Senate

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Ralph Willis, MP)

General outline and financial impact

TAXATION LAWS AMENDMENT BILL (NO. 4) 1995

Capital gains tax - amendments relating to value shifting

Amends the CGT provisions of the income tax law to:

•

introduce specific provisions for the transfer of depreciable assets between commonly owned companies;

•

allow for grouping of assets for the purpose of determining whether adjustments to the cost bases of shares and loans in a transferor company are required; and

•

introduce other technical amendments to simplify and clarify the operation of the division.

Date of effect: The proposed amendments apply generally to assets transferred after 7.30 pm AEST on 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: The cost to revenue of this measure will be insignificant.

Compliance cost impact: The amendments will considerably reduce the compliance costs of company group reorganisations. Currently, the cost base adjustments apply on an asset by asset basis. The amendments will permit the grouping of some assets. The amendments also simplify the cost base adjustments in relation to transfers of depreciable assets by enabling companies to use data already available in their records.

Capital gains tax - increase in personal-use asset thresholds

Amends the CGT provisions to increase the thresholds applying to personal use assets. The new thresholds will be $500 for listed personal-use assets and $10000 for non-listed personal-use assets. The amendment will also:

•

include a measure in relation to listed personal-use assets to ensure that the threshold applies appropriately to sets of articles; and

•

ensure that where an asset is jointly owned, the threshold is apportioned appropriately.

Date of effect: The amendment to increase the thresholds for listed and non listed personal-use assets will apply to disposals of assets from 1 July 1995. The amendments relating to sets of listed personal-use assets and jointly held assets will apply to assets acquired after the date of Royal Assent.

Proposal announced: 1995-96 Budget.

Financial impact: A cost to revenue of up to $2 million per year is expected from the measures.

Compliance cost impact: An overall reduction in compliance costs is expected from the measures due to the reduction in the number of personal use assets to which CGT will apply.

Capital gains tax - taxable Australian assets

Amends the income tax law to ensure that CGT will apply to disposals of taxable Australian assets used to produce franked dividends or income subject to withholding tax.

Date of effect: Applies generally to disposals of taxable Australian assets on or after 20 September 1985. Where a private binding ruling has been issued to a taxpayer in accordance with the Taxation Administration Act 1953 in relation to a transaction entered into prior to 7.30 pm AEST on 9 May 1995, the terms of the ruling will prevail.

Proposal announced: 1995-96 Budget.

Financial impact: The financial impact of this measure is unquantifiable.

Compliance cost impact: This amendment is designed to remove any uncertainty in the law and will therefore reduce the cost of complying with the law. Non-residents who, in the absence of a private binding ruling, have not included in their returns realised gains on the disposals of affected taxable Australian assets will incur costs in amending earlier assessments to reflect the capital gains realised. However, the normal time limits on original and amended assessments will apply.

Capital gains tax - exempt receipts

Amends the CGT provisions to:

•

extend the CGT relief for disposals of shares in foreign companies which give rise to dividends, to shares created prior to 26 June 1992;

•

limit the CGT relief available under subsection 160ZA(7) for disposals of shares giving rise to dividends to amounts which are not paid out of capital, or share premium or revaluation reserves; and

•

limit the operation of subsection 160ZA(8) to eligible termination payments.

Date of effect: The proposed amendment to extend CGT relief to disposals of shares created before 26 June 1992 will apply to disposals of assets occurring on or after the commencement of the 1990-91 income year of the taxpayer (the year from which section 23AJ applies).

The amendments to limit the CGT relief provided by subsections 160ZA(7) and 160ZA(8) will apply to disposals occurring after 7.30 pm AEST on 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: The financial impact of these measures is unquantifiable.

Compliance impact: There will be some increase in compliance costs for resident companies as they have to obtain information from foreign companies regarding the source from which dividends are paid. However, only resident companies with a 10% or greater voting interest in the foreign companies will be affected.

Capital gains tax - compulsory rollover of assets

Amends the CGT provisions to require that, where a company disposes of an asset to a related company and the disposal gives rise to a capital loss, there will be a compulsory rollover of the asset for CGT purposes. An exception will be provided for assets transferred to companies which are to be sold outside the group in the income year of the transfer or the next income year. Cost base adjustments for transfers of interests in controlled foreign companies and foreign investment funds are also included.

Date of effect: The amendment will apply to the transfer of assets between related companies taking place after 7.30 pm AEST on 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: There is insufficient data available on which a reliable estimate of the revenue impact of this amendment can be made. However, the measure has the potential to prevent a significant future loss to revenue.

Compliance cost impact: There will be no increase in compliance costs as a consequence of the compulsory rollover of loss assets. Companies are already required to determine the CGT consequences of asset transfers whether or not a gain or loss is to be realised at the time of the transfer. There will be a marginal increase in record keeping requirements for the rollover assets. Where a loss is able to be realised on the transfer of an asset because the transferee company is to be sold within two income years, records have to be maintained to confirm that the sale takes place and that the asset is not reacquired by the transferor in the four year period following the transfer.

Capital gains tax - amendment or replacement of trust deeds

Amends the income tax law to provide that CGT will not apply where a complying approved deposit fund (ADF) converts to a complying superannuation fund, or an existing complying superannuation fund or complying ADF amends its trust deed in order to comply with the Superannuation Industry (Supervision) Act 1993, (the SIS Act) provided that there is no change in the assets of the fund or interests of members in the fund.

Date of effect: Applies to disposals of assets occurring on or after 12 January 1994.

Proposal announced: 1995-96 Budget.

Financial impact: The revenue impact of this proposal is insignificant.

Compliance cost impact: None.

Dividend imputation

Amends the income tax law as a result of the increase in the company tax rate from 33% to 36% to require companies to establish a class C franking account and to convert existing class A and class B franking account balances into that account.

These amendments include the correction of certain existing defects in the dividend imputation provisions to ensure they are not replicated when implementing the new class C franking account arrangements. As a result:

•

mutual life insurance companies will be entitled to a franking rebate for franked dividends received through a trust or partnership; and

•

non-mutual life insurance companies will not be entitled to a deduction for the imputation credit attached to a franked dividend received through a trust or partnership if a franking rebate is available.

Date of effect:

The class C franking account arrangements will apply from 1 July 1995.

The life insurance company amendments will apply from the time the defects in the current provisions first arose. This means from 22 August 1990 for the mutual life company amendment, and from 7 December 1990 for the non-mutual life company amendment.

Proposal announced: The class C franking account arrangements were announced in the 1995-96 Budget. The other amendments have not previously been announced.

Financial impact:

There is insufficient data available on which a reliable estimate of the revenue impact of the class C franking account arrangements can be made. However, it is considered that the revenue impact is minimal.

The mutual life insurance company amendment will prevent an unintended gain to the revenue arising over a period of years.

The non-mutual life insurance company amendment will prevent a significant potential loss to the revenue.

Compliance cost impact:

The class C franking account arrangements will reduce compliance costs for most companies because they will convert from the present dual franking account system to a single franking account. Initial costs will be incurred in establishing the class C franking account but these are not expected to be significant.

The other amendments will have no impact on compliance costs.

Franking credits - international profit misallocation

Amends the income tax law to deny franking credits under the imputation system for tax paid by companies as a result of a transfer pricing or non-arm's length dealing adjustment made under the Income Tax Assessment Act 1936 or a double taxation agreement.

Date of effect: 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: Estimated gains to revenue are $3 million in the 1994-95 year, $21 million in the 1995-96 year and $25 million for subsequent years.

Compliance cost impact: A slight increase in compliance costs by those companies which have misallocated or shifted profits offshore. Modification to franking accounts would need to be made to ensure that franking credits do not arise in relation to tax payable as a result of a transfer pricing or non-arm's length dealing adjustment.

Demutualisation of insurance companies

Inserts a new Division into the income tax law to deal with the taxation treatment of certain transactions likely to take place in the course of the demutualisation of a life or general insurance company.

Date of effect: Applies to entities that existed as mutual life or general insurance companies at 7.30 pm AEST on 9 May 1995 and which undertake a demutualisation arrangement after that date.

Proposal announced: 1995-96 Budget.

Financial impact: The nature of the measure is such that the cost to revenue cannot be reliably estimated.

Compliance cost impact: Most costs incurred in the demutualisation process will be incurred irrespective of the taxation consequences. There will be some costs incurred in ascertaining the 'embedded value' of a life insurance company or the 'net tangible asset value' of a general insurance company. These costs are inevitable if the general tax system is to apply to subsequent transactions in the shares of the demutualised companies.

Establishment costs of horticultural plants

Amends the income tax law to allow capital expenditure incurred in establishing plants for horticulture to be written off for taxation purposes.

Date of effect: Applies to expenditure incurred in establishing horticultural plantations after 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: There is expected to be a cost to revenue of $1 million in 1997-98, $2 million in 1998-99 and $4 million in 1999-2000.

Compliance cost impact: Taxpayers will need records to show what capital expenditure they incur in establishing plants for horticulture, and when those plants become capable of use in horticulture or are destroyed. Other records may be needed, if plants are sold or if 'safe harbour' effective life rates are chosen.

Forestry plantations

Amends the income tax law to ensure that tax is only levied on the net proceeds of the sale of standing timber, where taxpayers who conduct timber operations purchased the timber as an existing forest or plantation.

Date of effect: Applies to sales of standing timber after 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: There is expected to be a cost to revenue of $1 million in 1995-96 and $4 million in subsequent years.

Compliance cost impact: The records of the cost of acquisition of standing timber, already routinely kept by taxpayers in these circumstances, will now be required for taxation purposes.

Research & development

Amends the income tax law to deny deductions under section 73B for expenditure incurred to a private tax exempt body, where that expenditure is not fully at risk.

Date of effect: Expenditure incurred from 7.30 pm AEST 9 May 1995. Arrangements with at least finance scheme approval before that time have the benefit of transitional rules.

Proposal announced: 1995-96 Budget.

Financial impact: There is expected to be a gain to revenue of $20 million in 1995-96, $85 million in 1996-97, $120 million in 1997-98 and $145 million in 1998-99.

(Note: The revenue gain of this measure is less than was announced in the 1995-96 Budget because of a change to the transitional arrangements.)

Compliance cost impact: There will be a minor compliance cost impact on syndicates that were approved by 9 May 1995. Those syndicates will not be affected by the proposed amendment if they registered with the Industry, Research and Development Board and had documented contractual arrangements in place by 3 August 1995.

Sales tax - exemption for rice milk

Amends the Sales Tax (Exemptions and Classification) Act 1992 to provide for an exemption for beverages consisting principally of rice milk.

Date of effect: The amendments will apply from the date of introduction of the Bill.

Proposal announced: The measure was announced by the Treasurer in a Press Release dated 20 September 1995.

Financial impact: The cost to revenue of exempting rice milk from sales tax is estimated to be less than $300,000 per annum.

Compliance cost impact: This measure will reduce compliance costs that might otherwise be incurred in the sale of certain rice milk beverages. That is, manufacturers, importers, and wholesalers of rice milk, that is exempt from sales tax, will no longer need to lodge returns in relation to that rice milk.

Trust losses

Inserts a new Schedule , dealing with trust losses, into the income tax law. This Schedule sets out rules that have to be satisfied by trusts before a deduction is allowed for prior year and current year losses.

Date of effect: Subject to certain transitional arrangements, the proposed measures will apply to all trafficking in trust losses from 7.30 pm AEST on 9 May 1995.

Proposal announced: 1995-96 Budget.

Financial impact: The measures will prevent a significant erosion of the tax base that would otherwise have arisen from trafficking in trust losses. The estimated gain to revenue from the measures is $90 million in 1995-96, $185 million in 1996-97, $155 million in 1997-98 and $65 million in 1998-99.

Cost of compliance: The measures will mainly apply where there is an attempt to use trust losses to obtain an unjustified benefit.

There will be some costs for trusts in monitoring the ownership of trust interests to ensure that the continuity of ownership test is satisfied. This is unlikely to be a problem for trusts that have natural persons as beneficiaries. However, it will be more difficult to monitor changes of interests in trusts where there are entities interposed between the loss trust and the final beneficiaries. Special tracing rules will apply to family trusts which will assist in reducing compliance costs in this area.

Trusts with a large of number of beneficiaries, such as some unit trusts, will also face difficulties in testing for changes in ownership. However, for listed, widely held public unit trusts, concessional rules have the effect that ownership should be tested generally only where there are abnormal transactions. Abnormal transactions would include those associated with activity in the nature of takeover or merger. Consequently, the costs will be kept to a minimum consistent with the objectives of the measures. Moreover, listed, widely held public unit trusts would generally have to test for continuity of ownership only if they fail the same business test.

Concessional rules for testing changes in ownership are also provided for widely held public unit trusts that are not listed.

The new provisions have been written in the simplified drafting style. This should assist taxpayers in obtaining a clear understanding of the provisions and therefore help to minimise costs of complying with the law.

Non-compulsory uniforms or wardrobes

Amends the income tax law to transfer responsibility for the maintenance of the Register of Approved Occupational Clothing (the Register) from the Textiles, Clothing and Footwear Development Authority (TCFDA) to the Department of Industry, Science and Technology.

Date of effect: 1 March 1996.

Proposal announced: 1995-96 Budget.

Financial impact: This change will have no impact on revenue.

Compliance cost impact: This change will have no impact on the compliance cost of employers. The Register will continue to be administered in the same way and it is envisaged that the application procedure will remain unchanged. The new administration unit will have the same address as the former TCFDA.

INCOME TAX (FRANKING DEFICIT) AMENDMENT BILL 1995

Amends the Income Tax (Franking Deficit) Act 1987 to impose class C franking deficit tax. The liability for class C franking deficit tax is provided for as part of the class C franking account arrangements introduced by the Taxation Laws Amendment Bill (No. 4) 1995.

Date of effect: 1 July 1995.

Proposal announced: The class C franking account arrangements were announced in the 1995-1996 Budget on 9 May 1995.

Financial impact: There is insufficient data available on which a reliable estimate of the revenue impact of the class C franking account arrangements can be made. However, it is considered that the revenue impact is minimal.

Compliance cost impact: The class C franking account arrangements will reduce compliance costs for most companies because they will convert from the present dual franking account system to a single franking account. Initial costs will be incurred in establishing the class C franking account but these are not expected to be significant.

INCOME TAX (DEFICIT DEFERRAL) AMENDMENT BILL 1995

Amends the Income Tax (Deficit Deferral) Act 1994 to impose class C deficit deferral tax. The liability for class C deficit deferral tax is provided for as part of the class C franking account arrangements introduced by the Taxation Laws Amendment Bill (No. 4) 1995.

Date of effect: 1 July 1995.

Proposal announced: The class C franking account arrangements were announced in the 1995-1996 Budget on 9 May 1995.

Financial impact: There is insufficient data available on which a reliable estimate of the revenue impact of the class C franking account arrangements can be made. However, it is considered that the revenue impact is minimal.

Compliance cost impact: The class C franking account arrangements will reduce compliance costs for most companies because they will convert from the present dual franking account system to a single franking account. Initial costs will be incurred in establishing the class C franking account but these are not expected to be significant.

Chapter 1 - Capital gains tax - amendments relating to value shifting

Overview

1.1 The provisions contained in Part 1 of Schedule 1 of the Bill will amend the capital gains tax (CGT) provisions in Division 19A of Part IIIA of the Income Tax Assessment Act 1936 (the Act). Division 19A operates to prevent timing advantages that could arise when assets are transferred and values are shifted between shares and loans in commonly owned transferor and transferee companies. The Schedule also contains other technical amendments designed to simplify and clarify the operation of Division 19A.

Summary of the amendments

Purpose of the amendments

1.2 The main purpose of the amendments is to reduce compliance costs for corporate taxpayers especially in relation to assets being transferred as part of corporate restructures. The amendments are in response to submissions received which have emphasised that the continued application of Division 19A in its current form could act as a disincentive to corporate restructuring.

Date of effect

1.3 The amendments, which were foreshadowed by the Treasurer in the 1995-96 Budget, apply to assets transferred after 7.30 pm AEST on 9 May 1995. [Item 17]

Background to the legislation

1.4 Division 19A applies to transfers of assets between companies under 'common ownership' (as defined at section 160ZZRB) and provides for adjustments to the cost bases of shares and loans held in the transferor and transferee companies in circumstances where a 'value shift' is taken to have occurred. The Division provides a number of tests to be applied in determining whether there has been a value shift, and therefore whether consequential cost base adjustments are required.

