Subdivisions 820-FA and 820-FB into the ITAA 1997. [Schedule 13, items 4 to 14]

Chapter 7 - Research and development amendments

Outline of chapter

7.1 This chapter explains some amendments needed to ensure that the income tax laws existing provisions for R&D deductions interact properly with the consolidation provisions and preserve the policies behind both regimes to the greatest extent possible.

Context of reform

7.2 The income tax law contains a number of provisions that aim to encourage companies to invest in R&D activities. The amendments are intended to ensure that this aim is not frustrated because a company is a part of a consolidated group or because it joins or leaves such a group.

Summary of new law

7.3 The amendments make a number of changes to the ITAA 1936 to preserve the operation of the R&D provisions for situations involving consolidated groups. They ensure that:

a head company qualifies for the R&D deductions while any of its subsidiary members do;
the expenditure history needed to access some R&D deductions is not affected by the consolidation history rules;
clawing back the concessional part of an R&D deduction when expenditure is recouped is still possible even though the deduction was claimed by the head company of a consolidated group but the recoupment was received by a company that left the group; and
simply consolidating does not allow 2 concurrent deductions for one amount of R&D expenditure. This is done by setting off one deduction against the other.

Comparison of key features of new law and current law
New law Current law
A head company of a consolidated group, that does not otherwise qualify for R&D deductions for particular activities, will still be able to claim them if one of its subsidiaries is incorporated in Australia and registered for those activities. A company can only claim R&D deductions if it is incorporated in Australia and, usually, only if it is registered for particular R&D activities.
For the purposes of working out entitlements to the extra R&D incremental expenditure deduction, a subsidiary members expenditure history from before it joined a consolidated group and, when it leaves, from while it was in the group, are exclusively attributed to the head company or the subsidiary member.

Both a company and the head company of its consolidated group can count the companys history before it joined the group.

Similarly, both a company that has left a consolidated group and its former head company can count the history of its time in the group.

Claw back of the deduction for R&D expenditure to 100% can be applied against a consolidated groups assessments for earlier years if a subsidiary member recoups the expenditure after it has left the group. The deduction for R&D expenditure that is recouped is clawed back from 175% or 125% to 100%. This can involve amending a companys assessments from earlier years.
Deductions that can now be claimed under other provisions (because joining a consolidated group has broken the link to the original R&D expenditure) are reduced by the amount of the deduction that is claimed under the R&D provisions. Deductions for an amount of R&D expenditure can only be claimed under the R&D provisions.

Detailed explanation of new law

Registration and eligible companies

7.4 A pre-requisite for the operation of the R&D provisions is that the company is an eligible company. This is defined to mean a company incorporated under Australian law. Such a company could join a group that has a head company not incorporated under Australian law. This would mean that the subsidiarys activities would not be covered by the R&D provisions while it was in the consolidated group.

7.5 Similarly, a requirement for most of the R&D provisions is that the company is registered in relation to its R&D activities under section 39J of the Industry Research and Development Act 1986. If a registered company joins a consolidated group, the head company usually will not be registered for its activities and so will not be covered by the R&D provisions.

7.6 These problems are addressed by an amendment that applies the R&D provisions as if the head company of a consolidated group was both an eligible company and registered in relation to particular activities for so long as are any of its subsidiaries. [Schedule 11, item 7, section 73BAB of the ITAA 1936]

Increment expenditure history

7.7 Some R&D expenditure is eligible for an extra 50% deduction on top of the normal 125% R&D deduction. To access the extra 50%, an R&D group must have incurred eligible expenditure (called incremental expenditure) for the previous 3 years and must have spent more in the current year than it spent on average over those 3 previous years.

7.8 That excess is then distributed amongst the members of the R&D group in proportion to their current years increase in incremental expenditure. Each can claim the extra 50% on its share of the distribution, or on the amount of incremental expenditure that it deducted at 125%, if that is less.

7.9 If a company joins or leaves a consolidated group, its ability to access the extra 50% could be affected by:

the consolidation entry and exit history rules (which would allow the entity to count its incremental expenditure while it was in a consolidated group even though the head company of the group was already counting it); and
the fact that it would not have deducted its R&D expenditure at 125% while it is in a consolidated group because it would have been deducted by the groups head company.

7.10 These outcomes would usually reduce access to the extra 50% deduction. To address that issue, the amendments aim to put the entity in the same position for the purposes of working out access to the extra 50%, that it would have been in if it had never been in a consolidated group.

7.11 The amendments do that by, for those purposes, treating the incremental expenditure incurred and deducted by a company that joins a consolidated group as instead having been incurred and deducted by the groups head company. [Schedule 11, item 7, subsection 73BAC(1) of the ITAA 1936]

7.12 Similarly, for those purposes a company that leaves a consolidated group is taken to have incurred the incremental expenditure that it actually incurred while in the group and to have deducted the amounts that the head company deducted for that expenditure. [Schedule 11, item 7, subsection 73BAD(1) of the ITAA 1936]

7.13 The R&D provisions already contain rules about the history of incremental expenditure. To ensure that those history rules continue to operate as intended, the amendments provide for the order in which the various history rules apply.

7.14 When a company joins an R&D group and a consolidated group at the same time, the R&D rules about its increment history will apply first. If those rules bring that history into the R&D group, the amendments will then attribute it to the consolidated groups head company. [Schedule 11, item 7, subsection 73BAC(2) of the ITAA 1936]

7.15 When a company leaves an R&D group and a consolidated group at the same time, the amendments will apply first to attribute the relevant increment history to the company. The existing R&D rules about increment history will then apply to work out whether the history stays within the R&D group or goes with the company. [Schedule 11, item 7, subsection 73BAD(2) of the ITAA 1936]

Recoupments and grants

7.16 Sometimes a company will claim deductions at the 125% or 175% level for R&D expenditure that is reimbursed by a grant or other recoupment from a government body. In such cases, the existing law claws back the deduction to just 100%. The claw back is directed first at the current year but can affect assessments of earlier years.

Claw back against former group

7.17 There can be cases where the head company will claim the 125% or 175% deduction for expenditure made by a subsidiary but the subsidiary will recoup that expenditure after it has left the consolidated group. Because the subsidiary did not have an assessment for the time it was in the group, the claw back will not be able to target its assessments for those years.

7.18 To address that, the amendments allow the extra 25% or 75% to be clawed back from the head company to the same extent that it would have been clawed back from the subsidiary if it had never been in the consolidated group. [Schedule 11, item 7, subsection 73BAE(1) of the ITAA 1936]

Notification and penalty

7.19 The head company may not be aware of the amount of the recoupment that its former subsidiary has received or even that it received the recoupment at all. The amendments solve that by requiring the subsidiary to notify the head company of the amount that it will have to use for its claw back calculation. It must do so within 60 days of the end of the financial year of the recoupment. By that time the subsidiary will be in a position to calculate the information it must supply to the head company. [Schedule 11, item 7, subsection 73BAE(2) of the ITAA 1936]

7.20 Failing to notify the head company of the relevant amount for its claw back calculation could constitute a taxation offence under section 8C of the TAA 1953 and, on conviction, that could result in a fine of up to $2,200 (or more for repeat offences).

7.21 The amendments make it possible for an administrative penalty to also be imposed for failing to notify the head company. The amendments do that by expanding an existing penalty provision about failing to supply the Commissioner with required information so that it also covers failing to notify the head company of the relevant amount for its claw back calculation. [Schedule 11, items 14 and 15, subsections 286-75(3) and 286-80(2) of Schedule 1 to the TAA 1953]

7.22 The amount of the administrative penalty is 1 penalty unit (currently $110) for each 28 days that the failure continues (to a maximum of 5 penalty units). However, that penalty is multiplied by 2 for medium sized taxpayers and by 5 for large taxpayers (see subsections 286-80(3) and (4) of Schedule 1 to the TAA 1953).

Preventing double deductions

7.23 The existing provisions that allow deductions for R&D expenditure (e.g. for core technology expenditure) also provide that no other deductions are allowed for that expenditure. When a company enters a consolidated group, its depreciating assets are taken to have been acquired by the groups head company for a new payment (see paragraph 701-55(2)(a) of the May Consolidation Act). Because that new payment is not the original R&D expenditure, the existing provisions that prevent double counting would not apply.

7.24 To stop any double counting, the amendments reduce any depreciation deduction under Division 40 of the ITAA 1997 and any notional Division 40 deduction under section 73BC of the ITAA 1936 by the amount that is deductible under section 73B of the ITAA 1936. [Schedule 11, item 7, subsections 73BAF(1) and (2) of the ITAA 1936]

Example 7.1: Depreciation deduction reduced Formaldehyde Ltd spends $1 million to buy the patent to a drug for the purposes of researching an improved drug. It then joins a consolidated group and the cost setting amount for the patent becomes $1.2 million. In year 1, Formaldehyde spends $600,000 researching the improved drug and, because of the single entity rule, the groups head company, Benzedrine Ltd is taken to have spent that money. Because of the entry history rule, Benzedrine is also taken to have spent $1 million buying the patent, so it can deduct $200,000 of it under the core technology provisions (i.e. a third of the $600,000 research expenditure) (see subsections 73B(12A) and (12B) of the ITAA 1936).The notional Division 40 deduction for the patent is $60,000. The amendment will reduce that to nil because of the core technology deduction. The patents adjustable value will still decline to $1.14 million even though the depreciation deduction was reduced to nil.

7.25 If the deduction under section 73B of the ITAA 1936 exceeds the depreciation deduction, the excess is carried over to reduce future years depreciation deductions. [Schedule 11, item 7, subsection 73BAF(3) of the ITAA 1936]

Example 7.2: Carry forward of reduction amount Continuing the previous example, Benzedrine spends $75,000 on research in year 2, so it can deduct a further $25,000 of the cost of the patent under the core technology provisions. That will reduce year 2s notional Division 40 deduction from $60,000 to $35,000. However, $140,000 of the reduction amount was unused from year 1, so that unused amount will reduce the notional Division 40 deduction to nil and the remaining $105,000 will carry forward to future years.

Objects provision

7.26 The amendments add an objects clause for the new R&D provisions. It explains that their purpose is to ensure that the R&D concession interacts properly with the consolidation regime. [Schedule 11, item 7, section 73BAA of the ITAA 1936]

7.27 Objects clauses have no direct operation. However, by explaining the underlying purpose of other provisions, they can influence the interpretation of the law towards aligning with that purpose.

Attaching history to activities

7.28 The existing exit history rule (section 701-40 of the May Consolidation Act) provides an entity which leaves a consolidated group with the history of the things that happened to any asset, liability or business that the entity takes with it.

7.29 Although unlikely, it is possible in the R&D case that a company could leave without any of these things but in circumstances where some history should attach to it. For example, it might leave a group with a registration for activities, where the registration is not an asset and the activities do not amount to a business but it still needs the history of those activities so that the R&D provisions can apply to it. Therefore, an amendment adds registration under section 39J of the Industry Research and Development Act 1986 for particular R&D activities to the list of things that history attaches to when an entity leaves a consolidated group. [Schedule 11, item 11, paragraph 701-40(2)(d) of the ITAA 1997]

Consequential amendments

Definitions

7.30 A number of definitions are added to the ITAA 1936 to ensure that terms used in the amendments have the same meanings as they do in the consolidation provisions. Each of the definitions provides that the term has the same meaning as it does in the ITAA 1997. The terms are:

consolidated group;
head company of a consolidated group or MEC group;
MEC group;
member of a consolidated group or MEC group;
subsidiary member of a consolidated group or MEC group; and
tax cost is set.

[Schedule 11, items 1 to 6, subsection 6(1) of the ITAA 1936]

Notes

7.31 Some notes are added to the consolidation history rules to draw readers attention to their modified operation when the R&D history rule applies. [Schedule 11, items 8 to 10, section 701-5 and subsection 701-40(1) of the ITAA 1997]

Penalties

7.32 Some minor changes are made to the guide material and objects clause for Division 286 of Schedule 1 to the TAA 1953 to reflect the fact that the amendments expand the administrative penalty provisions to cover a company failing to inform its former head company of relevant claw back amounts. [Schedule 11, items 12 and 13, sections 286-1 and 286-25 of Schedule 1 to the TAA 1953]

Chapter 8 - Technical amendments to consolidation

Outline of chapter

8.1 This chapter explains various technical amendments concerning the losses rules, periods in which taxpayers must notify the Commissioner and the MEC group membership rules.

Context of reform

8.2 In response to suggestions made during the consultation process the following technical amendments have been made:

the rectification of technical deficiencies in the consolidation losses rules; and
correcting an anomaly in the existing MEC group membership rules that unnecessarily restricts the ability of companies to join an existing consolidated group or MEC group.

Summary of new law

Amendments to the losses rules

Amendments to Subdivision 707-B

8.3 Amendments to Subdivision 707-B of the May Consolidation Act will ensure that the COT operates appropriately in relation to structures where an entity outside the group is interposed between the head company and a subsidiary that has transferred certain losses to the head company.