1.5 In the absence of cost base adjustments, companies under common ownership could transfer assets for low or negligible consideration, and realise a capital loss (or reduced capital gain) on a subsequent disposal of shares or loans in the transferor company. It would be inappropriate to allow a capital loss (or reduced gain) in these circumstances where the transferred asset remains within the commonly owned group of companies.

1.6 The criteria, methods and formulae for determining whether cost base adjustments are required are contained in sections 160ZZRE, 160ZZRF and 160ZZRFA. The criteria include:

•

whether the transferred asset is a pre or post CGT asset in the hands of the transferor;

•

whether the asset was acquired by the transferor company before or after the date of 'common ownership' with the transferee. Sections 160ZZRE (post CGT assets) and 160ZZRFA (pre CGT assets) deal with assets acquired when the transferor and the transferee are under common ownership and section 160ZZRF deals with both pre and post CGT assets acquired before common ownership occurs; and

•

the consideration paid for the asset, the asset's market value and cost base (indexed or reduced) for CGT purposes.

Explanation of the amendments

1.7 The proposed amendments to Division 19A will:

•

provide an outline for the Division as amended by this Bill [item 2; new subsection 160ZZRAAA] . The amendments will also introduce new subdivision headings as partitions within the Division. New Subdivision A contains the Division's outline and interpretation provisions and new Subdivision B details how the existing provisions apply and how the amendments being proposed will apply to grouped and depreciable assets. New Subdivisions C and D contain amendments to deal with grouped and depreciable assets respectively. Existing provisions which deal with other assets and other adjustments are to be within new Subdivisions E and F respectively;

•

introduce an anti-avoidance measure so that cost base adjustments will be made to shares or loans in a company in respect of newly created assets, which are vested in a related company. For example, rights relating to an existing underlying asset could be created and vested in a related company for consideration less than its market value while ownership of the underlying asset remains with the transferor [item 5; new section 160ZZRBA] ;

•

simplify the tests used to determine whether a value shift has occurred where an asset that was acquired by a commonly owned company before it came to be under common ownership with the transferee company is transferred to another group company. These amendments, which compare the consideration for the transfer of the asset with the asset's market value at the time of common ownership (indexed from common ownership to when the transfer occurs), are contained in new Subdivisions A and C;

•

enable a commonly owned company to group assets which are transferred to a particular transferee company in a given year of income for the purposes of applying Division 19A [new Subdivision C] ;

•

insert new rules to be applied in determining when a value shift will be taken to have occurred as a consequence of the transfer of a depreciable asset between commonly owned companies [new Subdivision D] ;

•

modify and extend the current tests used in subsection 160ZZRE(6) to determine whether a value shift has occurred. The current provisions only apply where shares, loans or shares of different classes are owned by the same taxpayer. The amendments will recognise situations where interests in the transferor are held by more than one member of the company group [items 10 and 11] ;

•

make technical and consequential amendments to the operation of Division 19A as it relates to consequential adjustments to the cost bases of indirectly held interests in a transferor company (to reflect the value shift) and compensatory increases in the cost bases of equity interests in a transferee company [items 3, 9, 15 and 16; new subsection 160ZZRE(1B)] .

1.8 The amendments referred to above are explained in the following sections.

Section 1 - Anti-avoidance measure for newly created assets

Summary of current legislation

1.9 Any asset deemed under subsections 160M(6) and (7) (for example the right to exploit a trademark) to have been created and disposed of by a taxpayer will generally be, for the purposes of Division 19A, a post CGT, post common ownership asset.

1.10 Paragraphs 160M(6A)(c) and 160M(7)(d) provide that the cost base of such assets for CGT purposes will be limited to the amount of any costs which are incidental to the disposal of the asset. To determine whether a value shift has occurred for the purposes of Division 19A in relation to post CGT/post common ownership assets, section 160ZZRE requires a comparison between the consideration for the transfer of the asset and the lesser of the asset's indexed cost base or market value.

1.11 As the indexed cost base of such assets will be nil, Division 19A cannot currently apply where the asset is vested in a commonly owned company for low or nil consideration.

Amendments proposed

1.12 The Bill proposes an amendment to Division 19A so that the cost base, the indexed cost base and the reduced cost base of an asset to which subsections 160M(6) or (7) apply at a particular time will be equal to the market value of the asset at that time. [Item 5; new section 160ZZRBA]

1.13 Therefore, where the consideration for the transfer of the newly created asset is less than its market value, the cost bases of shares and loans in the company creating the new asset will be reduced pursuant to section 160ZZRE by an amount equal to the amount by which the market value of the asset exceeds the consideration for the transfer.

Section 2 - Simplification of tests in relation to assets acquired prior to the date of common ownership

Summary of current legislation

1.14 Where a transferred asset was acquired prior to the date of common ownership of the transferor and transferee companies, subsections 160ZZRF(2) and (3) require a determination of reasonable cost base adjustments in shares and loans in the transferor having regard to a number of tests. Section 160ZZRB provides the criteria which must be satisfied for two companies to be treated as being under common ownership for the purposes of applying Division 19A.

1.15 Subsections 160ZZRF(2) and (3) deal with assets acquired by the transferor after 19 September 1985 (post CGT assets) and before 20 September 1985 (pre CGT assets) respectively.

1.16 The tests in subsection 160ZZRF(2) to determine whether the cost base adjustments are reasonable for post CGT assets have regard to (at paragraph 160ZZRF(2)(e)) the consideration given on disposal of the asset to the transferee. There is no comparable test in subsection 160ZZRF(3) in relation to pre CGT assets. The amendments proposed will achieve consistency in this regard.

Amendments proposed

1.17 The Bill proposes an amendment to the operation of these provisions in relation to both pre and post CGT assets acquired before the time of common ownership of the transferor and transferee companies. Taxpayers may elect that, where the consideration for the transfer of a pre common ownership asset exceeds the 'indexed common ownership market value' amount of the asset, the tests in section 160ZZRF will be taken to have been satisfied. [Item 13; new subsections 160ZZRF(4) and (6)]

1.18 The 'indexed common ownership market value' amount is determined by the application of an indexation factor to the amount that was the market value of the asset at the time that the transferor and transferee companies came under common ownership. [Item 5; new subsection 160ZZRBB(1)]

1.19 The Bill proposes the repeal of the tests in subsections 160ZZRF(2) and 160ZZRF(3) [item 12] and the introduction of new subsection 160ZZRF(5) which will apply in relation to both pre and post CGT assets. The matters required to be considered in new subsection 160ZZRF(5), to determine whether cost base reductions to a share or loan are required as a consequence of the transfer of a pre common ownership asset are a restatement of the matters contained in existing subsection 160ZZRF(3).

Section 3 - Grouping of assets to be transferred

Summary of current legislation

1.20 As illustrated in the example below, the current application of Division 19A could result in cost base reduction calculations being required in circumstances where no overall value shift has actually taken place in respect of interests held in the transferor. This is because Division 19A does not recognise and account for higher consideration given for the transfer of a second asset.

Example

1.21 Company A transfers a post common post/ownership CGT asset to commonly owned company B for consideration of $50. The indexed cost base of the asset is $100 and its market value is $150. In the course of the same group restructure, another asset is transferred by company A to B for cash consideration of $100. This asset has an indexed cost base of $50. By section 160ZZRE, a value shift of $50 has occurred in relation to the first asset, and the cost base of shares and loans in company A must therefore be reduced. However, the increased consideration given for the transfer of the second asset, is not taken into account.

1.22 In addition, currently where a group of assets is transferred, whether consequential cost base reductions are required and the extent of those cost base reductions must be determined on an asset by asset basis. This leads to unnecessary compliance costs for taxpayers.

Amendments proposed

Transferor may elect to group assets

1.23 The Bill proposes to introduce a new Subdivision C into Division 19A to provide that, at the election of a transferor company, assets to be transferred to a particular transferee company in a given year of income may be 'grouped' for the purposes of the applying the Division [item 8] . All of the assets in a particular group must be transferred to the same transferee in the same year of income of the transferor [new subsection 160ZZRDE(3), new paragraphs 160ZZRDF(1)(b), 160ZZRDG(1)(b), and 160ZZRDH(1)(c)] .

1.24 Under the amendments proposed, assets may be allocated to the following three groups [new subsection 160ZZRDE(2)] :

•

depreciable property group

•

pre-common ownership group; and

•

post-common ownership group.

1.25 These groups are described in more detail below.

Depreciable assets groups

1.26 The criteria which determine whether an asset can be allocated to a depreciable asset group are contained in new subsections 160ZZRDF(1) and (2) and include the following:

•

the asset is a depreciable asset [paragraph 160ZZRDF(1)(a)] ;

•

the asset's original cost to the transferor was less than $1million [paragraph 160ZZRDF(1)(c)] ; and

•

the asset is not a building [paragraph 160ZZRDF(1)(d)] .

1.27 Item 4 introduces new definitions into section 160ZZRA of the Act for 'original cost' and 'written down value' of an asset for the purposes of applying Division 19A as amended by the Bill. Original cost means the consideration for the last acquisition of the asset and the written down value is defined as the greater of the book written down value and the depreciated value for tax purposes.

Application of new Subdivision D to depreciable assets

1.28 New Subdivision D contains the provisions for the application of Division 19A to depreciable assets. Subdivision D will apply to depreciable assets where the total consideration for the disposal of the depreciable assets is less than the sum of the written down values of the assets in the group [new paragraph 160ZZRDF(2)(a)] . In addition the sum of the market values of the assets in the group must not exceed the sum of the written down values of the assets in the group by more than 10% [new paragraph 160ZZRDF(2)(b)] .

1.29 By grouping depreciable assets, the Division will be applied as if all the grouped assets were one asset that:

•

was disposed of for the sum of the consideration received for all the grouped assets [new paragraph 160ZZRDF(3)(b)] ; and

•

had a written down value equal to the sum of the written down values of all the grouped assets [new paragraph 160ZZRDF(3)(c)] .

1.30 Depreciable assets may be pre or post CGT assets which were acquired before or after the date of common ownership of the companies.

Pre-common ownership asset groups

1.31 An asset can be allocated to this group if, in addition to meeting certain other criteria, it was acquired by the transferor before the transferor and transferee came under common ownership [new paragraph 160ZZRDG(1)(a)] . As with depreciable assets, for an asset to be within this group its original cost must be less than $1 million, and the asset cannot be land or a building [new paragraphs 160ZZRDG(1)(c) and (d)] .

Post-common ownership asset groups

1.32 The acquisition time in relation to common ownership is the main distinguishing feature between pre-common and post-common asset groups. An asset can be allocated to the post-common asset group if, in addition to meeting certain other criteria, it was acquired by the transferor:

•

on or after 20 September 1985; and

•

at or after the time when the transferor and transferee came under common ownership. [New paragraph 160ZZRDH(1)(a)]

1.33 The condition imposed whereby a post-common ownership asset must be a post CGT asset means that section 160ZZFRA, which applies to pre CGT assets, will have no application in relation to the grouping provisions. As with depreciable and pre-common assets, other criteria to be satisfied for an asset to be within the post-common ownership asset group are that its original cost is to be less than $1 million and the asset cannot be land or a building. [New paragraphs 160ZZRDH(1)(c) and (d)]

Application of existing provisions in Division 19A to pre-common and post-common assets groups

1.34 In relation to pre common and post common ownership asset groups, the proposed amendments provide that existing tests and cost base reduction formulae set out in sections 160ZZRF [new subsections 160ZZRDG(2) and (3)] and 160ZZRE [new subsections 160ZZRDH(2) and (3)] are to be applied as if the group of assets were a single asset.

1.35 For assets in the pre common ownership group, section 160ZZRF will apply if the total consideration received on disposal is less than the sum of all the indexed common ownership market values at the time of disposal of those assets. [New subsection 160ZZRDG(2)]

1.36 For assets in the post-common ownership group, section 160ZZRE will apply if the sum of the total consideration on disposal of those assets is less than the sum of the 'indexed threshold amounts' in respect of all the assets in the group. [New subsection 160ZZRDH(2)]

1.37 The indexed threshold amount for an asset is defined as the lesser of the indexed cost base and the market value of each asset. [Item 9; new subsection 160ZZRE(1B)]

Shares or loans created after the disposal of the first asset in the group

1.38 New section 160ZZRDI is necessary to enable Division 19A to apply appropriately in situations where a share or a loan in a transferor comes into existence after the time when the first of a group of assets is disposed of during a year of income but before the transfer of the last asset to be included in the group. [Item 8]

1.39 Grouped assets are deemed to have been disposed of at the time when the first asset in a group was transferred (the adjustment time), regardless of when in the year of income the actual transfer of the asset occurs. Therefore, a share or loan may relate to an asset which is transferred and which, by virtue of the new grouping provisions, will be deemed to have been transferred before the share came into existence. Cost base adjustments would be inappropriately limited to shares and loans held by the transferor prior to the adjustment time even though value had been shifted out of the share or loan subsequently created. By new subsection 160ZZRDI(3) where subsection 160ZZRDI(1) applies in relation to a share or loan, the share or loan will be taken to have been existence at the adjustment time. An exception applies if new shares are issued in replacement of a share that is, or is to be cancelled [new subsection 160ZZRDI(2)] .

Section 4 - Depreciable assets

Summary of current legislation

1.40 Sections 160ZZRE and 160ZZRF, which are referred to in the Background to this chapter, currently operate in the same way in relation to the transfer between companies under common ownership of a depreciable asset as for any other asset. To comply with the current provisions, a transferor is required to determine the market value of each asset.

Amendments proposed

1.41 The Bill will insert new Subdivision D to provide specific formulae for determining the cost base reductions in respect of shares and loans in a transferor company where a value shift takes place as a consequence of the transfer of a depreciable asset. The criteria to be satisfied for an asset to be a depreciable asset are contained in new subsection 160ZZRDB(1) [item 8] and described in Section 3 above.

1.42 Under the amendments proposed in relation to depreciable assets, the transferor will merely be required to compare the consideration given for the transfer of the asset with the written down value of the asset. The concept of written down value is explained in Section 3 above. [Item 4]

1.43 The application of new Subdivision D is not elective. New subsection 160ZZRDB(2) [item 8] in new Subdivision B provides that new Subdivision E (which contains existing sections 160ZZRE and 160ZZRF) will not have any operation in relation to assets to which Subdivision D applies. It would generally be expected that the written down value of a depreciable asset will be less than either its indexed cost base or its indexed common ownership market value described in new subsection 160ZZRBB(1) which is inserted by Item 5 .

1.44 If the asset being disposed of is not a depreciable asset, then sections 160ZZRE, 160ZZRF or 160ZZRFA may apply in relation to the transfer and it will be necessary to go though the tests set out in whichever is the relevant section.

Cost base adjustments for depreciable assets under Division 19A

1.45 Once the tests to determine whether the asset being transferred is a depreciable asset are satisfied, the formulae in new Subdivision D, are applied to determine if cost base reductions to shares and loans in the transferor company are required. These tests are substantially the same as the existing tests in section 160ZZRE which apply to transfers of post CGT assets acquired after the time of common ownership of the transferor and transferee companies. [Item 8, new sections 160ZZRDJ, 160ZZRDK, 160ZZRDL, 160ZZRDM and 160ZZRDN]

1.46 Where both shares and loans are held in a transferor company, cost base reductions are applied firstly across the shares, and only to the loans if the cost base of all the shares has been reduced to nil. [New subsection 160ZZRDL(4)]

1.47 New subsection 160ZZRDJ provides that the cost base adjustments to shares in the transferor company will be required where the consideration for the disposal of the asset is less than the written down value of the asset [item 4] . For these purposes the operation of subsection 160ZD(2) which deems market value to have been received for the disposal of an asset where no consideration is received, or the amount received is less than the market value of the asset is specifically excluded by section 160ZZRA. Therefore the written down value must be compared to the actual consideration given.

1.48 To determine the amount by which the cost base of each post CGT share in the transferor is to be reduced, each share is taken to have been disposed of for an amount equal to the indexed cost base of the share [item 8, new subsection 160ZZRDJ(2)] and reacquired for a new cost base reflecting the proportionate value reduction of the share [new subsections 160ZZRDJ(3), (4) and (5)] .