Ensuring losses cannot leave a consolidated group

8.4 Amendments will also ensure that losses cannot leave a consolidated group with a leaving subsidiary pursuant to the exit history rule.

A head companys use of its own losses may be apportioned in the formation year

8.5 Where a consolidated group forms part way through the head companys income year, the head companys use of its own prior year losses (transferred to itself on consolidation) will be unrestricted in respect of income broadly attributable to the pre-consolidation period. The head companys use of its own losses continues to be subject to their available fraction in respect of income attributable to the post-consolidation period.

Amendments to the MEC group membership rules

8.6 The amendments to the MEC group membership rules will ensure that an eligible tier-1 company acquired by a new foreign parent company is not required to join the same consolidated group or MEC group as other eligible tier-1 companies acquired at that time by the foreign parent except where the foreign parent acquires all of the eligible tier-1 companies in an existing MEC group.

Comparison of key features of new law and current law
New law Current law
In determining whether a head company has passed the COT in respect of a COT loss (see paragraph 8.7) transferred to it by another company (the test company), changes to the membership interest or voting power of an entity interposed between the head company and the test company are not taken into account. In determining whether a head company has passed the COT in respect of a COT loss transferred to it by another company (the test company), changes to the membership interest or voting power of an entity interposed between the head company and the test company are taken into account.
Losses cannot leave a consolidated group with a leaving subsidiary. It could be argued that losses can leave a consolidated group with a leaving subsidiary pursuant to the exit history rule.
Where a consolidated group forms part way through the head companys income year, the head companys use of its own losses (transferred to itself) will be unrestricted in respect of income broadly attributable to the pre-consolidation period. The head companys use of its own transferred losses is subject to their available fraction from the start of the income year in which the group formed.
Where a foreign parent company acquires some, but not all, of the eligible tier-1 companies in an existing MEC group, those acquired eligible tier-1 companies will not be required to join the same consolidated group or MEC group. Where a foreign parent company acquires some, but not all, of the eligible tier-1 companies in an existing MEC group, those eligible tier-1 companies may join another consolidated group or MEC group only if all the acquired companies join the same group.

Detailed explanation of new law

Amendments to the losses rules

Amendments to Subdivision 707-B

8.7 Subdivision 707-B of the May Consolidation Act includes modifications to the application of the COT in relation to COT losses transferred to the head company of a consolidated group by a joining subsidiary. (COT losses are losses transferred because the COT was passed.) The modifications essentially ensure that anything that happens after the transfer time to membership interests or voting power in a subsidiary member of the group, and that would be relevant in determining whether the joining subsidiary passed the COT, is not taken to have happened. This is consistent with the consolidation single entity principle.

8.8 The provisions in the May Consolidation Act did not deal with cases where there was an entity outside the group (e.g. a non-resident entity) interposed between the head company and the subsidiary that transferred the losses to the head company. Those provisions did not therefore ignore changes in membership or voting power in such an interposed entity. The amendments will ensure that in these cases changes in ownership or voting power of the interposed entity are also effectively ignored for the purposes of applying the COT. [Schedule 6, items 1 and 2]

Ensuring losses cannot leave a consolidated group

8.9 The amendments close off any argument that losses of a consolidated group, either incurred by the group or transferred to the head company when a subsidiary joined the group, could leave the group with a leaving subsidiary pursuant to the exit history rule. Such an outcome would be inconsistent with the policy intent of the consolidation regime which requires that losses remain with the head company of the group. [Schedule 6, item 5, section 707-410]

A head companys use of its own losses may be apportioned in the formation year

Amendment

8.10 Section 707-335 of the May Consolidation Act will be amended to ensure that a head companys use of its own prior year losses, transferred to itself on formation of the consolidated group, will be unrestricted for the pre-formation period. Their use for the post-formation period will continue to be subject to their available fraction.

Current rule

8.11 A head companys use of its own prior year losses is subject to their available fraction from the start of the income year in which the group is formed. That is, where a group is formed part way through the head companys income year, the head company does not receive the benefit of the unrestricted use of its own losses for the period from the start of the income year until formation.

Discussion

8.12 On formation of a consolidated group, losses made by a company (in its capacity as a single entity) for income years prior to the formation year may be transferred to the company (in its capacity as the head company of the group). An available fraction is calculated for the transferred losses which is used to limit their annual rate of use by the group.

8.13 A head company that joins a consolidated group part way through its income year does not work out its taxable income or loss up to the joining time (unlike subsidiary members). Therefore, in the absence of an apportionment rule, the head company would be obliged to apply the available fraction for its own transferred losses to its income and gains for the whole year to determine the amount of the losses it could use that year.

8.14 The available fraction is a proxy for determining the amount of the groups income that can be regarded as having been generated by the transferring loss entity. It is not appropriate for that proxy to be applied in respect of income generated by the head company as a single entity prior to formation of the group. An amendment will therefore be made to section 707-335 of the May Consolidation Act to allow the head company to apportion its use of its own losses in the formation year. Apportionment will be on the basis of the number of days in the pre-formation period. [Schedule 6, items 3 and 4, paragraphs 707-335(1)(a) and 707-335(3)(e)]

8.15 Also, apportioning a head companys use of its own losses in this way better matches the treatment of subsidiary members who can use and transfer their own losses for their non-membership period prior to joining.

Amendment details

8.16 The apportionment rule in section 707-335 of the May Consolidation Act is drafted as a general principle in that if it applies in respect of a transferred loss, the group cannot use more of the loss than is reasonable having regard to the matters listed. This means 2 changes must be made:

first, the rule will be amended so that it now applies in any case where a head companys own losses are transferred to itself during the income year [Schedule 6, item 3, paragraph 707-335(1)(a)]:

-
currently the rule only applies to a head companys own losses transferred to itself during the income year if there is also a subsequent adjustment to the numerical value of their available fraction during the year (e.g. because another loss entity joined the group); and

second, the principle in paragraph 707-335(3)(e) will be repealed and another substituted [Schedule 6, item 4, paragraph 707-335(3)(e)]:

-
the repealed principle ensured that the first available fraction for a head companys own loss bundle applied from the start of the formation income year until the adjustment of the numerical value of the fraction during that year.

8.17 The new principle treats a head companys own losses transferred to itself as being in a bundle with an available fraction of one for the pre-formation period. Giving the losses an available fraction of one ensures that their use is unrestricted for the pre-formation period.

8.18 The other principles set out in section 707-335 are also relevant. For a more detailed discussion of the other principles, see paragraph 8.46 of the explanatory memorandum relating to the May Consolidation Act.