1.49 To determine this proportionate reduction in value, the market value of the share is compared to the market value of all shares (both pre and post CGT) held in the transferor company. [New subsection 160ZZRDJ(5)]

Shares of different classes

1.50 There may be shares of more than one class held in the transferor company. These may or may not be held by the same taxpayer. New section 160ZZRDK provides that where different classes of shares are held in a transferor, and the application of cost base reductions as provided by the formula in new subsection 160ZZRDJ(5) would be unreasonable, then cost base reductions will instead be made on a 'reasonable' basis. Subsection 160ZZRE(6) is an equivalent provision in Division 19A.

1.51 The criteria for determining whether cost base reductions are 'reasonable' are set out at new section 160ZZRDK. The taxpayer is required to have regard to the circumstances in which post CGT shares in the transferor were acquired, and the extent to which their market value is reduced as a consequence of the value shift. That is, the cost base reductions should reflect the value that has been shifted out of the post CGT shares.

Loans to transferor - depreciable assets

1.52 If the cost base reduction rules have applied in relation to the shares in a transferor company, and as a consequence the cost bases of all post CGT shares in the transferor have been reduced to nil, or there are no post CGT shares in a transferor [new section 160ZZRDL] , it is necessary to determine whether consequential cost base adjustments are also required to post CGT loans held in the transferor company [new section 160ZZRDM] .

1.53 The section will only apply to loans where the value of the loan will be reduced as a consequence of the transfer of the asset. The formula provided by [new section 160ZZRDM] will apply to all non arms length loans subject to [new section 160ZZRDN] which is described at paragraph 1.57 below.

1.54 Where the threshold tests are satisfied, the loan will be taken to have been disposed of [new subsection 160ZZRDM(1)] and re-acquired for an amount which reflects the 'total excess share reduction amount' [new subsections 160ZZRDM(2), (3), (5) and (6)] .

1.55 The total excess share reduction amount is the proportion of the difference between the consideration received for the transfer of the asset and the written down value of the asset which has not been offset by a share reduction amount as described in new subsection 160ZZRDJ(5).

1.56 Where no amount of the total excess share reduction amount has been applied to reduce the cost base of post CGT shares in the transferor (for example if there are none) then the whole amount of the share reduction amount will be available to reduce the cost base of qualifying loans. [New subsection 160ZZRDM(4)]

More than one loan

1.57 If there is more than one loan in the transferor company, whether held by a related company or otherwise and whether or not arms length, the general rules are modified so that the cost base of the loan is reduced on a 'reasonable' basis having regard to the circumstances in which the loan was acquired and the extent of the actual value that has been shifted out of the loan. A disproportionate actual value shift may occur between (for example) secured and unsecured loans. [New section 160ZZRDN]

Section 5 - Modification and extension of 'reasonable test' for certain assets transferred

Summary of current legislation

1.58 Section 160ZZRE operates to determine the amount by which the cost base, indexed cost base or reduced cost base of directly held shares in (or, in some cases, loans to) the transferor will be reduced as a result of the transfer of an asset.

1.59 Subsection 160ZZRE(6) operates to provide relief from the formulae in subsections (3) and (4) where the application of those formulae would produce unreasonable results in relation to cost base reductions. The subsection prevents the operation of subsections (3) and (4) and modifies the cost base reductions having regard to the circumstances in which the post CGT share or loan was acquired and the extent of the reduction in the market value of the post CGT share or loan.

1.60 As currently drafted, subsection 160ZZRE(6) only applies where pre and post CGT shares and loans, shares of different classes or more than one loan are owned by the same taxpayer. However, where a value shift occurs, the reduction in the value of shares and loans in the transferor company will be spread across all shareholders and/or creditors.

Amendments proposed

1.61 The Bill proposes an amendment to the tests referred to in paragraph 160ZZRE(6)(b) to remove the current restriction that the shares and loans to which subsection 160ZZRE(6) relates must belong to the same taxpayer. [Items 10 and 11; new sub-subparagraphs 160ZZRE(6)(b)(ii)A and B]

Section 6 - Minor technical and consequential amendments

Summary of current legislation

1.62 Section 160ZZRG currently applies to reduce the cost base, the indexed cost base or the reduced cost base of underlying interests in the transferor, through shares or loans, acquired after 19 September 1985. Section 160ZZRH operates to increase the relevant cost base of a share or underlying interest in a share in the transferee company acquired after 19 September 1985.

1.63 The current application of subsection 160ZZRD(2) limits the operation of sections 160ZZRG and 160ZZRH to situations where section 160ZZRE applies. That is, where consideration for the transfer is less than the indexed cost base or the market value of the asset.

Amendments proposed

1.64 The Bill proposes an amendment to remove the current limitations to the operation of sections 160ZZRG and 160ZZRH. This will be achieved by deleting subsection 160ZZRD(2) and replacing it with new subsection 160ZZRE(1B) which will not limit the operation of sections 160ZZRG and 160ZZRH. [Items 3, 7 and 9]

1.65 New Subdivision F will head existing sections 160ZZRG and 160ZZRH. Section 160ZZRG applies to reduce the relevant cost base of underlying interests, acquired after 19 September 1985, through holding shares in or providing loans to the transferor company who disposes of an asset which results in a shift in value under the Division. Section 160ZZRH applies in a compensatory manner to increase the relevant cost base of interests in the transferee company.

1.66 Because of the restructure of the Division through the use of Subdivisions, the existing references in paragraph (d) of section 160ZZRH to operative provisions in Division 19A will be replaced with references to the new Subdivisions containing those provisions [item 15] . Further, a new subsection 160ZZRH(2) will be introduced to ensure that increases in the interests in the transferee (from acquiring an asset) under existing section 160ZZRH will not exceed the total of the adjustments made under 'earlier sections' in Division 19A in relation to that asset [item 16] .

Chapter 2 - capital gains tax - Various amendments

Overview

2.1 Part 2 of Schedule 1 of the Bill will amend the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1936 (the Act) to:

•

increase the current thresholds of $100 and $5,000 for listed and non-listed personal-use assets to $500 and $10,000; and

•

introduce safeguard provisions to prevent exploitation of the proposed $500 threshold for listed personal-use assets;

•

ensure that CGT will apply to all gains realised by non-residents on the disposal of taxable Australian assets;

•

extend CGT relief provided by subsection 160ZA(7) to assets created on or before 25 June 1992;

•

limit CGT relief in relation to tax exempt non-portfolio dividends;

•

provide that CGT relief for capital amounts included in whole or in part in a taxpayers assessable income will apply only to eligible termination payments;

•

generally prevent capital losses being realised when assets are transferred between related companies; and

•

provide CGT rollover relief for disposals of assets occurring as a consequence of the conversion of a complying approved deposit fund (ADF) to a complying superannuation fund, or where an existing complying ADF or complying superannuation fund amends or replaces its trust deed to comply with the Superannuation Industry (Supervision) Act 1993.

Section 1 - Increase in personal-use asset thresholds

Summary of the amendments

Purpose of the amendments

2.2 The amendments will provide the first increase in the thresholds for personal-use assets since the CGT legislation was introduced in 1985. The increase in the CPI since that date has eroded the value of the thresholds.

2.3 The increased thresholds will:

•

ease the record keeping requirements for taxpayers in relation to some personal-use assets already acquired; and

•

reduce the scope of personal use assets to which the CGT provisions will apply.

2.4 The proposed amendments will also ensure that the new listed personal-use asset threshold of $500 applies appropriately where an asset is jointly owned or forms part of a set of articles.

Date of effect

2.5 The increased thresholds for listed and non-listed personal-use assets will apply to disposals of assets on or after 1 July 1995. [Subitem 34(1)]

2.6 The safeguard measures relating to the joint ownership and sets of listed personal-use assets will apply to assets acquired after Royal Assent of the Bill. [Subitems 34(2) and (3)]

Background to the legislation

2.7 A personal-use asset is defined in subsection 160B(1) of the Act as an asset (other than land, or a building that is deemed to be a separate asset from the land by virtue of section 160P) which is kept primarily for the personal use and enjoyment of the taxpayer or associates of the taxpayer. The definition also extends to options and debts in respect of such assets.

2.8 The CGT provisions distinguish between:

•

a 'listed' personal-use asset, being an asset which costs more than $100 and which is listed in subsection 160B(2). Examples include a stamp, coin, antique, and an interest in such assets; and

•

a 'non-listed' personal-use asset which is described in subsection 160B(3), in a 'catch-all' way, as being a personal-use asset other than a listed personal-use asset.

Non-listed personal-use assets

Below the $5,000 threshold

2.9 The CGT provisions currently operate to remove non-listed personal-use assets which fall below the $5,000 threshold from the CGT provisions. Where the cost base and indexed cost base is less than $5,000, section 160ZG deems the cost base and indexed cost base to be $5,000. Where the actual consideration on disposal is less than $5,000, section 160ZE deems the consideration to be $5,000.

Safeguard provisions to prevent exploitation of the threshold

2.10 Safeguard provisions also apply in situations where parts of a non listed personal-use asset are sold separately for less than $5,000 in order to take advantage of the $5,000 threshold. Subsections 160ZE(2) and 160ZG(2) operate to pro-rate the $5,000 threshold in these situations and, in effect, treat the part of the asset sold as a separate asset.

2.11 The CGT provisions also address potential exploitation of the $5,000 threshold in situations involving the disposal of non-listed personal use assets which would ordinarily be disposed of as a set of articles. Subsection 160B(4) provides that where the disposal of a set of articles involves 2 or more transactions (for example, a transaction for a specific article), each article disposed of is to be treated as a disposal of part of the asset represented by the set of articles.

Explanation of the amendments

2.12 The Bill proposes amendments to the CGT provisions to increase the thresholds for listed and non-listed personal-use assets. The thresholds proposed are:

•

$500 to replace the current $100 threshold for listed personal use assets [item 20] ; and

•

$10,000 to replace the current $5,000 threshold for non-listed personal-use assets [items 27 and 28] .

Safeguard measures for listed personal-use assets

2.13 In relation to listed personal-use assets, safeguard provisions are proposed to prevent the exploitation of the new threshold. This threshold could be exploited in two ways. As explained above, safeguard provisions currently only apply to 'protect' the threshold for non-listed personal-use assets.

Set of articles

2.14 Where a listed personal-use asset forms part of a set of articles, the particular article could be sold separately to take advantage of the threshold. As explained in the Background above, subsection 160B(4) currently safeguards the $5,000 threshold for non-listed personal-use assets which are ordinarily disposed of as a set of articles. The subsection provides that the set of articles is deemed to constitute a single asset and each article disposed of is treated as the disposal of a part of that asset.

2.15 The Bill proposes to extend the operation of subsection 160B(4) to include listed personal-use assets. [Item 22]

Joint ownership - an interest in a listed personal-use asset

2.16 Within the listed personal-use assets in subsection 160B(2), subparagraph 160B(2)(a)(vii) provides that an interest in a listed asset is itself a listed personal-use asset. This means that where a listed personal use asset is jointly owned, the full threshold is currently available to each part owner of the asset. As a result, an asset could fall outside the CGT provisions even though its total cost exceeds the current $100 or proposed $500 threshold.

2.17 An amendment is proposed to address similar concerns to those which arise on the disposal of part of a non-listed personal-use asset. In particular, the amendment will address situations where a listed personal use asset is an interest in a personal-use asset.

2.18 In these circumstances, the threshold test will be referenced to the market value of the asset at the time the interest is acquired rather than, as the current law provides, the value of the interest. [Item 21; new subsection 160B(2A)]

2.19 The following example illustrates how the joint ownership provision will operate.

Example

2.20 An antique worth $800, being a listed personal-use asset, is purchased jointly by two taxpayers for $400 each. Each taxpayer has acquired a listed personal use asset for $400 as represented by their interest in the antique. Without a safeguard provision, each interest would not be caught by the CGT provisions as the cost of the interest ($400) does not exceed the proposed $500 threshold.

2.21 Under the amendment proposed by new subsection 160B(2A) , the asset, as represented by a $400 interest, will come within the CGT provisions as the total value of the underlying asset ($800) when the interest was acquired exceeded the proposed $500 threshold.

Section 2- Taxable Australian assets

Summary of the amendments

Purpose of the amendments

2.22 The Bill proposes an amendment to ensure that CGT will apply in relation to gains realised by non-residents on the disposal of taxable Australian assets used solely to produce franked dividends or income subject to withholding tax in Australia.

Date of effect

2.23 Generally, the amendments will apply to disposals of taxable Australian assets taking place after 19 September 1985, which is the date on which the introduction of the CGT provisions was announced. However, the amendments will not apply in relation to transactions which had been commenced to be carried out prior to 7.30 pm AEST on 9 May 1995, where the transaction was covered by a private binding ruling issued by the Commissioner of Taxation under Part IVAA of the Taxation Administration Act 1953. [Subitems 35(1) and (2)]

Background to the legislation

2.24 Non-residents are subject to CGT only on gains and losses realised on disposals of taxable Australian assets. Section 160T of the Act defines disposals of assets which will be deemed to be disposals of taxable Australian assets for these purposes. Disposals of taxable Australian assets include a disposal of a share in a resident public company of which the taxpayer (and/or associates of the taxpayer) holds a ten percent or greater interest, any shares in a resident private company, or an asset that has been used to carry on a trade or business wholly or partially through a permanent establishment in Australia.

2.25 Subsection 160Z(6) and paragraph 160Z(9)(c) provide an exemption from CGT for gains and losses realised on the disposal of assets (including taxable Australian assets) used solely for the purpose of producing 'eligible exempt income'. Subsection 160Z(10) defines 'eligible exempt income' as generally being 'exempt income'. The term 'exempt income' is defined in subsection 6(1) of the Act as including income which is not assessable income.

2.26 Section 128D of the Act provides that certain income (eg income in relation to which withholding tax is payable such as royalties paid to a non resident taxpayer, or on which withholding tax would, but for another provision of the Act be payable, such as franked dividends paid to non residents) shall not be included in the assessable income of a taxpayer. This exemption reflects the fact that tax has already been paid in relation to the income.

2.27 It has been argued that the CGT exemption for assets used to produce 'eligible exempt income' will apply to disposals of taxable Australian assets used solely to produce income which, by section 128D is not included in a taxpayers assessable income. Therefore, assets used through a permanent business establishment in Australia to produce royalty income or shares in Australian companies which are used to produce franked dividends or dividends subject to withholding tax would not be subject to CGT on disposal. This interpretation of the application of the legislation is contrary to the clear intention of Parliament as reflected in paragraphs (b), (c) and (d) of the definition of disposals of taxable Australian assets in section 160T.

Explanation of the amendments

2.28 The Bill amends subsection 160Z(10) of the Act to specify that 'exempt income' for the purposes of subsection 160Z(6) and paragraph 160Z(9)(c) will not include income to which section 128D applies [item 23] . Because this amendment reflects the clear intention of Parliament in relation to gains realised on disposals of taxable Australian assets as reflected in section 160T, it will apply to disposals of taxable Australian assets occurring on or after 20 September 1985, which is the date on which the enactment of the CGT provisions was announced [subitem 35(1)] .

2.29 The clarifying amendment will not apply where a transaction covered by a private binding ruling from the Commissioner of Taxation (i.e. a ruling to which Part IVAA of the Taxation Administration Act 1953 applies) was commenced to be carried out prior to 7.30 pm AEST on 9 May 1995 [subitem 35(2)] . This will ensure that, if a taxpayer received a ruling contrary to the intended operation of the Act, the taxpayer will still be able to rely on that ruling provided the relevant transaction was commenced prior to the announcement of this clarifying amendment.

Section 3 - Exempt receipts

Summary of the amendments

Purpose of the amendments

2.30 The Bill will:

•

provide uniform CGT relief for non-portfolio dividends received by resident companies from non-resident companies where the dividend is exempt from tax under section 23AJ of the Act, irrespective of whether the shares in the non-resident company were issued before, on or after 25 June 1992;

•

ensure that CGT relief for the tax exempt non-portfolio dividends referred to above will not be available in relation to dividends paid out of share capital accounts, share premium accounts or asset revaluation reserves of the non-resident company; and

•

provide that the CGT tax relief under subsection 160ZA(8) in relation to capital amounts which are expressly included in part in the assessable income of a taxpayer will apply only to eligible termination payments (ETPs).