Example 8.1

Diagram of periods before and after consolidation

A group forms on day 101 of its head companys income year.A $700 prior year tax loss is transferred from the head company to itself. The available fraction for the loss is taken to be one before the group forms. After formation, the available fraction works out to be 0.300.For that income year, the head company has income of $600 (and no deductions). The maximum amount of the loss that the head company can use for the year may be worked out like this:Period prior to consolidation

$600 * (100 / 365) * 1 = $164

Period after consolidation

$600 * (265 / 365) * 0.300 = $131

The maximum amount of tax losses the head company can use from its bundle for the income year is $295 ($164 + $131).

Amendments to the MEC group membership rules

8.19 Where a company becomes an eligible tier-1 company in relation to a top company from which an existing MEC group (the first MEC group) has formed, the provisional head company of the group may specify in a notice to the Commissioner that it wishes the company to join the group as a new eligible tier-1 company member. Similar rules also apply where the company becomes an eligible tier-1 company in relation to a top company which wholly-owns the head company of a consolidated group. In these instances, the head company may specify in a notice to the Commissioner that a MEC group (also referred to as the first MEC group) is to come into existence with both companies as original eligible tier-1 company members of the group.

8.20 Rules currently apply to ensure certain companies must be specified in the notice to the Commissioner if at least one of the companies specified was a member of another MEC group (the second MEC group) immediately before the time it became an eligible tier-1 company of the top company. In these circumstances, each eligible tier-1 company of the second MEC group that became an eligible tier-1 company of the top company of the first MEC group must be specified in the notice for the notification to take effect.

8.21 Whilst this rule is appropriate where all of the eligible tier-1 companies in the second MEC group are acquired by the top company of the first MEC group, it is unnecessarily restrictive where only some of those companies are acquired by the top company of the first MEC group. In those instances, as the eligible tier-1 companies have exited the second MEC group as a result of their acquisition by the top company, those companies should be treated in the same manner as any other company acquired by the top company who was not previously a member of a MEC group.

8.22 The rule discussed in paragraph 8.20 will now be restricted in its operation to the circumstances where all of the eligible tier-1 companies in the second MEC group are acquired by the top company of the first MEC group [Schedule 8, items 4 and 5, paragraphs 719-5(4)(d) and 719 40(1)(f)]. Restricting the operation of the rule in this manner will continue to ensure consistency with the irrevocability status of the choice to consolidate the second MEC group by ensuring either:

the second MEC group continues to exist; or
all of the members of the second MEC group become members of the first MEC group.

Application and transitional provisions

Amendments to the MEC group membership rules

8.23 The amendments will apply in relation to notices given under paragraphs 719-5(4)(c) and 719-40(1)(e) irrespective of whether they were given before, at or after the commencement of item 6 of Schedule 8 to this bill. [Schedule 8, item 6]

Chapter 9 - Technical changes in relation to foreign tax credit provisions

Outline of chapter

9.1 This chapter explains the phasing out of the existing grouping rules for foreign tax credits and other rules concerned with the use of foreign tax credits.

Context of reform

9.2 The rules for terminating the current section 160AFE of the ITAA 1936 and applying the new section 160AFE were introduced in the June Consolidation Bill. However, these rules were not fully developed and did not apply appropriately in some cases to a head company of a consolidated group with a SAP. The rules also did not apply appropriately to a head company where the consolidation day was not the first day of an income year and was before 1 July 2003.

9.3 The rule introduced in Schedule 9 of the June Consolidation Bill, allowing for accelerated use of a joining entitys excess foreign tax credits from earlier years, did not deal adequately with cases involving SAPs.

9.4 It is arguable that the exit history rule may provide a means for an entity that left a consolidated group to claim excess foreign tax credits that the head company would also have claimed. The rule explained in this chapter has been introduced to ensure there is no double counting of excess foreign tax credits.

Summary of new law

9.5 The rules contained in this bill ensure that:

the current section 160AFE operates until the time a consolidated group is formed or until 1 July 2003, whichever is the earlier. The only exception (which is contained in item 3 of the June Consolidation Bill) is where a head company with a SAP forms a consolidated group from the beginning of the first income year starting after 30 June 2003 but before 1 July 2004. In that situation the current section 160AFE will operate until the end of the income year before the consolidation day;
the new section 160AFE will apply from the beginning of the day after the day the current section 160AFE ceases to apply and for all subsequent income years that end after that day;
a head company gains accelerated use of a joining entitys excess foreign tax credits from earlier years where the head company has a SAP and the companies were members of a wholly-owned group prior to consolidation. This rule applies where the consolidated group is formed in the transitional period (1 July 2002 to 30 June 2004); and
there is no double counting of excess foreign tax credits and that once excess foreign tax credits of subsidiary members have become those of the head company they do not leave the consolidated group.

Comparison of key features of new law and current law
New law Current law
The new section 160AFE will continue to allow the carry forward and use of excess foreign tax credits for all taxpayers including those with SAPs. Section 160AFE contains rules to deal with the transfer, carry forward and utilisation of excess foreign tax credits. This section applies to all companies including those with SAPs.
The additional transitional rules ensure that the current and amended section 160AFE will apply appropriately to companies with a SAP and to a head company that forms a consolidated group partway through an income year. The current transitional rules contained in the June Consolidation Bill work for companies that consolidate at the beginning of an income year. They dont work for companies that consolidate partway through an income year nor for a company with a SAP that doesnt consolidate before 1 July 2004.
For a head company to be able to use foreign tax credits in the year the group is formed, the consolidated group must be formed before 1 July 2004. For a head company to be able to use foreign tax credits in the year the group is formed, the income year in which the consolidated group is formed must end before 1 July 2004.
Excess foreign tax credits that the head company of a consolidated group has cannot leave the group with an entity that leaves the group. There is no specific rule.

Detailed explanation of new law

Applying the new section 160AFE to a company with a SAP

9.6 The current section 160AFE of the ITAA 1936 deals with the transfer of foreign tax credits between wholly-owned group members and the carry forward of excess foreign tax credits. The new section 160AFE (in Schedule 10 to the June Consolidation Bill) only provides for the carry forward of excess foreign tax credits.

9.7 Both the current and new section 160AFE generally operate on an income year basis and apply to entities with ordinary income years and to those with SAPs. The current section 160AFE is effective at the end of an income year. However, a consolidated group may form on a day that is partway through an income year. Items 5 to 9 of Schedule 15 to this bill, as described in paragraphs 9.9 to 9.23, enable the current section 160AFE to apply to a period that is less than an income year as though the period were an income year.