Date of effect

2.31 CGT relief for disposals of shares giving rise to non-portfolio dividends which are exempt from income tax under section 23AJ will apply to disposals of shares in the 1990-91 year of income (the year from which section 23AJ applies) and in subsequent years of income. [Item 1, Part 1, Schedule 6]

2.32 The proposals to:

•

deny CGT relief under subsection 160ZA(7) (in relation to non-portfolio dividends paid out of share capital accounts, share premium accounts or revaluation reserves); and

•

apply the relief under subsection 160ZA(8) only to disposals of assets giving rise to ETP's;

will apply to disposals of assets after 7.30 pm AEST on 9 May 1995 (Budget night). [Item 36]

Background to the legislation

2.33 Subsection 160ZA(4) of the Act operates to prevent double taxation by providing CGT relief for capital gains realised on the disposal of an asset where, as a consequence of the disposal, an amount is also included in the taxpayer's assessable income.

2.34 Subsection 160ZA(7) extends the CGT relief provided by subsection 160ZA(4) in circumstances where, as a consequence of the disposal of an asset, an amount which would otherwise be included in the assessable income of the taxpayer is specifically exempt from tax or is concessionally taxed under another provision of the Act. The CGT relief provided by subsection 160ZA(7), currently applies only to the disposal of assets (including shares) created after 25 June 1992.

2.35 Section 23AJ of the Act exempts from tax certain non-portfolio dividends received by an Australian company from a foreign company. A non portfolio dividend is a dividend paid in relation to shares which have a voting interest of at least 10 per cent. The exemption for dividends provided by section 23AJ applies to receipts which are 'exempting receipts' for the purposes of section 380 of the Act and which are received by a resident company during its 1990-91 income year or any subsequent year of income.

2.36 Subsection 160ZA(7) applies to exempt from CGT an amount received on the disposal of a share to the extent that the amount received on the disposal is treated as a dividend which is exempt under section 23AJ.

2.37 However, as described above, the relief provided by subsection 160ZA(7) applies only to assets created after 25 June 1992, which is the date of commencement of the subsection. Therefore, subsection 160ZA(7) does not provide for a reduction in any capital gains arising on the disposal of shares in foreign companies where the shares were issued before 26 June 1992.

2.38 Subsection 160ZA(8) applies where part of an otherwise non assessable amount is specifically included in the assessable income of a taxpayer. The subsection provides that, for the purposes of the application of subsection 160ZA(4), the whole of the amount is to be taken to have been included in assessable income. Therefore, the whole amount of the receipt will be excluded from CGT even though only a part of the payment will be taxable as income.

Explanation of the amendments

Exempt dividends

2.39 The Bill amends section 47 of the Taxation Laws Amendment Act 1993 to provide that subsection 160ZA(7) will apply to disposals of assets occurring during or after the 1990-91 year of income of the taxpayer, which is the date from which the income tax exemption for non-portfolio dividends under section 23AJ applies. [Item 1, Part 1, Schedule 6]

2.40 The Bill also proposes new subsection 160ZA(7A) which specifies that disposals of shares in foreign companies giving rise to non-portfolio dividends which are exempt from tax under section 23AJ, will only qualify for CGT relief to the extent that the dividend is not paid out of share capital, share premium accounts or asset revaluation reserves. [Paragraphs (a), (b) and (c) of item 25]

2.41 In addition, CGT relief will not be available under subsection 160ZA(7) in relation to disposals of shares giving rise to non-portfolio dividends which are attributable to amounts transferred from a share capital account, a share premium account or an asset revaluation reserve of the non resident company. This is because the underlying amounts out of which the dividend is paid would not have been subjected to tax in the foreign country. [Paragraph (d) of item 25]

2.42 The term 'share premium account' is defined in subsection 6(1) of the Act. Paragraphs (a) and (b) of the definition of 'share premium account' provide that where an amount which is not a share premium, or an amount that cannot be identified in the books of the company as a share premium, has been credited to the account, the account will cease to be a share premium account. However, by new subsection 160ZA(7A) , paragraphs (a) and (b) of the definition of 'share premium account' are to be disregarded for the purposes of the application of that subsection.

Eligible termination payments

2.43 Item 26 of the Bill amends subsection 160ZA(8) so that, for the purposes of the application of subsection 160ZA(4), only capital amounts that are eligible termination payments will, where included in part in the assessable income of a taxpayer, be taken to be wholly included.

2.44 This is consistent with the original purpose of subsection 160ZA(8). The current provision is stated in general terms and could provide relief in cases where it was not intended that relief be available.

Section 4 - Compulsory rollover of assets

Summary of the amendments

Purpose of the amendments

2.45 The amendments will ensure that the existing option in the CGT provisions, which allows a capital loss to be realised in the hands of a transferor, will generally no longer be available where a loss asset is transferred between related companies.

2.46 The amendments proposed will also:

•

exempt certain asset transfers from the compulsory rollover provisions being proposed. For example, where the transferor and transferee companies are 'related' at the time the asset is transferred but intend to become 'unrelated' by virtue of the transferee company being sold or floated by the company group; and

•

cater for situations where an amount of assessable income in respect of the asset being transferred has been attributed to the transferor under the controlled foreign companies (CFC) or foreign investment funds (FIF) provisions in Parts X and XI of the Act. In these situations, any 'attribution surplus' will be carried forward with the rolled over asset and used to reduce any capital gain or increase any capital loss in respect of the transferee's subsequent disposal.

Date of effect

2.47 The amendments will apply to assets transferred between related companies after 7.30 pm AEST on 9 May 1995. [Item 37]

Background to the legislation

2.48 When a rollover election is made under section 160ZZO, the CGT provisions do not apply to the disposal of the asset from the transferor to the transferee. In addition, paragraphs 160ZZO(e) and (f) provide that, when a rollover occurs, the asset maintains its CGT attributes in the hands of the transferee. Thus, the rollover provisions operate so that an asset acquired before 20 September 1985 will remain a pre CGT asset while the realisation of accrued gains on assets acquired after that date will be delayed for CGT purposes.

2.49 The current optional nature of the CGT rollover provisions in section 160ZZO of the Act allows related companies (defined in section 160G as companies within a company group sharing 100% common ownership) to offset a capital loss realised by the transfer of an asset to a related company against capital gains realised on third party transactions. As the related companies effectively represent a single entity, the capital loss does not represent a loss to the related companies as a group.

2.50 Due to the potential for capital gains to be sheltered by intra group capital losses, it is proposed to limit the realisation of capital losses to asset transfers where a loss is incurred by the related companies as a group. Consequently, the proposed amendments will generally require a compulsory rollover when asset transfers, which would give rise to a capital loss, are made between related companies.

Explanation of the amendments

Compulsory rollover

2.51 Subject to the exception explained below, the proposed amendments will alter the rollover option currently available through paragraph 160ZZO(1)(d) and make it compulsory to rollover assets which are transferred between related companies where the transfer would have resulted in a capital loss. Optional rollover relief will still apply to asset transfers between:

•

related companies which realise a capital gain; or

•

related companies which realise a capital loss and which fall within the exception explained below. [Item 29]

Exception to compulsory rollover

2.52 In response to submissions received, the amendments will provide that the compulsory rollover measures explained above will not apply where an asset is transferred to a related company which is to be sold or floated. Where a related company becomes unrelated, section 160ZZOA requires the company to make a deemed disposal and reacquisition of any rolled over assets held.

2.53 The exception proposed will enable the consequences of the deemed disposal and reacquisition to be avoided by allowing the transferor to transfer rather than rollover loss assets into the transferee company. Thus, the transferee can be sold or floated free of any potential capital gains tax implications. Also, the transferor will be able to offset capital gains and losses realised on assets transferred to the related transferee company.

2.54 The amendments will provide that a CGT rollover of a loss asset between related companies will not be compulsory where an election is made by both transferor and transferee companies [item 30, new subsection 160ZZO(1AA)] . An election for the compulsory rollover provisions not to apply can be made when it is intended that, before the end of the year of income after the year in which the disposal takes place:

•

the companies will cease to be related; and

•

the transferor, together with related companies of the transferor, will not hold 50% or more of the shares in the transferee company [item 30, new subsection 160ZZO(1AB)] .

2.55 If an election is made under new subsection 160ZZO(1AB) but the intentions expressed in that election are not met, no capital loss will be taken to have been realised by the transferor at the time when the asset was disposed [new subsection 160ZZO(1AC)] .

2.56 The amendments [new subsection 160ZZO(1AD)] will also provide that no capital loss will be taken to have been realised by the transferor if an election is made under new subsection 160ZZO(1AB) and one of the following events occurs within 4 years of the disposal of the asset by the transferor. The events include:

•

the asset being subsequently acquired by the transferor or a company related to the transferor; and

•

the asset being acquired by a company and, at the time of acquisition, the transferor, together with other companies related to the transferor, holds 50% or more of the shares in the company.

2.57 In determining whether these events occur, it is necessary for the amending provisions to disregard the period between the asset's disposal (when the transferor was related to the transferee) to when that relationship ceased.

2.58 New subsection 160ZZO(3) [item 30] updates the election mechanism currently contained in paragraph 160ZZO(1)(d). There will no longer be a requirement for the election to be given to the Commissioner. Consistent with recent practice, the elections under both new subparagraph 160ZZO(1)(d)(ii) and subsection 160ZZO(1AB) must be in writing and retained for 5 years in accordance with section 262A.

Cost base adjustments

2.59 Where a transferor company has an interest in a CFC or FIF, an 'attribution surplus' could exist in relation to that asset under section 370 of the Act in the case of an interest in a CFC, or section 604 in the case of an interest in a FIF. The surplus reflects the attributable income in respect of which tax has been assessed and can be applied to exempt that income from tax when it is subsequently received.

2.60 When a transferor disposes of the interest and an attribution surplus in respect of the CFC or FIF exists at the time of disposal, sections 461 and 613 of the Act operate to prevent double taxation by reducing the disposal consideration by the amount of the attribution surplus.

2.61 An anomaly arises if the interest in the CFC/FIF is disposed of to a related company and the disposal gives rise to a capital loss which is compulsorily rolled over under the CGT provisions. The benefit of the attribution surplus would be lost in this situation because there is currently no provision for the surplus to be transferred to the transferee company.

2.62 The Bill proposes that where:

•

new subsection 160ZZO(1AA) [item 30] applies to the disposal of an interest in a CFC/FIF to a related transferee so that a compulsory rollover occurs [item 31, new paragraphs 160ZZO(4)(a) and (b)] ; and

•

the original transferor's consideration on disposal is reduced under sections 461 or 613 as explained above [item 31, new paragraph 160ZZO(4)(c)] ;

then, new subsection 160ZZO(4) [item 31] will apply. The new subsection will operate to specify the CGT implications for the subsequent disposal of the asset by the transferee. The implications will be that the relevant cost base will be increased, at the time of that disposal, by the amount of the attribution surplus used to reduce the original transferor's consideration in respect of the asset. This adjustment will only be available to the first transferee company.

2.63 The Bill will also amend subsection 160ZZO(9A) to enable section 170, which deals with the amendment of assessments, to apply to give effect to new subsections 160ZZO(1AC) and (1AD) which are explained above under the heading 'Exception to compulsory rollover'. [Item 32]

Example

2.64 Company A disposes of an asset, being an interest in a CFC, to related Company B. On disposal, A's consideration received from B is reduced by $400, being the attribution surplus in respect of the asset. This creates a loss on the disposal such that a compulsory rollover of the asset would be required under the proposed amendments.

2.65 B disposes of the asset to an unrelated party for $1700 when the indexed cost base of the asset was $1200. When calculating the capital gain on disposal, the amendments proposed will allow B to use an indexed cost base of $1600 ($1200 increased by the attribution surplus of $400).

Section 5 - Amendment or replacement of trust deeds

Summary of proposed amendments

Purpose of amendments

2.66 The amendments will provide CGT rollover relief for disposals of assets occurring as a consequence of the conversion of a complying approved deposit fund (ADF) to a complying superannuation fund, or where an existing complying ADF or complying superannuation fund amends or replaces its trust deed to comply with the Superannuation Industry (Supervision) Act 1993.

Date of effect

2.67 The amendment will provide CGT rollover relief for disposals of assets occurring on or after 12 January 1994, which is the commencement date of certain amendments to subsection 160M(3) of the Act that deal with transfers of property to trusts and settlements of trusts. [Item 38]

Background to the legislation

2.68 Section 160M of the Act sets out the transactions which will constitute a disposal or acquisition of an asset for CGT purposes. Subsection 160M(1) provides that a change in the ownership of an asset will be taken be a disposal and acquisition of the asset.

2.69 Subsections 160M(1A) and 160M(3) apply specifically in relation to trusts. Subsection 160M(1A) provides that a change in the legal ownership of an asset (for example a change in the identity of a trustee where no beneficiary is absolutely entitled to the asset) shall not constitute a change in the ownership of the asset unless there is also a change in beneficial ownership.

2.70 Subsection 160M(1A) is expressed to be subject to subsection 160M(3) whereby a change will be taken to have occurred in the ownership of an asset by the creation of a trust (by declaration or settlement) over the asset. An exception to this rule applies where a trust is created by the transfer of an asset to the trust from another trust, and the beneficiaries and terms of the trusts are identical (subparagraph 160M(3)(a)(ii)). Subsection 160M(3) may apply where there is a change in the beneficial but not the legal ownership of an asset.

2.71 Following changes to the Superannuation Industry (Supervision) Act 1993 (the SIS Act) both superannuation funds and approved deposit funds (ADF's) may need to replace or amend their trust deeds in order to comply with the SIS Act. In addition, many ADF's will wish to convert to superannuation funds, since ADF's are now less attractive than superannuation funds as investment vehicles. In either case, the amendment or replacement of the superannuation fund or ADF trust deed will result in a change in the terms of the trust.

Explanation of the amendments

2.72 The Bill proposes new section 160ZZPJ [item 33] which grants a CGT rollover for disposals of assets which occur as a consequence of the amendment or replacement of the trust deed of a complying ADF or a complying superannuation fund [new paragraphs 160ZZPJ(1)(a), (b) and (d)] . The terms 'complying ADF' and 'complying superannuation fund' have the same meaning as in subsection 267(1) of the Act [new subsection 160ZZPJ(9)] . The amendment of the trust deed must be for the purpose of complying with the SIS Act or to enable an ADF to convert to a complying superannuation fund.

2.73 A requirement for the granting of a CGT rollover for disposals of assets occurring as a consequence of the amendment or replacement of an ADF or superannuation fund trust deed is that the members of the fund and the assets of the fund do not change as a consequence of the disposal [new paragraph 160ZZPJ(1)(c)] . Provided that the limitations in new subsection 160ZZPJ(1) are satisfied, the identity of the trustee (i.e. the legal ownership of the asset) is irrelevant.

2.74 Where the requirements for the granting of a rollover have been satisfied, Part IIIA will not apply in respect of any disposal constituted by the amendment or replacement of the trust deed [new subsection 160ZZPJ(2)] . The rollover is not elective.

2.75 As a consequence of the rollover, assets of the original fund (the first trust) acquired prior to 20 September 1985 will also be taken to have been acquired by the second trust before 20 September 1985. [New subsection 160ZZPJ(3)]

2.76 In relation to post CGT assets, in determining the amount of any capital gain or loss realised by the second trust on a subsequent disposal of the asset, the amount that would have been the indexed cost base or the reduced cost base (as the case may) of the asset if the first trust had disposed of the asset at the time of the rollover, will also be taken to be the relevant indexed cost base or reduced cost base of the asset to the second trust at that time. [New subsections 160ZZPJ(5), (6) and (7)]

2.77 If the second trust disposes of the asset within 12 months of the day on which the asset was last acquired by the first trust prior to the day on which the rollover took place (the last acquisition day), indexation of the cost base of the asset will not be available. [New subsections 160ZZPJ(8) and (3)]

Chapter 3 - Dividend imputation

Overview

3.1 Schedule 2 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) as a result of the increase in the company tax rate from 33% to 36%.

3.2 The amendments will require companies to establish a class C franking account and to record franking credits and debits and distribute imputation credits to shareholders by reference to tax paid at 36%. The value of existing class A and class B franking account balances will be preserved by converting them to the equivalent class C franking account balance.

3.3 The amendments will also correct certain existing defects in the dividend imputation provisions. As a result:

•

mutual life insurance companies will be entitled to a franking rebate for franked dividends received through a trust or partnership; and

•

non-mutual life insurance companies will not be entitled to a deduction for the imputation credit attached to a franked dividend received through a trust or partnership if a franking rebate is available.

3.4 The Income Tax (Franking Deficit) Amendment Bill 1995 and the Income Tax (Deficit Deferral) Amendment Bill 1995 will amend the Income Tax (Franking Deficit) Act 1987 and the Income Tax (Deficit Deferral) Act 1994 respectively to impose class C franking deficit tax and class C deficit deferral tax.

Summary of the amendments

Purpose of the amendments

3.5 The purpose of the amendments is to:

•

allow companies to record class C franking credits and debits and to distribute imputation credits to shareholders by reference to tax paid at 36%; and

•

correct certain existing defects in the dividend imputation provisions relating to life assurance companies.

Date of effect:

3.6 The class C franking account amendments will apply from 1 July 1995.

3.7 The amendments to correct the defects in the current provisions relating to life assurance companies will apply from the time the defects first arose. This means that the mutual life assurance company amendment will apply from 22 August 1990, and the non-mutual life assurance company amendment will apply from 7 December 1990.

Background to the legislation

3.8 The dividend imputation system contained in Part IIIAA of the Income Tax Assessment Act 1936 (the Act) operates to attribute (or impute) company tax to resident shareholders when dividends are paid to them out of profits. Resident individual shareholders are effectively subject to tax on the before-tax profit (consisting of the dividend and the imputed company tax component) but are entitled to a rebate of tax (the 'franking rebate') for the imputed company tax.

3.9 A dividend with an imputation credit attached to it is known as a 'franked dividend'. A resident company can pay a franked dividend by declaring a dividend to be franked to a specified percentage before paying it. The extent to which a dividend is franked depends, in broad terms, on the amount of taxed profits available for distribution by the company as reflected in its franking accounts. Non-resident shareholders are exempt from dividend withholding tax to the extent of the franked amount of a dividend.

Franking accounts

3.10 From the beginning of its 1994-95 franking year, a company must maintain two franking accounts: a class A franking account which represents profits taxed at the 39% and 49% company tax rate, and a class B franking account which represents profits taxed at the 33% company tax rate. Each franking account consists of franking credits that add to the amount of taxed profits that can be distributed as franked dividends, and of franking debits which reduce that amount.

3.11 Franking credits arise mainly at the time of payment of company tax instalments or company tax assessed, or when franked dividends are received from other resident companies. Franking debits arise mainly when the company franks the dividends it pays to its own shareholders. A franking debit also arises when company tax is refunded.

3.12 If, at the end of the franking year, there is a deficit in a franking account, that is, total franking debits of a particular class exceed total franking credits of the same class, the company becomes liable for franking deficit tax. Franking deficit tax is due and payable on the last day of the month after the end of the franking year. A penalty tax, the franking additional tax, may also be imposed if the company has over-franked dividends and its franking deficit at the end of the franking year is more than 10 per cent of the franking credits arising during the year.

3.13 If an instalment of tax paid in a franking year is refunded in the following franking year, and a franking deficit would have arisen if the refund had occurred at the end of the previous franking year, the company is liable to deficit deferral tax.

Calculation of franking credits and franking debits

3.14 The amount of a franking credit or franking debit that arises from the payment or refund of company tax is calculated by adjusting the tax amount by a factor based on the relevant company tax rate.

3.15 For a class A franking credit or debit, the relevant company tax rate is generally 39%. Applying the factor 61/39 to a tax amount of, say, $390 results in a class A franking credit of $610. This represents an amount that could be distributed as a fully franked class A franked dividend. However, in relation to tax paid for the 1986-87 and 1987-88 income years, the tax rate was 49% and the relevant factor is 51/49.

3.16 For class B franking credits and debits, the relevant company tax rate is 33%. Applying the factor 67/33 to a tax amount of, say, $330 results in a class B franking credit of $670. This represents an amount that could be distributed as a fully franked class B franked dividend.

Franked dividends

3.17 Companies also receive franking credits from the receipt of franked dividends, and franking debits from the payment of franked dividends. The amount of the credit or debit is the franked amount of the dividend. For example, if a company declares a dividend to be franked to 100 per cent, that is, the dividend is fully franked, there arises in the company's franking account, at the time the dividend is paid, a franking debit of an amount equal to the amount of the dividend.

3.18 If that dividend is a class B dividend of, say, $670, a resident individual shareholder must include in assessable income the amount of the imputation credit, $330, as shown on the dividend statement provided by the company, in addition to the amount of the dividend. Thus the $1,000 is included in assessable income and the shareholder is entitled to a franking rebate of $330.

3.19 If the dividend is paid to a non-resident shareholder, the non-resident is exempt from dividend withholding tax to the extent of the franked amount of the dividend.

Life assurance companies

3.20 Mutual life assurance companies do not receive franking credits or franking debits.

3.21 Non-mutual life assurance companies are limited in the amount of income they can distribute to shareholders rather than to policyholders. Broadly speaking, subject to solvency and capital adequacy standards, they can distribute as dividends to shareholders all their 'non-fund income' (i.e. income other than their statutory fund income), but only 20 per cent of their statutory fund income (income derived from assets included in their life, superannuation, roll-over or accident and disability insurance business). Because of this limitation, franking credits for tax on the part of the statutory fund component of income that is not available for distribution to shareholders (80 per cent) are excluded in franking account calculations. For these companies, franking credits and debits relating to the payment and refund of tax on their statutory fund income, and dividends received from their statutory fund, are reduced by adjusting franking debits and credits.

3.22 An adjusting franking debit or credit reverses the effect on the franking account of the part of the ordinary franking credit or debit that is attributable to tax on the statutory fund component of the company's taxable income. The net effect of the adjusting franking debits and credits is that the franking account excludes amounts that are not available for distribution to shareholders.

3.23 Ordinary and adjusting franking credits and debits for tax amounts relating to the 1993-94 and later years of income are generally recorded in the company's class B franking account. The exceptions are the franking credits and debits that represent the portion of the statutory fund component of the company's income that is available for distribution to shareholders. They are calculated by reference to 20 per cent of the statutory fund component of company tax and are recorded in the class A franking account. This is because the special life assurance company tax rate, currently 39 per cent, applies to this income.

Company tax rate increase

3.24 Following the increase in the company tax rate from 33% to 36% with effect from the 1995-96 income year, it is necessary to amend the dividend imputation provisions so that companies can record franking credits and debits by reference to tax paid at 36%. Shareholders receiving franked dividends from profits taxed at 36% will also need to be able to calculate imputation credits and a franking rebate by reference to the 36% company tax rate.

Explanation of the amendments

Class C franking account

3.25 During their 1995-96 franking year companies will establish a class C franking account and post class C franking credits and debits to that account. The class C franking account will represent company tax paid at the rate of 36%.

3.26 To allow companies to maintain and operate a class C franking account, the Act will be amended by extending definitions of class A and B franking account terms to class C franking account terms. [Items 3 to 14; amended section 160APA]

3.27 Most of the provisions relevant to the operation of class A and class B franking accounts are extended by simply incorporating references to class C franking account terms and restricting the application of class B franking account credits and debits to years prior to the 1995-96 income year. However, not all references to class A or B franking account terms are relevant to the class C franking account. For instance, they may relate to the company tax payment system that operated prior to the 1995-96 income year. These references are not extended.

Class C franking credits

3.28 The table below shows the class A and class B franking credit provisions that are extended to provide for class C franking credits. These amendments will allow companies to calculate franking credits by reference to the new company tax rate of 36%.

Class C franking debits

3.29 The table below shows the class A and class B franking debit provisions that are extended to provide for class C franking debits. These amendments will allow companies to calculate franking debits by reference to the new company tax rate of 36%.

Class C franking account balance

3.30 In addition to the extension of the class A and B franking credit and debit terms to equivalent class C franking credits and debits, the amendments will allow the ascertainment of a class C franking account surplus or deficit at any particular time during the franking year. This is achieved by providing for the calculation of the surplus and deficit in the same way as the class A and B franking account surpluses and deficits are calculated. [Items 17 and 18; new subsections 160APJ(1B) and 160APJ(4)]

What happens to the class A and B franking accounts?

3.31 Companies, other than life assurance companies, will convert their existing class A and B franking account balances to a class C franking account at some stage during their 1995-96 franking year. A surplus will be converted to a class C franking credit; a deficit will be converted into a class C franking debit. Therefore most companies will revert to a single franking account with consequent reductions in compliance costs.

3.32 Life assurance companies will continue to pay tax at 39% on their statutory fund income. To avoid the distortions that would arise by on-going conversion of tax paid at 39% into an equivalent class C franking credit, life assurance companies will convert only their class B franking account and will continue to maintain a class A franking account. However, if they subsequently cease to be a life assurance company (but remain a company which is required to maintain franking accounts) they will convert their existing class A franking account to an equivalent class C franking account at the time the company ceases to be a life assurance company. [Item 158; new subsections 160ASJ(1) and 160ASJ(2)]

3.33 The conversion factor for a class A franking account balance is:

39/61 * 64/36


[Item 158; new subsections 160ASG(1) and 160ASG(2)]

3.34 For example, a company with a class A franking surplus of, say, $10,000 would convert that surplus into a class C franking account credit of $11,366.12 (i.e. $10,000 * 39/61 * 64/36).

3.35 The conversion factor for a class B franking account balance is:

33/67 * 64/36


[Item 158; new subsections 160ASH(1) and 160ASH(2)]

3.36 For example, a company with a class B franking deficit of, say, $20,000 would convert that deficit into a class C franking account debit of $17,512.43 (i.e. $20,000 * 33/67 * 64/36).

3.37 The conversion of the class A and B franking account to the class C franking account using these conversion factors preserves the value of the underlying imputation credits for ultimate shareholders.

When do companies convert?

3.38 Companies will be required to convert to the class C franking account at the time the first of the following events occurs:

•

when the first class C franking credit of the company arises (e.g. from the payment of a company tax instalment in respect of the 1995-96 income year, or upon the receipt of a class C franked dividend) [item 158; new paragraph 160ASF(a)] ;

•

at the end of their 1995-96 franking year [item 158; new paragraph 160ASF(b)] .

3.39 Companies will have the option of converting to the class C franking account before these times. However, companies will not have the option of converting before this Bill was introduced into Parliament. Nor will they be able to convert after the conversion times mentioned above.

3.40 To exercise the option of converting early, a company will be required to make a written declaration that it has converted to the class C franking account. Such a declaration will be irrevocable and cannot operate retrospectively. [Item 158; new subsection 160ASF(2)]

3.41 For most companies the 1995-96 franking year will be the 1995-96 financial year (i.e. the year commencing 1 July 1995). However, for early balancing companies the 1995-96 franking year will generally be the income year that is adopted in lieu of the income year that balances on 30 June 1996. For example, where a company has a substituted accounting period ending 31 December 1995 in lieu of 30 June 1996, its 1995-96 franking year will be the period 1 January 1995 to 31 December 1995. [Item 16; new section 160APBA]

How are class A and B credits and debits treated after conversion?

3.42 After a company has converted to the class C franking account it may receive a class A or class B franking credit or debit. For example, it may receive a class A or B franked dividend from a company that has not yet converted, or, following an amended assessment, it may receive a refund of tax for a year prior to the 1995-96 income year.

Equivalent class C franking credits and debits

3.43 Life assurance companies will still be able to post a class A franking credit or debit to their class A franking account. Other companies, however, will have to convert the credit or debit to an equivalent class C franking credit or debit. Similarly, all companies, including life assurance companies, will have to convert class B franking credits and debits received after conversion to the equivalent class C franking credit or debit.

3.44 The conversion factor for class A franking credits and debits is:

39/61 * 64/36


[Item 158; new subsections 160ASI(1) and 160ASI(2)]

For class B franking credits and debits it is:

33/67 * 64/36


[Item 158; new subsections 160ASI(3) and 160ASI(4)]

3.45 For example, if after conversion a company receives a fully franked class A dividend of $100 and a fully franked class B dividend of $200, the following calculation would be performed to convert the attached imputation credits into the company's class C franking account:

3.46 In this example, the class A franking credit of $100 has been increased to reflect the fact that the imputation credits which the franking credits represent are now worth 36% rather than 39%. By increasing the franking credits (and therefore the amount that can be distributed as a fully franked dividend) the value of the 39% imputation credits is preserved. Conversely, the class B franking credits are reduced because the imputation credits they represent are now more valuable (calculated by reference to 36% rather than 33%).

Neutralisation of original class A or B franking credit or debit

3.47 The conversion of class A and B franking credits and debits into equivalent class C franking credits and debits does not prevent those class A or B credits and debits arising. However, the effect of a class A or B franking credit which is converted to a class C franking credit is neutralised by means of an offsetting franking debit equal to the amount of the credit. Similarly class A or B franking debits are neutralised by means of an offsetting franking credit. [Item 158; new section 160ASI]

3.48 It is necessary for the original class A or B franking credit or debit to arise even though it is converted to the class C equivalent because some franking credit and debit provisions dealing with life assurance companies depend on a previous franking debit or credit arising. For example if, after its class C conversion time, a life assurance company pays its final payment of tax under section 221AZD of the Act for its 1994-95 income year, a class B franking credit will arise under paragraph 160APMC(b). This franking credit will give rise to a class B franking debit under paragraph 160AQCJ(1)(b), which in turn will give rise to a class A franking credit because of subsection 160APVH(1)(e).

3.49 The amendments will ensure that the above result is still achieved, but they will effectively eliminate the relevant class B franking credits and debits by means of the neutralising franking debits and credits.

Can a company pay a class A or B franked dividend after conversion?

3.50 Class A and B franking debits arising from the payment of class A and B franked dividends by a company which has converted to the class C franking account before the dividends' reckoning day are specifically excluded from the provisions explained above which convert class A and class B franking debits to equivalent class C franking debits. [Item 158; new paragraph 160ASI(2)(b) and subsection 160ASI(4)]

3.51 Therefore, a company could pay a class A or B franked dividend even if it no longer has a class A or class B franking account on the dividend's reckoning day. However, the amendments ensure that no advantage can arise from doing this, either for the paying company or its shareholders.

3.52 To prevent any advantage arising from the payment of a class A franked dividend with a reckoning day after a company has converted its class A franking account, the payment will give rise to a class A franking debit. Because all future franking credits will be class C franking credits (any class A franking credit that does arise will be neutralised by a corresponding franking debit), a company that pays a class A franked dividend in these circumstances will be unable to eliminate the resulting class A franking account deficit. Therefore, at the end of the franking year, the company will be liable to pay class A franking deficit tax and franking additional tax for over-franking its dividends. [Item 158; new paragraph 160ASI(2)(b)]

3.53 If, however, a company pays a class B franked dividend with a reckoning day after it has converted to the class C franking account, a class C franking debit will arise equal to the amount that would have been the class B franking debit from the payment of the dividend (i.e. the class B franked amount of the dividend). This results in a greater debit to the class C franking account than is represented by the imputation credits distributed to the shareholders. [Item 158; new subsection 160ASI(5)]

What if the dividend had a reckoning day before conversion?

3.54 If the reckoning day for a dividend occurs before the class C conversion time, the dividend would have a class A or class B required franking amount. Therefore the company will pay the dividend as class A or B franked even if, at the time of payment, it has converted to the class C franking account.

3.55 The amendments will ensure that no adverse consequences flow to the company or the shareholder in relation to these dividends. This is achieved by converting the class A or B franking debit to an equivalent class C franking debit and neutralising the class A or B franking debit by an equivalent credit. [Item 158; new section 160ASK]

Class C franking account returns and assessments

3.56 Consistent with the obligation imposed on companies in relation to their class A and B franking accounts, the amendments will:

•

require companies to lodge class C franking account returns;

•

provide for the issuing of assessments for remitting class C franking deficit tax and class C deficit deferral tax;

•

provide for the imposition of additional tax by way of penalty on companies which fail to meet their dividend imputation obligations; and

•

require companies to maintain relevant class C franking account records.

3.57 The table below lists these amendments.

What is the class C required franking amount for a dividend?

3.58 The required franking amount represents the minimum extent to which a dividend should be franked having regard to the balance in the company's franking accounts at the time it is paid.

3.59 Section 160AQE of the Act currently provides the general formula for determining the required franking amount of a dividend. Subsection 160AQDB(1) applies this formula to calculate the class A required franking amount for the dividend. Subsection 160AQDB(2) then provides that any of the required franking amount that is not a class A required franking amount is the class B required franking amount.