9.8 Item 2 in Schedule 10 to the June Consolidation Bill provides that the repeal and replacement of section 160AFE will apply to income years and non-membership periods commencing after 30 June 2003. However, item 2 will not apply if the taxpayer has a SAP, instead item 5 or 7 of Schedule 15 to this bill applies depending on whether or not a consolidated or MEC group has formed [Schedule 15, item 2] . Item 2 would also not apply where a taxpayer that has a SAP forms a consolidated or MEC group from the first day of the income year starting after 1 July 2003 and before 1 July 2004. In this case item 3 of Schedule 10 of the June Consolidation Bill or item 6 of Schedule 15 to this bill would apply. As item 2 of Schedule 10 could not have applied then neither could item 5 or 7 of Schedule 15 to this bill.

Taxpayers with SAPs that dont form a consolidated or MEC group

9.9 Item 5 applies to a taxpayer with a SAP, provided item 3 of the June Consolidation Bill does not apply, where the taxpayer has not become a member of a consolidated or MEC group at 1 July 2003. The current section 160AFE applies until and including 30 June 2003 and not at any later date. The new section 160AFE applies to the taxpayer from 1 July 2003. [Schedule 15, subitem 5(2)]

9.10 The period from the beginning of the SAP income year until 30 June 2003 is treated as though it were an income year (the short period income year) to allow the current section 160AFE to operate [Schedule 15, subitem 5(3)] . In particular, the current section 160AFE allows a credit company to transfer excess credits to an income company if both companies are group companies. This means that group companies may (if they meet the condition contained in item 8) transfer excess credits (as determined under the current section 160AFE) for the period ending 30 June 2003. The excess credits that are transferred have to be used for the income year in which that short period income year occurs. That is, the transferred credits cant be carried forward for 5 years. The condition in item 8 is explained in paragraphs 9.14 to 9.16.

The head company of a consolidated or MEC group with a SAP

9.11 Item 7 applies to a taxpayer with a SAP that becomes the head company of a consolidated group on the day the group comes into existence and that consolidation day is on or after 1 July 2003. However, the consolidation day is not the beginning of the first income year starting after 1 July 2003 (those cases are dealt with by item 3 of the June Consolidation Bill). The taxpayer can choose to apply the current section 160AFE for the period ending 30 June 2003, but not any later, to determine whether it has excess foreign tax credits to transfer to other group members. The new section 160AFE applies to the taxpayer from 1 July 2003 whether it chooses to do this or not. [Schedule 15, item 7]

9.12 If the taxpayer chooses to apply the current section 160AFE, the period from the beginning of the SAP income year until 30 June 2003 is treated as though the period were an income year [Schedule 15, subitem 7(3)] . Applying the current section 160AFE allows a credit company to transfer excess credits to an income company if both companies are group companies. This means that group companies may (if they meet the condition contained in item 8) transfer excess credits at the end of 30 June 2003 to reduce the Australian tax liability of other members of the group. The excess credits that are transferred (and we are not talking about a consolidated group) have to be used for the income year in which that short period income year occurs. That is they cant carry them forward for five years.

9.13 If the head company chooses to apply the current section 160AFE it will mean the head company will have to make a notional calculation of its Australian income tax liability at 30 June 2003 to determine whether it has excess foreign tax credits at that time. The head company is not required to actually end an income year and pay any income tax liability for itself for the period treated like an income year. It is considered unlikely that a head company would choose to treat a period like an income year unless it wanted to transfer excess credits to other members of the wholly-owned group because it will receive any excess credits from other group members upon formation of the consolidated group.

The 12 month rule

9.14 To maintain the integrity of the current section 160AFE that only allows transfers between group companies that have been group companies for the whole of the income year (which is usually 12 months) a 12 month rule applies.

9.15 Where a period is treated as though it were an income year, the requirement in paragraph 160AFE(1D)(b) is changed from an income year test to a 12 month test. A credit company can transfer excess credits to an income company only if they are group companies continuously for 12 months. For the purposes of items 5 and 7 the continuous 12 month period will be the 12 months ending at 30 June 2003. For item 6 cases the continuous 12 month period will be the 12 months ending on the day before the consolidation day. [Schedule 15, items 8 and 9]

9.16 The 12 month rule may be reduced where either the credit company or income company are not in existence for the whole period. In this situation the credit company and income company must be group companies for a continuous period from the time they are both in existence until 30 June 2003 for items 5 and 7 cases. For item 6 cases it will be the continuous period from the time they are both in existence until the consolidation day. [Schedule 15, subitem 8(2), paragraph(b) and subitem 9(2), paragraph (b)]

Applying the new section 160AFE to a head company that consolidates partway through an income year

9.17 Item 3 of the June Consolidation Bill is an exception to the application of the new section 160AFE provided for in item 2 of that bill. Item 3 of that bill ensures that the new section 160AFE applies to a consolidated group or MEC group that came into existence prior to 1 July 2003. Item 6 of Schedule 15 to this bill applies instead of item 3 where consolidation occurs before 1 July 2003 and partway through an income year. [Schedule 15, item 3]

9.18 Item 6 applies to a taxpayer that becomes the head company of a consolidated or MEC group that came into existence on a day that is not the beginning of an income year. The day the group came into existence must be on or after 1 July 2002 and before 1 July 2003. This provision applies to taxpayers that have a normal income year and to those that have a SAP. [Schedule 15, item 6]

9.19 If the taxpayer does not have a SAP the taxpayer can choose that the period from 1 July 2002 until the consolidation day is treated as though the period were an income year for the purpose of applying the current section 160AFE [Schedule 15, subitem 6(3)] . Similarly, if the taxpayer has a SAP the taxpayer can choose to treat the period from the beginning of the income year in which the consolidation day occurs until just before the consolidation day as though the period were an income year [Schedule 15, subitem 6(4)] .

9.20 If the taxpayer makes the choice to treat the particular period as though it were an income year, the current section 160AFE will apply for that period. This will allow the prospective head company to transfer excess credits to an income company if both companies are group companies and the condition in item 8 is met (see paragraphs 9.14 to 9.16). As there would be compliance costs involved for a head company making a choice to treat a period like an income year it is expected that the head company would only make a choice if it had excess credits to transfer to other group companies.

9.21 The rule in item 6 is not necessary for entities that become subsidiary members of a consolidated group as section 701-30 of the May Consolidation Act treats a non-membership period as though it were an income year. This would mean the current section 160AFE would apply to non-membership periods that occur before a consolidation day that is before 1 July 2003 to allow subsidiary members to transfer excess credits to other group members. Of course, entities that become subsidiary members of a consolidated group no longer need to apply either the old or new section 160AFE unless they once again are not members of any consolidated group. In that case, items 2 and 3 of the June Consolidation Bill have the result that the new section 160AFE applies.

9.22 Entities that become subsidiary members of a consolidated group can transfer excess credits to the head company under section 717-15 or 717-20 of Schedule 6 to the June Consolidation Bill. If entities become subsidiary members of a consolidated group in the transitional period, the time of use of the transferred excess credits by the head company would be governed by section 717-15 or 717-20 of Schedule 9 to the June Consolidation Bill.

9.23 The rules for the transitional period for the phasing out of foreign tax credit grouping provisions are different to rules for phasing out the loss grouping provisions. The difference reflects the view that foreign tax is generally paid at specific points in time and is not necessarily evenly spread across a period.

Periods are not earlier income years

9.24 Item 10 ensures that the period that is treated like an income year in item 5, 6 or 7 is not treated as an earlier year of income when determining excess foreign tax credits under the new section 160AFE at the end of the real income year that includes that period.

9.25 Where a head company has chosen to treat a period like an income year and has applied the current section 160AFE to transfer excess credits to other group members, the head company cannot double count the foreign tax paid in that part-year period to determine its own foreign tax credits at the end of the income year in which the consolidation day occurred.

Example 9.1

Example of consolidated groups and foreign income

Assume:A wholly-owned group of A Co, B Co and C Co has been a group with the same members continuously from 1 January 1999. The three companies use a SAP from 1 January to 31 December.The group becomes a consolidated group on 1 July 2003 and A Co is the head company.All foreign income is of the same class.All domestic income and income tax in relation to that income is ignored for this example. A Co For the income year 1 January 2003 to 31 December 2003 A Co pays foreign tax of $1,750 on foreign income that will be included in its assessable income for the year.A Co determines that $1,000 of foreign tax relates to the period from 1 January 2003 until 30 June 2003 and that the remainder relates to the period 1 July 2003 to 31 December 2003.The Australian tax payable on the same foreign income for the period 1 January 2003 to 30 December 2003 is $800. The Australian tax on the remainder of the foreign income for the period 1 July 2003 to 31 December 2003 is also $800.As B Co and C Co are members of the consolidated group from 1 July 2003, A Co will be assessed on any foreign income derived by B Co and C Co from 1 July 2003. B Co and C Co B Co and C Co each have a non-membership period from 1 January 2003 to 30 June 2003. As they are members of a consolidated group at the end of their year of income they will only calculate their Australian tax liability for the non-membership period (i.e. from 1 January 2003 to 30 June 2003 (section 701-30 of the May Consolidation Act)).C Co doesnt receive any foreign income. B Co receives foreign income that it includes in its assessable income for the non-membership period. B Co pays $150 foreign tax on the foreign income. The Australian tax payable on that foreign income is $300.B Co derives further foreign income (and pays foreign tax of $50) after 30 June 2003 but A Co will be assessed on that foreign income and A Co will be deemed to have paid and been personally liable for the foreign tax (section 717-10 of the June Consolidation Bill). Applying item 6 A Co chooses to treat the period from 1 January 2003 to 30 June 2003 like an income year and applies the current section 160AFE. A Co has excess credits it can transfer to B Co (as the condition in item 8 is satisfied) of $200. However, B Co can only use $150 so A Co and B Co enter into an agreement that A Co transfer $150 of its excess credits to B Co.At 31 December 2003 A Co calculates its income tax liability. A Co includes in its assessable income the foreign income it has derived from 1 January 2003 to 31 December 2003 and foreign income B Co has derived from 1 July 2003 to 31 December 2003. The total foreign tax paid on that foreign income is $1,800 ($1,750 by A Co and $50 by B Co). The equivalent Australian tax payable on the foreign income is $1,750.However, A Co cannot use all the $1,750 foreign tax it has paid as it has transferred $150 of the amount to B Co. A Co can only claim a foreign tax credit under section 160AF of the ITAA 1936 of $1,650 (i.e. $1,750 - $150 + $50). Therefore, A Co will be required to pay a further $100 ($1,750 - $1,650) Australian income tax.

Accelerated access to foreign tax credits in the transitional period

9.26 The rule contained in this bill ensures that sections 717-15 and 717-20 of the IT(TP) Act 1997contained in Schedule 9 to the June Consolidation Bill apply in the situation where the head company of a wholly-owned group consolidates before 1 July 2004 but has a SAP [Schedule 15, item 1, section 717-30 of the IT(TP) Act 1997] . The rule will substitute this condition for the condition in paragraph 717-15(1)(b) and paragraph 717-20(1)(b). The condition being replaced by the rule in this bill applies to the head company of a wholly-owned group that consolidates before 1 July 2004 where the head company has a year of income ending on 30 June.

9.27 Provided the other conditions in these sections are also satisfied, the head company of a consolidated group will be able to utilise excess foreign tax credits of an earlier year or non-membership period transferred to the head company in the income year in which the group is formed rather than have to wait until the next income year.

Excess foreign tax credits do not leave a group

9.28 An entity does not have excess foreign tax credits from earlier years that belong to a head company of a consolidated group when the entity ceases to be a subsidiary member of the group. The exit history rule contained in section 701-40 of the May Consolidation Act will not operate to allow excess foreign tax credits to leave a consolidated group. [Schedule 7, item 2, section 717-30]

Chapter 10 - Imputation rules - transitional and other amendments

Outline of chapter

10.1 Schedules 16 to 18 to the New Business Tax System (Consolidation and Other Measures) Bill (No. 1) 2002 contain amendments relating to the new simplified imputation system.

10.2 The amendments in Schedule 18 will amend the IT(TP) Act 1997 to provide transitional rules relating to:

franking periods for early and late balancing companies;
the conversion of franking accounts on a tax paid basis for early balancing companies; and
the determination of FDT liability for late balancing companies.

10.3 The amendments in Schedule 16 will amend the ITAA 1936 to:

remove the inter-corporate dividend rebate under sections 46 and 46A for franked dividends paid after 30 June 2002; and
remove the inter-corporate dividend rebate under sections 46 and 46A for unfranked dividends paid within wholly-owned company groups generally after 30 June 2003.

10.4 The amendments in Schedule 17 will amend the ITAA 1936 to:

broaden the exceptions to the benchmark rule, which requires that all dividends paid by a company in a certain period (a franking period) be franked to the same extent; and
replicate provisions in former Part IIIAA of the ITAA 1936 relating to distributions on non-share equity interests.

10.5 The New Business Tax System (Franking Deficit Tax) Amendment Bill 2002 will make consequential amendments to the New Business Tax System (Franking Deficit Tax) Act 2002. These amendments are required because of the proposed amendments to the IT(TP) Act 1997 concerning the determination of FDT liability for late balancing companies.