3.60 For companies that have not converted to the class C franking account before the reckoning day for a dividend, the calculation of the class A and class B required franking amounts of the dividend will remain unchanged. [Items 80 and 81; amended subsection 160AQDB(2)]

3.61 Companies that have converted will not have a class B franking surplus. Therefore the class B required franking amount for a dividend with a reckoning day after conversion will be nil. [Item 82; new subsection 160AQDB(3)]

3.62 The class C required franking amount for a dividend with a reckoning day after the class C conversion time will be worked out using the formula:

Gross required franking amount - Class A required franking amount

[Item 82; new subsection 160AQDB(4)]

The class C franking surplus will be taken into account when applying the general formula in section 160AQE to calculate the gross required franking amount. [Item 84; new paragraph 160AQE(6)(c)]

3.63 This formula will apply to both general companies and to life assurance companies. However, companies, other than life assurance companies, that have converted to the class C franking account will not have a class A franking account surplus and therefore the class A required franking amount for the dividend will be nil.

3.64 Consistent with the current rules, the class C required franking amount specifies only the minimum extent to which a dividend must be class C franked. A company will be able to frank a dividend in excess of the class C required franking amount. However, if a company does so, and there is a class C franking deficit at the end of the franking year, the company will be liable to pay class C franking deficit tax and may be liable to pay franking additional tax. [Items 92 and 151; new subsections 160AQJ(1B) and 160ARX(3)]

3.65 The under-franking rules will also apply in relation to the class C franking account. Thus, where the class C required franking amount is not less than 10% of the dividend and the dividend is not franked to that amount, a class C franking debit arises equal to the amount by which the class C required franking amount exceeds the franked amount of the dividend. [Item 49; new subsection 160APX(1B)]

What is the effect of earlier franked dividends on the class C required franking amount?

3.66 In certain situations, the required franking amount of a dividend will be affected by the required franking amount or the franked amount of an earlier dividend. Anomalies could arise if the class C required franking amount of a dividend is affected by class A or class B franked dividends. Therefore the amendments explained below have been made in relation to the formulas in subsections 160AQE (2) and (3).

Reduced franking surplus

3.67 In the formula in subsection 160AQE(2), the RFS component is the franking surplus of the company on the reckoning day for the current dividend reduced by the franked amount or required franking amount of unpaid dividends with an earlier reckoning day than the current dividend. It is possible for the company's class C conversion time to occur after the reckoning day of the earlier dividend but before the reckoning day of the current dividend. In these cases there may be a class C franking surplus of the company for the purposes of the current dividend, but the franked amount or required franking amount to reduce that surplus may be a class A or class B amount.

3.68 To prevent class C franking surpluses being reduced by class A or class B franking amounts in these cases, the amendments provide for the conversion of the class A or class B franking amounts to an equivalent class C franking amount. [Item 158; new section 160ASL]

Over-franked earlier dividends

3.69 Subsection 160AQE(3) provides that if a company over-franks a dividend (the 'earlier franked dividend') in relation to which there is a committed future dividend, that committed future dividend has to be franked at least to the same extent.

3.70 The committed future dividend (i.e. the current dividend referred to in subsection 160AQE(3)) may have a reckoning day after the class C conversion time, but the earlier franked dividend may have a reckoning day before conversion. Therefore the class C required franking amount of the current dividend may be affected by the class A or class B franked amounts of earlier dividends. To prevent the class C required franking amount of a dividend being distorted by the class A or class B franked amount of earlier dividends, the amendments will convert the class A or class B franked amounts to equivalent class C franked amounts. [Item 158; new section 160ASM]

Correction of error in subsection 160AQE(2)

3.71 The amendments also correct a small error that currently exists in subsection 160AQE(2). Under the definition of 'SD' (i.e. substituted dividends) in subsection 160AQE(2) the current reference to subsection 160ACQB(4) is corrected to section 160AQCB(4). A reference to the equivalent class C franking debit provision, new subsection 160AQCB(4A), is also inserted. [Item 83; amended subsection 160AQE(2)]

How does a company pay a class C franked dividend?

3.72 Section 160AQF of the Act specifies the circumstances in which a dividend may be franked and how it is franked. Broadly, a frankable dividend is franked if a resident company makes a declaration before the reckoning day that the current dividend is a franked dividend to the extent of a certain percentage (not exceeding 100 per cent).

3.73 The franking rules set out in section 160AQF for class A and B franked dividends will be extended to class C franked dividends. To determine the class C franked amount of a dividend a company needs to make a declaration that a dividend is class C franked to the percentage specified in the declaration. [Items 85 and 87; new subsections 160AQF(1AAA) and 160AQF(1AC)]

3.74 Dividend statements provided to shareholders will be required to set out how much of the dividend has been class C franked and the amount of class C imputation credits that are attached. This is the same information currently required for class A and B franked dividends. [Items 88, 89, 90 and 91; amended section 160AQH, and new subparagraph 160AQH(b)(iva)]

What happens if a company has already declared a dividend to be class A or B franked?

3.75 Circumstances may arise where, before it converts to the class C franking account, a company declares a dividend to be class A or class B franked under section 160AQF of the Act, but, because the reckoning day of the dividend is after conversion, the dividend should have been class C franked.

3.76 Ordinarily, section 160AQF declarations cannot be varied: subsection 160AQF(2). However, an exception will be made where the declaration was made before the class C conversion time but the dividend to which the declaration relates (or at least one of the dividends if there is more than one) has a reckoning day after conversion. In these cases, the declaration can be varied to take into account the fact that the dividend should be class C franked. [Item 158; new subsection 160ASN(1)]

How can a company frank a class A or B franked dividend to the same extent as a class C franked dividend?

3.77 Section 160AQF requires a company to frank all dividends to which a particular resolution relates to the same extent. If some of those dividends have a reckoning day before conversion, and some have a reckoning day after conversion, it would not be possible to frank all the dividends to the same extent.

3.78 However, it is possible to pay a class C franked dividend which is substantially similar to a class A or class B franked dividend. For example, a $100 fully-franked class B franked dividend is substantially similar to a $100 dividend which is class C franked to $88. This is because the value of the imputation credits attached to each dividend is the same.

3.79 Provided the franked amount of all the dividends with reckoning days after conversion is substantially similar to the franked amount of dividends with reckoning days before conversion, the requirements of section 160AQF will have been met. For these purposes, a fully-franked class C franked dividend will be substantially similar to a fully-franked class A franked dividend even though the imputation credits attached to the class A franked dividend will have a greater value than those attached to the class C franked dividends. In this case, the company would have franked the class C franked dividend to the maximum extent possible to ensure equivalence with the class A franked dividend. [Item 158; new subsection 160ASN(2)]

Class C franking deficit tax

3.80 Section 160AQJ of the Act imposes a liability to franking deficit tax on a company where the class A or class B franking account balance of that company is in deficit at the end of its franking year.

3.81 Similarly, where a company has a class C franking account balance in deficit at the end of its franking year a class C franking deficit tax liability will arise. The amount of the class C franking deficit tax is calculated using the formula:

franking deficit * company tax rate / [1-company tax rate]


[Item 92; new subsection 160AQJ(1B)]

3.82 Where a company incurs a liability to class C franking deficit tax, that amount will be able to be offset against assessed tax of the company in the same way as class A and B franking deficit tax can currently be offset. [Items 95 and 97; amended subsection 160AQK(1)]

3.83 The Income Tax (Franking Deficit) Amendment Bill 1995 amends the Income Tax (Franking Deficit) Act 1987 to allow class C franking deficit tax to be imposed.

What transitional franking deficit tax provisions will operate?

3.84 Under the current dual-franking account system, companies are not permitted at the end of the franking year to offset a franking deficit that arises in one franking account against a franking surplus that arises in the other franking account. This prevents a company paying class A franked dividends (which are more valuable for resident shareholders) when it does not have any (or sufficient) class A franking credits.

3.85 Without amendment the conversion to a class C franking account would provide companies with an opportunity to effectively offset a class A deficit with a class B surplus. This would enable a company to over-distribute class A franking credits prior to conversion. To prevent this the Act will be amended to ensure that, where a liability to class A franking deficit tax would have arisen but for the conversion to a class C franking account, that liability will remain. [Subitem 159(1)]

3.86 The amendments will also ensure that where a liability to class A franking additional tax would have arisen but for the conversion to a class C franking account, the liability will also remain. [Subitem 159(3)]

3.87 The amendment will only apply to companies whose class A franking account is in deficit at the time of conversion. If this condition is met it is necessary to determine whether, had the conversion not taken place, the company would have been liable to class A franking deficit tax or franking additional tax at the end of that franking year. To determine this, it is necessary to make the following assumptions:

•

the class A franking account balance was not converted to a class C account balance but remained as it was; and

•

any class C franking credit or debit arising after conversion that would have given rise to a class A franking credit or debit if the amendments were not made did give rise to such a credit or debit (for example, receipt of a class A franked dividend or payment or refund of company tax for an income year prior to 1993-94). [Subitem 159(1)]

Example

3.88 The following example illustrates how the class A franking deficit tax will be preserved in these circumstances.

On 30 May 1996 a company has a class A franking deficit of $100,000 and a class B franking surplus of $20,000. On 1 June 1996 the company pays a company tax instalment of $10,000 (at 36%) giving rise to a class C franking credit of $17,778. The payment of company tax triggers conversion of the class A and B franking account balances into the class C franking account.

In addition the company enters into the following transactions before the completion of its 1995-96 franking year:

•

10 June 1996 - payment of a fully franked class C dividend of $20,000 giving rise to a class C franking debit of $20,000.

•

15 June 1996 - receipt of a fully franked class A dividend of $60,000 giving rise to a class C franking credit of $68,197.

3.89 The franking account entries for the company are shown in the following table:

3.90 At the end of the franking year the company has a class C franking account deficit of $30,174 and a notional class A franking account deficit of $40,000. The amendment will apply here to preserve the class A franking deficit tax of $25,574 (i.e. $40,000 * 39/61) (see section 160AQJ). Class A franking additional tax may also apply if the requirements of section 160ARX are satisfied.

Compensatory class C franking credit

3.91 If a company pays franking deficit tax because of the above amendment, it is appropriate to exclude from the class C franking account balance the amount attributable to the class A franking deficit. This is because the payment of franking deficit tax has offset the amount of that deficit. This result is achieved by giving rise to a class C franking credit at the end of the franking year equal to the class A franking deficit converted to the equivalent class C amount. [Subitem 159(2)]

3.92 In the above example this amount is:

$25,574 * 64/36 = $45,464


Posting this class C franking credit to the class C franking account will result in a carry forward surplus of $15,291. If the class C franking account was already in surplus, the amount of that surplus would have been increased by $45,464.

Class C deficit deferral tax

3.93 Sections 160AQJA and 160AQJB impose a liability to class A or B deficit deferral tax where an instalment of tax paid in the income year is refunded in the following franking year and a franking deficit would have arisen if the refund had occurred at the end of the previous franking year.

3.94 Where an instalment of tax paid in respect of the 1995-96 or later income year is refunded in the following franking year, and a class C franking deficit would have arisen if the refund had occurred at the end of the previous franking year, a class C deficit deferral tax liability will also arise. Equivalent to the class A and B deficit deferral tax, the amount of the class C deficit deferral tax is calculated using the formula:

class C deficit deferral amount * 36/64


[Item 94, new section 160AQJC]

3.95 Class B deficit deferral tax will now only apply in relation to refunds of company tax instalments for years prior to 1995-96. Class A deficit deferral tax will continue to apply to life assurance companies. [Item 93; amended subsection 160AQJB(1)]

3.96 Where a company incurs a liability to class C deficit deferral tax, that amount will be able to be offset against assessed tax of the company in the same way as class A and B deficit deferral tax can currently be offset. [Items 96 and 98; amended subsection 160AQK(1)]

3.97 The Income Tax (Deficit Deferral) Amendment Bill 1995 amends the Income Tax (Deficit Deferral) Act 1994 to allow class C deficit deferral tax to be imposed.

What are the tax effects of the class C franking account for shareholders?

3.98 Under section 160AQT of the Act, non-corporate resident shareholders who receive class A or B franked dividends are required to include in their assessable income the amount of the imputation credit together with the amount of the dividend (the grossed-up amount of the dividend). The shareholder is then entitled to a franking rebate equal to the amount of the imputation credit under section 160AQU of the Act.

3.99 Non-corporate resident shareholders who receive a class C franked dividend will be required to include in their assessable income the class C imputation credits attached to the dividend using the formula:

class C franked amount * (company tax rate/ [1 - company tax rate])


[Items 99 and 100; new subsections 160AQT(1AB) and 160AQT(1C)]

3.100 As with class A and B franked dividends, the shareholder will be entitled to a franking rebate equal to the amount of the imputation credit under section 160AQU of the Act.

Dividends paid to trusts and partnerships

3.101 Under Division 7 of Part IIIAA of the Act, class A and class B franked dividends received indirectly through partnerships and trusts are, broadly speaking, treated in the hands of partners and beneficiaries in the way that such dividends would have been dealt with if received directly. In other words where a partnership or trust derives franked dividends, that income retains its character when it is distributed to a partner or beneficiary.

3.102 The same treatment will apply to class C franked dividends. The following table details the amendments made to extend this treatment to class C franked dividends.

3.103 The last four amendments listed in the above table relate to the potential rebate amount in relation to a trust or partnership amount. Because of the definition of 'potential rebate amount' in section 160APA, if there is a combination of class A, class B and class C potential rebate amounts in relation to the trust or partnership amount, then the potential rebate amount is the sum of those amounts.

Correction of defective provisions

Section 160AQZA

3.104 Section 160AQZA of the Act allows a franking rebate for dividends paid to the statutory funds of a life assurance companies where those dividends are received through a trust or partnership. These dividends are treated in the same way as dividends received by individuals (the life assurance company includes the grossed-up amount of the dividend in its assessable income and receives a rebate of the imputation credit).

3.105 When section 160AQZA was first introduced into the Act, subsection 160APQ(3) prevented any franking credit arising for dividends paid to the statutory funds of a life assurance company. Therefore, the proviso in the section 'apart from subsection 160APQ(3)' was appropriate. However, subsection 160APQ(3) now allows a franking credit to arise, although reduced by 80 per cent. The proviso in subsection 160APQ(3) is therefore no longer appropriate and has been amended by making section 160AQZA operative where subsection 160APQ(3) applies to reduce a franking credit arising under 160APQ(1). [Item 126, new section 160AQZA]

3.106 An additional defect in section 160AQZA that applies to mutual life assurance companies has also been corrected. Under section 160APKA, no franking credits arise to mutual life assurance companies. However, because section 160AQZA is based on the premise that franking credits will arise, mutual life assurance companies were effectively denied a franking rebate. To overcome this defect section 160AQZA will apply as if section 160APKA did not exist. [Item 126, new section 160AQZA]

3.107 Because the defect in section 160AQZA produces a result that is clearly unintended and inconsistent with policy, the amendments will apply from the time the defect came into existence. This means that the amendments to section 160AQZA will affect dividends received through a trust or partnership after 21 August 1990 (the date from when section 160APKA denies franking credits for mutual life assurance companies). [Subitem 160(2)]

Section 160AR

3.108 Ordinary companies receive a franking credit for franked dividends received but do not 'gross up' the dividend or receive a franking rebate. However, section 160AQT, in conjunction with section 160AQW, requires all companies to include in their assessable income the gross-up of their share of franked dividends received by a trust or partnership. To ensure they are not taxed on amounts which they do not receive (and do not get a rebate for), section 160AR allows shareholders who receive a franking credit for the dividend (i.e. companies) a deduction for the gross-up.

3.109 At the time section 160AR was enacted, life assurance companies received a rebate but did not receive franking credits for statutory fund dividends because of the former subsection 160APQ(3). Therefore section 160AR would not apply. However, now they do receive franking credits (but reduced by 80 per cent). Therefore, it is arguable that section 160AR applies to allow a deduction for the gross-up of dividends paid to the statutory fund of the company, even though section 160AQZA also allows a rebate for that amount. This is inappropriate since the deduction is intended to apply only where the franking rebate is not available.

3.110 Section 160AR has therefore been amended so that it only applies when a franking credit arises under section 160APQ which is not reduced by subsection 160APQ(3) [Items 127, 128, 130 and 131; amended section 160AR]

3.111 The defect in section 160AR also produces a result that is clearly unintended and inconsistent with policy. Therefore it is appropriate for the amendments to apply from the time the defect came into existence. This means that the amendments to section 160AR will apply to deny a deduction in relation to dividends received through a trust or partnership during a company's first franking year that commences after 6 December 1990, and subsequent franking years. [Subitems 160(3) and (4)]

Chapter 4 - Franking credits - international profit misallocation

Overview

4.1 Schedule 2 of the Bill will amend Part IIIAA of the Income Tax Assessment Act 1936 (the Act) to provide that no franking credits arise under the imputation system for tax paid by companies where a payment of tax is made in relation to profits which have been misallocated offshore through transfer pricing or non-arm's length dealings.

Summary of the amendments

Purpose of the amendments

4.2 The amendments of the income tax law will ensure that franking credits, in certain circumstances, cannot be used to largely negate the additional company tax payable as a result of an adjustment to reflect arm's length dealings where profits have been misallocated offshore. In certain circumstances, franking credits could, instead of relieving the second tier of tax on company profits, be used to frank profit distributions that would not otherwise be franked dividends. This could occur where the 'profits' which have been taxed under the transfer pricing or non-arm's length dealing adjustment provisions of Division 13 of the Act or a double taxation agreement have been misallocated to an offshore affiliate. Where 'profits' have been shifted or misallocated offshore, unlike other additional tax situations, they are not available for distribution by an Australian resident company.

Date of effect

4.3 The amendment will apply to original and amended assessments which issue after the 1995-96 Budget announcement on 9 May 1995, irrespective of the income year to which the misallocation of profit adjustment relates.

Background to the legislation

4.4 Both Division 13 and the double tax agreements entered into by Australia with other countries contain provisions aimed at ensuring that the Australian revenue is not disadvantaged by transfer pricing practices and non-arm's length dealings which shift or misallocate profits offshore. For taxation purposes, these provisions provide for profits to be notionally increased in accordance with arm's length principles ie. a misallocation of profit adjustment.

4.5 Under the current imputation system for tax paid by companies, a misallocation of profit adjustment resulting in additional tax payable by an Australian resident company will give rise to a franking credit. In certain circumstances, this franking credit may be used to largely negate the additional tax payable by the resident company.

4.6 This occurs, for example, where an Australian resident company misallocates profits to a foreign affiliate and is subsequently subject to a transfer pricing adjustment which notionally increases the profits of the Australian resident company for taxation purposes. The notionally increased 'profits', however, are not actual profits of the Australian resident company and are not available to that company for distribution by way of a dividend. Any franking credit arising as a result of the transfer pricing adjustment could therefore, under the present system, be used to frank distributions of profits which would otherwise be unfranked. In other words, the franking credit could be used to reduce the amount of profits it could otherwise distribute only as unfranked dividends.

4.7 On the other hand, an Australian resident company, which has complied with the arm's length principles embodied in the income tax law, would have actual profits available for distribution. It could not use franking credits arising from payment of tax on its actual profits to reduce the amount of profits which it could otherwise distribute only as unfranked dividends. Generally, unfranked dividends are subject to withholding tax if paid to a non-resident shareholder and are fully taxable if paid to a resident shareholder. Franked dividends are exempt from withholding tax if paid to a non-resident shareholder and resident shareholders obtain the benefit of the franking rebate from the dividend.

4.8 To remedy this anomaly, the proposed amendment will provide that no franking credits arise where a payment of tax is made in relation to a misallocation of profit adjustment. Similarly, where a misallocation of profit adjustment is subsequently reduced (eg. upon objection, review or appeal), a franking debit will not arise upon the issue of an amended assessment where the payment of tax for the original misallocation of profit adjustment did not give rise to a franking credit.

Explanation of the amendments

4.9 Under the provisions of Part IIIAA of the Act, the amount of franking credits or debits arising from the payment or refund of tax is equal to the 'adjusted amount' of the tax paid or refunded. (In this chapter, references to a refund of tax includes reductions of tax and crediting or applying tax refunds against other liabilities.)

4.10 Under section 160APA of the Act the 'adjusted amount' is determined by the formula:

Basic amount*(1-applicable general company tax rate/applicable general company tax rate)


In relation to franking credits and debits arising from the payment and refund of tax, the 'basic amount' is the amount of tax paid or refunded.

4.11 To exclude franking credits or debits arising from the payment or refund of tax where those amounts are attributable to a misallocation of profit adjustment, the basic amount will be reduced by the 'reduction amount'. [Item 15; new subsections 160APAAA(1) and (3)]

4.12 The 'reduction amount' will be defined to mean the payment of tax (either wholly or partly) that arises as a result of the application or operation of:

•

subsection 136AD(1), (2) or (3) or 136AE(1), (2) or (3). These provisions apply where, in relation to an international agreement, a taxpayer has supplied property for less than an arm's length consideration or no consideration or has acquired property for more than an arm's length consideration; or

•

paragraph 1 or 2 of Article 9 of the Vietnamese agreement or a provision of any other double taxation agreement that corresponds to either of those paragraphs. These provisions apply to international non-arm's length dealings between associated enterprises resident in tax treaty partner countries.

[Item 15; new subsection 160APAAA(2)]

4.13 A 'double taxation agreement' will be defined to mean an agreement within the meaning of the International Tax Agreements Act 1953. [Item 15; new subsection 160APAAA(4)]

4.14 The operation of the amendments is demonstrated in the following examples.

Example #1 - Ordinary company (tax paid)

Following an amended assessment, for its 1993-94 income year, a company pays additional tax of $30,000, three quarters of which (i.e. $22,500) is attributable to a misallocation of profit adjustment.

The franking credit resulting from the payment of additional tax would be calculated as follows:

•

section 160APMD (payment of tax after the final instalment)

class B franking credit = adjusted amount of the tax paid
= (basic amount less reduction amount) * 67/33 (section 160APA)
= ($30,000 - $22,500#) * 67/33
= $15,227


Example #2 - Ordinary company (tax refund)

A company receives a tax refund of $10,000 in relation to its 1992-93 income year, one quarter of which (ie. $2,500) is attributable to a reduction of a previous misallocation of profit adjustment for which a franking credit was previously denied.

The franking debit resulting from the refund would be calculated as follows:

•

section 160APYBA (refunds of company tax)

class A franking debit = adjusted amount of the tax refund
= (basic amount less reduction amount) * 61/39 (section 160APA)
= ($10,000 - $2,5000##) * 61/39
= $11,731

# This is the amount of tax paid that is attributable to the misallocation of profit adjustment

## The is the amount of tax refund attributable to the misallocation of profit adjustment




Chapter 5 - Demutualisation of insurance companies

Overview

5.1 The amendments contained in Schedule 3 of the Bill propose new Division 9AA of Part III of Income Tax Assessment Act 1936 (the Act) which provides a framework for the taxation consequences of certain transactions associated with the demutualisation of life and general insurance companies and affiliated companies. The provisions also address the taxation consequences of the disposal by members of their interests in the demutualising entity. Rules are provided for determining the deemed acquisition cost of shares in the demutualised entity (or in another entity) issued to former members of the mutual insurance company and other members of the policyholder/member group.

5.2 The amendments are described in the context of the taxation consequences for:

•

members and deemed members of demutualising life or general insurance companies or of an affiliated company (policyholder/members);

•

the trustee of any trust established for the purpose of:

-

exercising voting rights on behalf of policyholder/members prior to the issue of shares (a voting trust); or

-

selling or distributing shares on behalf of policyholder/members (a selling trust);

•

any new holding company or other company interposed between the former mutual company and the new shareholders;

•

the life or general insurance company which is demutualising.

5.3 This chapter also deals with the methods to be adopted when calculating the deemed acquisition cost of shares issued to policyholder/members as consideration for the disposal of their interests in the mutual company or an affiliated company.

Summary of amendments

Purpose of the amendments

5.4 The purpose of the amendments contained in Schedule 3 of the Bill is to provide a generic framework which specifies the taxation consequences of certain transactions likely to occur in the course of an arrangement for the demutualisation of a life or general insurance company or an affiliate company. [New sections 121AA and 121AD]

5.5 The basic requirements for a demutualisation are that the members of a mutual insurance company (or a mutual affiliate company) will agree to surrender their rights in the company (for example, the right to vote at meetings and/or the right to participate in the surplus of the company on winding up) in exchange for shares in the demutualised entity. The shares must generally be listed on the Australian Stock Exchange within 2 years from the commencement of the demutualisation arrangement. These requirements are reflected in demutualisation methods 1 to 7 [new sections 121AF to 121AL] which are discussed below.

5.6 Broadly, the amendments will:

•

ensure that capital gains tax will not arise as a consequence of any disposal constituted by the surrender by a member of a mutual insurance company or a mutual affiliate company (or any other member of the policyholder/member group) of his or her membership interests [table 1;item 1] ;

•

prescribe the date of acquisition and cost of acquisition of shares acquired by a policyholder/member as part of the demutualisation process [table 1; items 5 and 11] . In relation to equitable and legal assignments of interests in sale and voting trusts and rights to receive shares, similar deemed acquisition cost rules will also apply [table 1; items 3, 4 and 11] ;

•

prescribe the date of acquisition and cost of acquisition of ordinary shares acquired by the trustee of a sale trust for distribution to policyholder/members or sale on their behalf [table 1; items 5 and 9] ;

•

ensure that where a holding company or another interposed company acquires shares in a demutualising life or general insurance company, the deemed acquisition cost of those shares properly reflects the deemed acquisition cost of shares issued to policyholder/members. The deemed acquisition cost rules will apply to all shares in entities interposed between the holding company and a former mutual insurance company or mutual affiliate company [table 1; items 5, 6, and 7] ;

•

ensure that no capital loss can be realised by a policyholder/member, the trustee of a sale trust or an interposed company on the disposal of a demutualisation share, a right to receive a demutualisation share, or other interests in a voting or sale trust [table 1; items 3, 4, 5, 6, 7, 9, 11 and 12] ;

•

provide that where special shares representing the voting rights of policyholder/members are held by a trustee on behalf of the policyholder/members and the special shares are later converted to ordinary shares, no disposal will be taken to have occurred for capital gains tax purposes. Specifically, Division 19B of Part IIIA will not apply in relation to any value shift that may have taken place as a consequence of the conversion [table 1, item 8] ;

•

insert parallel provisions to those relating to capital gains tax set out at table 1, which will operate in circumstances where, as a consequence of a demutualisation transaction, an amount would be included in the assessable income of a taxpayer under a provision of the Act other than Part IIIA [table 2] ;

•

ensure that at the demutualisation resolution day the franking account balance of a demutualising general insurance company or mutual affiliate company and any wholly owned subsidiaries of the company or companies will be reduced to nil [table 2; item 12] ; and

•

ensure that no franking credit will arise in the franking account of a demutualised life or general insurance company, a mutual affiliate company or any wholly owned subsidiaries of the company or companies in relation to any dividend declared before the demutualisation resolution day and paid on or after the demutualisation resolution day [table 2; item 13] .

Date of effect

5.7 The amendments, which were foreshadowed by the Treasurer in the 1995-96 Budget, apply to mutual insurance companies and mutual affiliate companies that existed at 7.30 pm AEST on 9 May 1995. [Item 3]

Background to the legislation

What is a demutualisation?

5.8 For the purposes of the proposed amendments a mutual insurance company demutualises if it ceases to be a mutual insurance company (or a mutual affiliate company ) other than by ceasing to be an insurance company, or under a scheme approved by the Federal Court. [New subsections 121AD(1) and 121AD(2)]

5.9 New section 121AB defines the terms 'mutual insurance company ', 'insurance company', 'life insurance company' and 'general insurance company '. New section 121AC defines a mutual affiliate company to be a mutual company, limited by guarantee, the members of which include all of the policyholders of a mutual insurance company. The profits of a mutual affiliate company must not be divisible amongst its members in their capacity as members.

5.10 The demutualisation process commences on the demutualisation resolution day [new subsection 121AD(3)] , which is generally when the members of a mutual life insurance company or general insurance company or mutual affiliate company (broadly, a mutual organisation where the liability of members is limited by guarantee) agree that the mutual entity will become a company limited by shares. Where a mutual life insurance company ceases to be a mutual company because the whole of the life insurance business is transferred to another company under a court endorsed scheme, the demutualisation resolution day will be the day on which the business is transferred. The demutualisation process ends with the listing of the ordinary shares issued to former members of the mutual entity and other members of the policyholder/member group on the demutualisation listing day. The demutualisation listing day will be the day on which ordinary shares that are issued to the policyholder/member group are listed for quotation on the Australian Stock Exchange. [Table 1; note 4; new section 121AQ]

5.11 A demutualisation may follow the steps set out in demutualisation methods 1 to 7 [new sections 121AF to 121AL] which are described below. If one of these methods is not followed, the taxation consequences will not apply to any of the transactions undertaken in the course of the demutualisation [new subsection 121AE] .

Who is a policyholder/member?

5.12 The interest of a member in a mutual life or general insurance company can generally be characterised as a right to vote at meetings and to participate in any surplus of the company on winding up. The Memorandum and Articles of Association of a mutual company will describe the persons who are members of the company (generally the holders of insurance policies). For the purposes of demutualisation, new subsections 121AE(4) and 121AE(5) define a policyholder/member group of a mutual insurance company or a mutual affiliate company as including other specified categories of persons (i.e. employees, lapsed policyholders, beneficiaries and legal personal representatives of deceased policyholders, members of single member superannuation funds of which the trustee is a policyholder, charities and members of an affiliated mutual company). All of the taxation consequences described in tables 1 and 2 in new sections 160AS and 160AT will apply to all policyholder/members.

Explanation of the amendments

Methods of demutualisation

5.13 Tables 1 and 2 which are contained in new sections 121AS and 121AT at Subdivision C set out the taxation consequences of certain transactions that will or may occur in the course of a demutualisation. In order for these taxation consequences to apply in a particular case, it is necessary that the demutualisation be carried out in accordance with one of the 7 methods set out in new sections 121AF to 121AL . The Bill includes diagrams of the transactions involved in each of the demutualisation methods.

5.14 Each demutualisation method assumes that the demutualisation of the mutual company has been approved by members of the company or takes place pursuant to an order of the Federal Court. The demutualisation process commences on the demutualisation resolution day, being the day on which the resolution to proceed with the demutualisation is passed by the members of the company (or the date on which an order of the court becomes effective) [new section 121AD] , and concludes on the demutualisation listing day. The listing period , which is the period between the demutualisation resolution day and the demutualisation listing day will be 2 years, unless the Commissioner of Taxation allows an extension [new subsection 121AE(6)] .

5.15 In determining whether to grant an extension of time, the Commissioner will have regard to all relevant considerations including the steps already taken in the listing process and to market conditions affecting listing.

5.16 Other events or transactions may also occur in conjunction with, or as a consequence of, a demutualisation process. These may include:

•

the transfer of assets between companies related to the demutualising entity before or after the date of demutualisation;

•

the issue of shares in the demutualising entity to outside investors; and

•

restructuring to facilitate demutualisation.

5.17 Where these transactions (or other transactions which are not specifically included in the demutualisation methods set out in Schedule 3 of the Bill) take place, the specific tax treatment for the transactions which have been identified as being part of the demutualisation process will still apply. However, the related transactions will be subject to the existing general tax law.

5.18 Under each of the demutualisation methods, certain basic events or transactions must occur or happen. These transactions are listed in each of the demutualisation methods outlined in new sections 121AF to 121AL and are also represented as demutualisation method 1.

Demutualisation method 1

5.19 The transactions involved in demutualisation method 1 are:

•

membership rights (i.e. rights held by all policyholder/members in the mutual company) are extinguished [new paragraph 121AF(1)(a)] . Paragraph 5.12 above discusses who will be a policyholder/member of a mutual life or general insurance company or a mutual affiliate company and the nature of their rights in the company;

•

shares of only one class (ordinary shares) are issued to the members of the policyholder/member group (no shares of any other class may be issued to the policyholder/member group during the course of the demutualisation) [new paragraph 121AF(1)(b)] ; and

•

the shares are listed for quotation on the official list of the Australian Stock Exchange within the listing period [new paragraph 121AF(1)(c)] .