Context of reform

10.6 The amendments relating to franking periods, the conversion of franking accounts for early balancing companies, and the determination of FDT liability for late balancing companies are transitional rules to complement the general rules for the new simplified imputation system, which came into effect on 1 July 2002.

10.7 The rebate under sections 46 and 46A will be removed for franked dividends paid after 30 June 2002. The inter-corporate dividend rebate has been replaced by the general imputation tax offset under Division 207 of the ITAA 1997.

10.8 The removal of the rebate under sections 46 and 46A for unfranked dividends paid within wholly-owned company groups after 30 June 2003 is part of the removal of the grouping provisions. This is a consequence of the introduction of the consolidation regime.

10.9 The exemptions from the benchmark rule will be broadened to recognise further circumstances in which streaming is not possible or unlikely. This will give greater flexibility in franking dividends to companies that will fall within the broader exemptions.

10.10 As part of the simplified imputation system it is intended that the imputation provisions in former Part IIIAA of the ITAA 1936 that are still relevant be transferred to the ITAA 1997. The amendments relating to distributions on non-share equity interests continue that process by replicating provisions in former Part IIIAA of the ITAA 1936.

Summary of new law

Franking periods

10.11 A period during which all dividends paid by a company must be franked to the same extent under the benchmark rule is called a franking period. Where a franking period of an early or late balancing company would otherwise straddle 1 July 2002, it will be taken to start on 1 July 2002.

Conversion of franking accounts for early balancing companies

10.12 The franking account balance of early balancing companies will be converted on a tax paid basis at the end of 30 June 2002. The IT(TP) Act 1997 already provides for the conversion of franking account balances of normal and late balancing companies.

FDT liability for late balancing companies

10.13 An FDT liability will not be imposed on a late balancing company that has a franking account deficit at the end of its 2001-2002 income year. Any deficit will be carried forward at the start of the companys 2002-2003 income year. This concession will ensure that late balancing companies are not overly disadvantaged with the alignment of franking periods with income years.

10.14 It is possible, notwithstanding the deferral of any FDT liability arising at the end of the 2001-2002 income year, that some late balancing companies might still be disadvantaged by the imposition of FDT at the end of the income year. Such companies will be able to elect to have their FDT liability, if any, determined at 30 June rather than the end of their income year.

10.15 This election means that no late balancing company will be disadvantaged in respect to FDT by the alignment of franking periods and the income year under the new simplified imputation system.

Removal of rebate under sections 46 and 46A

10.16 The inter-corporate dividend rebate under sections 46 and 46A will be removed for franked dividends paid after 30 June 2002. Companies that receive such dividends will be entitled to an imputation tax offset under Division 207 of the ITAA 1997.

10.17 The inter-corporate dividend rebate under sections 46 and 46A will be removed for unfranked dividends paid within wholly-owned company groups after 30 June 2003 in most cases. In certain circumstances the rebate will be available for dividends paid after 30 June 2003 for company groups with SAPs.

Exemptions from the benchmark rule

10.18 The exemptions from the benchmark rule for public listed companies will be broadened and simplified. The benchmark rule requires that all distributions made in a franking period (generally a six month period for public companies) be franked to the same extent.

Non-share distributions

10.19 The provisions in former Part IIIAA of the ITAA 1936 relating to distributions on non-share equity interests will be replicated for the purpose of the new simplified imputation system. These rules make certain distributions on non-share equity interests unfrankable.

Detailed explanation of new law

Franking periods where the income year straddles 1 July 2002

10.20 The general franking period rules are set out in section 203-40 of the ITAA 1997. Because the income year of an early balancing company or a late balancing company straddles 1 July 2002, such companies would, in the absence of further amendments, have a franking period that straddles 1 July 2002. To ensure that the rules in the simplified imputation system, which applies from 1 July 2002, operate as intended, transitional rules are required to ensure that a franking period cannot start earlier than 1 July 2002.

10.21 The IT(TP) Act 1997 will be amended so that the franking periods of an early or late balancing company will be determined first by applying the rules in section 203-40, and the franking period that straddles 1 July 2002 will be taken to start on 1 July 2002. [Schedule 18, item 1, section 203-1 of the IT(TP) Act 1997]

Example 10.1: The 2001-2002 income year of a late balancing company that is a public company runs from 1 October 2001 to 30 September 2002. Applying subsection 203-40(2), the company would have two franking periods of 6 months starting on 1 October 2001 and 1 April 2002. Under section 203-1, the second franking period will run from 1 July 2002 to 30 September 2002.It should be noted that the new simplified imputation system, which does not apply to events that occur before 1 July 2002, will not apply in relation to earlier franking periods.

Conversion of franking account for early balancing companies

10.22 Rules for the conversion of franking accounts from a taxed income basis to a tax paid basis for normal and late balancing companies are set out in Division 205 of the IT(TP) Act 1997.

10.23 Under new section 205-15, the franking account balance of early balancing companies will also be converted to a tax paid basis at the end of 30 June 2002. This conversion will not result in a liability to FDT if the franking account was in deficit at that time. [Schedule 18, item 6, section 205-15 of the IT(TP) Act 1997]

10.24 Consequential amendments will be made to Division 205. [Schedule 18, items 2 to 5]

FDT for late balancing companies

10.25 Under the new simplified imputation system, a liability to FDT is determined at the end of a companys income year. For late balancing companies, however, this rule could result in an imposition of FDT liability that would not have arisen under the former imputation rules. (A late balancing companys FDT liability under the former rules was determined on 30 June.) For example, a late balancing company which balances at 30 September could have an FDT liability on 30 September 2002 under the new rules, whereas under the old rules any FDT liability would not have arisen until 30 June 2003.

10.26 To avoid this outcome, IT(TP) Act 1997 will be amended so that an FDT liability will not be imposed on a late balancing company that has a franking account deficit at the end of its 2001-2002 income year. Any deficit will be carried forward at the start of the companys 2002-2003 income year. This will give late balancing companies time to adjust to the new system. [Schedule 18, item 6, section 205-35 of the IT(TP) Act 1997]

10.27 It is possible, notwithstanding the deferral of any FDT liability arising at the end of the 2001-2002 income year, that some late balancing companies might still be disadvantaged by the imposition of FDT at the end of the income year. Such companies will be able to elect to have their FDT liability, if any, determined at 30 June rather than the end of their income year. This rule applies on an ongoing basis. [Schedule 18, item 6, sections 205-20, 205-25 and 205-30 of the IT(TP) Act 1997]

10.28 Companies that wish to have their FDT liability determined at 30 June for an income year will be required to make an election in writing before or on 30 June of that year. Only late balancing companies in existence on 1 July 2002 will be eligible to make an election.

10.29 An election will need to be made each year that a company wishes its FDT liability determined on 30 June. If a company does not make an election for an income year, so that its FDT liability during that year is determined on the last day of the income year rather than on 30 June, the companys FDT liability for later years will be determined under the general rule. The company would not subsequently be able to elect to have its FDT liability determined on 30 June in a later year.

10.30 Rules for determining the FDT liability of a company that makes the election are set out in new sections 205-25 and 205-30. [Schedule 18, item 7, sections 205-20, 205-25 and 205-30 of the IT(TP) Act 1997]

10.31 The New Business Tax System (Franking Deficit Tax) Amendment Bill 2002 will make consequential amendments to the New Business Tax System (Franking Deficit Tax) Act 2002 to reflect the amendments to the IT(TP) Act 1997.

Rebate under sections 46 and 46A

Franked dividends

10.32 A company that receives a franked dividend on or after 1 July 2002, whether directly or indirectly, is entitled to an imputation tax offset under Division 207 of the ITAA 1997. Section 46AA in the ITAA 1936 turns off the existing inter-corporate dividend rebate under sections 46 and 46A for franked dividends paid on or after 1 July 2002. [Schedule 16, item 1, section 46AA of the ITAA 1936]

Unfranked dividends paid within company groups

10.33 Sections 46 and 46A generally do not provide a rebate for unfranked dividends. However, a rebate is available for unfranked dividends paid within company groups because of the combined operation of subsections 46F(2) and (3).

10.34 As part of the introduction of the consolidation regime, the various grouping provisions of the ITAA 1936, including the inter-corporate dividend rebate under sections 46 and 46A for unfranked dividends paid within company groups, are to be removed. Although groups may consolidate from 1 July 2002, the removal of the grouping rules has been delayed for 12 months to ensure that small and medium sized businesses are not disadvantaged while they are preparing to make the election to enter consolidation.

10.35 Section 46AB turns off the rebate for unfranked dividends paid on or after 1 July 2003, subject to a transitional rule set out in section 46AC. This transitional rule is discussed below. The rebate will not apply to dividends paid on or after the date of consolidation, if the date of consolidation occurs before 1 July 2003. [Schedule 16, item 1, section 46AB and subsection 46AC(2) of the ITAA 1936]

10.36 A transitional rule is set out in section 46AC to provide a concession for groups with SAPs. The rebate will continue to apply to dividends paid after 30 June 2003 if the date of consolidation is the first day of the first income year starting after 30 June 2003 and before 1 July 2004. This is consistent with the treatment of other grouping provisions that are also being removed. [Schedule 16, item 1, section 46AC of the ITAA 1936]

10.37 Section 46AD is a technical provision to support the operation of sections 46AB and 46AC. Section 46AE is a technical provision to support the operation of subsections 46(2B) and 46(5B) after 30 June 2002. [Schedule 16, item 1, sections 46AD and 46AE of the ITAA 1936]

10.38 Section 46F, which will apply to dividends paid on or after 30 June 2002, will be amended to reflect the new imputation provisions in the ITAA 1997. [Schedule 16, items 2 and 3, section 46F of the ITAA 1936]

Exceptions to the benchmark rule

10.39 The benchmark rule requires that all distributions made in a franking period be franked to the same extent, to prevent the streaming of franking credits. Certain companies are exempt from the benchmark rule where streaming is not possible or unlikely.

10.40 The exemptions from the benchmark rule, set out in section 203-20, will be simplified and widened. [Schedule 17, item 2, section 203-20 of the ITAA 1997]

10.41 The exemptions have been widened as follows:

a 100% owned subsidiary of a company that is exempt from the benchmark rule will itself be exempt from the benchmark rule;
membership interests that do not carry a right to receive distributions will be ignored in determining whether a company is exempt from the benchmark rule; and
a listed public company with more than one class of membership interest will be exempt from the benchmark rule if the distribution and franking rights are the same for each class of membership interest.

10.42 The benchmark rule has also been simplified by:

stating a general rule for determining when the benchmark rule does not apply; and
providing specific examples where the benchmark rule does not apply.

10.43 These changes to section 203-20, which are concessional to taxpayers, will apply from 1 July 2002, that is, the commencement of the new simplified imputation system. [Schedule 17, subitem 6(1)]

Non-share dividends

10.44 New sections 215-10 and 215-15 will replicate provisions dealing with distributions on non-share equity interests in former Part IIIAA of the ITAA 1936, which was repealed from 1 July 2002 with the introduction of the new simplified imputation system. [Schedule 17, item 4, sections 215-10 and 215-15 of the ITAA 1997]

10.45 Section 215-10 makes certain distributions on non-share equity interests unfrankable. The relevant interests are hybrid instruments issued by Australian authorised deposit-taking institutions for the purposes of the Banking Act 1959. The purpose of this treatment is to align the taxation treatment of foreign branches of Australian ADIs with that of foreign subsidiaries of Australian ADIs and foreign independent entities. Section 215-10 replicates former section 160APAAAA.

10.46 Section 215-15 makes distributions paid on non-share equity interests debited to non-profit sources (e.g. share capital or asset revaluation reserves) unfrankable. A company cannot frank non-share dividends unless it has available frankable profits. The purpose of this treatment is to ensure that non-share dividends are treated in the same way as dividends paid on shares debited to non-profit sources, so that these distributions cannot be used to stream franking credits. Section 215-10 replicates former section 160APAAAB.

10.47 The rules for working out available frankable profits are set out in new sections 215-20 and 215-25. These rules were previously set out in section 160APAAAB. [Schedule 17, item 4, sections 215-20 and 215-25 of the ITAA 1997]

10.48 Items 1, 3 and 5 make minor consequential amendments relating to new sections 215-10 and 215-15. [Schedule 17, items 1, 3 and 5]

10.49 Sections 215-20 and 215-25 will apply from 1 July 2002, that is, the commencement of the new simplified imputation system. [Schedule 17, subitem 6(2)]

Application and transitional provisions

10.50 These amendments will generally apply to dividends paid on or after 1 July 2002.

10.51 However, the removal of the rebate under sections 46 and 46A for unfranked dividends paid within company groups will apply to dividends paid on or after 1 July 2003 in most cases. If the date of consolidation occurs before 1 July 2003, the rebate will not apply to dividends paid on or after the date of consolidation. For groups with SAPs, the rebate will be removed for dividends paid after the date of consolidation if the date of consolidation is after 30 June 2003 and before 1 July 2004.


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