Demutualisation method 2

5.20 New section 121AG describes the transactions which occur under this demutualisation method. In addition to the transactions described in demutualisation method 1 in new section 121AF , prior to the issue of the ordinary shares to policyholder/members, no more than 10 special shares in the former mutual insurance company are issued to the trustee of a voting trust who holds the shares for the benefit of policyholder/members. On the subsequent issue of ordinary shares [new paragraph 121AG(1)(c)] , the shares convert to, or are replaced by, ordinary shares [new paragraph 121AG(1)(b)] .

5.21 Policyholder/members may elect to receive ordinary shares either directly from the insurance company or to receive the shares or their cash equivalent from the trustee of a selling trust. The selling trust may or may not be the same trust as the voting trust. If a policyholder/member has elected to receive cash, the shares which issue to the trustee will be sold by the trustee on behalf of the policyholder/member. [New paragraph 121AG(1)(c)]

Demutualisation method 3

5.22 This method is a variation of demutualisation method 1 whereby shares in a demutualised insurance company are issued to a holding company [new paragraph 121AH(1)(b)] . Ordinary shares of only one class in either the holding company or another company which is the ultimate holding company of the wholly-owned company group are then issued to members of the policyholder/member group. If the issued shares are those of the ultimate holding company, the holding company must be a wholly-owned subsidiary of the ultimate holding company, either directly or through one or more other wholly-owned subsidiaries [new paragraph 121AH(1)(c)] . The term 'wholly-owned subsidiary' is defined at new subsection 121AP(3) .

Demutualisation method 4

5.23 This method combines methods 1 to 3 and, like method 3, provides for the interposition of a holding company, or chain of interposed companies, between the policyholder/members and the former mutual company [new paragraphs 121AI(1)(b) and (c)] . Method 4 also provides that prior to the issue of ordinary shares, special shares which later convert to ordinary shares [new paragraph 121AI(1)(d)] may be issued to the trustee of a voting trust [new paragraph 121AI(1)(c)] , and that policyholder/members may elect to receive shares directly from the holding company or to receive shares or their cash equivalent from the trustee of a sale trust. [New paragraph 121AI(1)(e)]

Demutualisation method 5

5.24 Method 5 is essentially the same as method 4 except that it does not provide for the issue of special shares to the trustee of a voting trust. [New section 121AJ]

Demutualisation method 6

5.25 This method relates to demutualisation arrangements entered into pursuant to an order of the Federal Court of Australia whereby, in the course of a demutualisation arrangement, the whole of the life insurance business of a mutual life insurance company is transferred to another company formed for that purpose [new paragraph 121AK(1)(b)] . For these purposes, the term 'life insurance business' has the same meaning as in the Life Insurance Act 1995 [new section 121AQ] .

5.26 Ordinary shares of only one class in the other company are issued. The policyholder/members will have elected to receive either the shares or their cash equivalent. If a policyholder/member has elected to receive cash, the shares will issue to the trustee of a sale trust to sell on his or her behalf [new paragraph 121AK(1)(d)] . Otherwise ordinary shares will issue directly to the policyholder/members or through the trustee [new paragraph 121AK(1)(c)] .

Demutualisation method 7

5.27 New section 121AL describes method 7 which applies where the demutualising entity comprises both an insurance company and a mutual affiliate company. A 'mutual affiliate company' is described at paragraph 5.9 above and is defined at new subsection 121AC(1).

5.28 Shares in the mutual insurance company and the mutual affiliate company are issued to a holding company [new paragraph 121AL(1)(b)] and ordinary shares of only one class are issued to former members of the mutual companies. The policyholder/members will have elected to receive the shares directly from the holding company or to receive the shares or their cash equivalent from the trustee of a sale trust. If a policyholder/member has elected to receive cash, the shares which issue to the trustee will be sold on his or her behalf [new paragraph 121AL(1)(c)] .

Taxation consequences of demutualisation

5.29 Subdivision C of Schedule 3 of the Bill sets out the taxation consequences for transactions which may occur in the course of demutualisation methods 1 to 7 which are described at paragraphs 5.19 to 5.28 above. The taxation consequences of each transaction in the demutualisation methods will generally arise under Part IIIA of the Act which deals with capital gains and losses. However, it is possible that for certain taxpayers, or in certain circumstances, as a consequence of a demutualisation transaction, an amount may be included in the assessable income of a taxpayer under another provision of the Act. Therefore, the Bill contains 2 tables which describe the taxation consequences of each transaction both under Part IIIA and other provisions of the Act.

Consequences for policyholder/members

Disposal of membership interests

5.30 All of the demutualisation methods described at new sections 121AF to 121AL (i.e. demutualisation methods 1 to 7) require the extinguishment of the interests of members (generally the right to vote at meetings and to participate in surplus on winding up) in the former mutual company. Some of these interests will have been acquired prior to 20 September 1985, and would therefore be pre CGT assets. However, in relation to membership interests acquired on or after 20 September 1985, CGT would otherwise apply on disposal. Membership interests will be extinguished in consideration for shares in the demutualised entity. These consequences are set out at tables 1 and 2 which are contained in new sections 121AS and 121AT respectively.

5.31 Table 1; item 1 provides that CGT will not apply on the disposal of membership interests. This applies both to rights held by policyholders in the mutual insurance company (or mutual affiliate company), as well as to those rights created by the company in favour of other members of the policyholder/member group.

5.32 Table 2; item 1 provides similar treatment where the extinguishment of membership rights would otherwise lead to an amount being included in the assessable income of a taxpayer under a provision of the Act other than Part IIIA, or allowed as a deduction from assessable income.

Acquisition by member/policyholders of shares in the demutualised entity

Deemed cost of acquisition of shares

5.33 All of the possible demutualisation methods (i.e. methods 1 to 7) require that shares in the demutualised entity will be issued to policyholder/members.

5.34 In relation to disposals of shares prior to the demutualisation listing day (the day on which ordinary shares, including shares issued to policyholder/members are listed for quotation on the Australian Stock Exchange [table 1; note 4] ), the cost of acquisition of the demutualisation shares will be taken to be an amount determined by reference to the embedded value of a life insurance company and the value of the net tangible assets of a general insurance company. This amount is the pre-listing day company valuation amount [table 1; note 2] .

5.35 The methods for determining the embedded value or value of the net tangible assets of a mutual insurance company are discussed in detail at paragraphs 5.78 and 5.107 below.

5.36 The pre-listing day company valuation amount will be allocated across all of the demutualisation shares issued to policyholder/members, and the amount relating to each share is taken to be the cost of acquisition of the share. [Table 1; items 5 and 11]

5.37 Prior to the demutualisation listing day, no capital loss will be available in relation to the disposal of a demutualisation share [table 1; subitem 5(1)] . This is a general rule applicable to all demutualisation shares and interests in demutualisation shares or in trusts that hold demutualisation shares.

5.38 For disposals of shares after the demutualisation listing day , the amount to be applied in determining the deemed cost of acquisition of demutualisation shares (the applicable company valuation amount [table 1; note 1] ) will be the lesser of the pre listing day company valuation amount (described above) and an amount determined by reference to the published price at which a demutualisation share was last traded on the listing day, multiplied by the number of demutualisation shares issued to policyholder/members (the listing day company valuation amount [table 1; note 3] ). This will be taken to be the total cost of acquisition of all of the demutualisation shares.

5.39 The total amount of the applicable company valuation amount is apportioned between all of the shares in the demutualised entity issued to policyholder/members in the course of the demutualisation arrangement and, in relation to any subsequent disposals of the shares, is taken to be the cost of acquisition of the shares.

Bonus shares

5.40 Division 8 of Part IIIA of the Act provides that, where bonus shares are issued to a taxpayer by a company and no part of the paid up value of the bonus shares is a dividend, the cost base of the original shares to which the bonus shares relate is to be apportioned between the bonus shares and the original shares.

5.41 Table 1; items 5 and 11 provide that where bonus shares ( non demutualisation bonus shares ) are issued to policyholder/members, the deemed acquisition cost of the demutualisation shares already issued to the policyholder/members to which the bonus shares relate (the demutualisation original shares ) will be apportioned between the demutualisation original shares and the non-demutualisation bonus shares in accordance with Division 8 of Part IIIA.

5.42 Where a disposal of the demutualisation original shares and/or the non-demutualisation bonus shares takes place prior to the demutualisation listing day, the amount apportioned between the shares to determine their deemed cost of acquisition will be the pre listing day company valuation amount (that is, the amount determined by reference to the embedded value of a life insurance company and the net tangible assets of a general insurance company).

5.43 If a disposal of the demutualisation original shares and/or the non demutualisation bonus shares occurs after the listing day, the amount apportioned between the shares to determine the deemed cost of acquisition will be the listing day company valuation amount (being the lesser of the pre listing day company valuation amount and an amount determined by reference to the price at which an ordinary share in the demutualised entity was last traded on the first day of listing). [Table 1;item 5(3)]

Actual consideration is also included

5.44 In any case, any amount that would be taken to be consideration for the acquisition of a share or an interest in a share for the purposes of section 160ZH of Part IIIA and which is actually given by a policyholder/member for the acquisition of a demutualisation share, will be included in the deemed acquisition costs of the share.

Date of acquisition of shares by policyholder/members

5.45 Policyholder/members will be taken to have acquired shares in the demutualised entity on the demutualisation resolution day. Indexation of the deemed cost of acquisition of the shares will therefore apply from this date. Demutualisation original shares and, by virtue of the operation of Division 8 of Part IIIA, any non demutualisation bonus shares will also be taken to have been acquired on the demutualisation resolution day. [Table 1;item 5]

Application of provisions other than Part IIIA

5.46 Table 2, items 3 and 8 contain parallel provisions to items 5 and 11 of table 1. They provide that where, as a consequence of a disposal of a demutualisation share by a policyholder/member, an amount would be included in the assessable income of the policyholder/member, an amount equal to the deemed net profit on the sale of the share should be included in assessable income. The profit included in assessable income will be the consideration for the disposal of the share reduced by the deemed acquisition cost of the share calculated in accordance with the formula for determining the acquisition cost of the share for capital gains tax purposes and described at paragraphs 5.33 to 5.44 above.

5.47 Table 2, items 3 and 8 also apply if, as a consequence of the disposal of a demutualisation original share or a non-demutualisation bonus share an amount would be included in the assessable income of a taxpayer. In determining the net profit to be included in the assessable income of the taxpayer, the applicable company valuation amount will be apportioned between the original and bonus shares in accordance with section 6BA of the Act.

Application to employees

5.48 The definition policyholder/member includes employees of the demututalising company. Generally, no amount will be included in the assessable income of an employee as a consequence of the distribution of a demutualisation share. However, where a share is issued as consideration for services provided, or to be provided, by the recipient, the general rules relating to employee share schemes will apply. [Table 2; item 10]

Disposals by policyholder/members of rights to receive shares and interests in trusts

5.49 All demutualisation methods require that shares in the demutualised company group must be listed for quotation on the Australian Stock Exchange within the listing period. New subsection 121AE(6) defines the listing period to be the period within 2 years of the date of demutualisation or such further time as the Commissioner allows.

5.50 In the listing period, a number of other events may occur. For example, the trustee of a voting trust may exercise the voting rights of members on their behalf (demutualisation methods 2 and 4) and/or shares may be issued to the trustee of a sale trust to sell on behalf of members or to transfer to members (demutualisation methods 2, 4, 5, 6, and 7).

5.51 At the time of the extinguishment of a members interest, the policyholder/member acquires enforceable rights (i.e. a right to receive shares in the demutualised company) and may also acquire interests in the property of a voting and/or sale trust. It is possible that in some circumstances a policyholder/member may assign these rights to a third person prior to the issue of shares in the demutualised entity.

5.52 By table 1; items 3 and 4 , if a policyholder/member assigns a right to receive shares, or an interest in the property of a sale or voting trust, Part IIIA of the Act will apply as if the member/policyholder had disposed of a share in the demutualised entity. Therefore, the deemed acquisition cost of the assigned asset will be determined by reference to the applicable company valuation amount and will apply in the same way as for the deemed acquisition cost of shares as described at paragraphs 5.33 to 5.44 above. Prior to the listing day, no capital loss can be realised on any disposal of a right to receive a share or an interest in the property of a sale or voting trust.

5.53 Table 2; item 2 proposes parallel rules where, as a consequence of the disposal of a right to receive shares or an interest in trust property, a provision of the Act other than Part IIIA would require that an amount be included in the assessable income of a taxpayer.

Distribution of shares by a trustee

5.54 Under demutualisation methods 2, 4, 5, 6 and 7 shares may be issued to the trustee of a sale trust to sell on behalf of policyholder/members or distribute directly to policyholder/members. Paragraphs 5.60 to 5.64 below discuss the taxation consequences of the sale of shares by a trustee. Where, as a consequence of the distribution by a sale trustee of ordinary shares to a policyholder/member, the policyholder/member has disposed of his or her interest in the trust, table 1;item 10 specifies that Part IIIA will not apply to that disposal. Part IIIA will also not apply to the disposal of the share by the trustee that occurs as a consequence of the distribution.

5.55 Table 2; item 10 provides that no amount will be included in, or allowed as a deduction from, the assessable income of a taxpayer in respect of the distribution of a demutualisation share by the trustee of a sale trust.

5.56 By table 1; items 5, 9, 10 and 11 , the date of acquisition of the share by the policyholder/member will be taken to be the demutualisation resolution day, regardless of whether the share is distributed directly to the policyholder/member or is sold on his or her behalf.

Application of rollover provisions

5.57 Table 1; note 5 defines a rollover provision to be section 160X or any provision of Division 17 of Part IIIA. Section 160X applies to assets forming part of a deceased estate. In relation to an asset acquired by the deceased on or after 20 September 1985, on a subsequent disposal of the asset, the beneficiary of the estate (or the legal personal representative of the deceased) will be taken to have acquired the asset for an amount equal to its cost base, indexed cost base or reduced cost base at the date of death. Other rollover provisions (eg. section 160ZZO which relates to transfers of assets between wholly-owned group companies) also deem the transferee of an asset to have acquired the asset for an amount equal to the cost base, the indexed cost base or the reduced cost base at the time of the transfer.

5.58 Table 1;item 12 provides that where a taxpayer has acquired an asset under a rollover provision, and the transferee disposes of the asset prior to the listing day, no capital loss will be available in relation to the disposal. For disposals after the listing day, for the purposes of applying the relevant rollover provision, the amount that will be taken to have been the cost base of the asset at the time of the rollover will be determined by reference to the deemed cost of acquisition rules set out at [table 1;item 5] and described at paragraphs 5.33 to 5.44 above. Therefore, if after listing it is determined that the listing day company valuation amount of shares is to be determined by reference to the published last traded price of a demutualisation share on the first day of listing of ordinary shares, then, for the purposes of calculating the capital gain or loss on a subsequent disposal of the shares, it is this amount that is taken to have been the cost base of the share to the transferor at the time of the rollover.

Application to trustees

What is the role of the trustee?

5.59 The trustee of a voting trust is issued special shares in the life or general insurance company (or a holding company or other company) to hold for the benefit of policyholder/members pending the issue of ordinary shares. The trustee will exercise voting rights on behalf of policyholder/members in that period. The trustee of a selling trust will be issued shares in the life or general insurance company (or a holding or other company) to distribute in specie to policyholder/members or to deal with for the benefit of the policyholder/members who have elected (or have been deemed to have elected) to receive cash rather than shares.

Sale of shares by a trustee on behalf of policyholder/members.

Date and cost of acquisition of shares by a sale trustee

5.60 The deemed cost of acquisition of shares, sold by the trustee of a sale trust on behalf of policyholder/members, will be determined as if the share were disposed of the by policyholder/member. Therefore, if the shares are sold prior to the listing date, the deemed cost of acquisition will be determined by reference to the pre-listing day company valuation amount. [Table 1; items 5 and 9]

5.61 Where bonus shares have also been issued to a sale trustee, the acquisition cost of the demutualisation original shares and the non-demutualisation bonus shares will be determined in accordance with Division 8 of Part IIIA. Therefore the deemed acquisition cost of the demutualisation original shares and the non demutualisation bonus shares will be determined by reference to the pre listing day company valuation amount or the listing day company valuation amount as the case may be. [Table 1; items 5 and 9]

5.62 Shares will be taken to have been acquired by the policyholder/member in the demutualisation resolution day or the date on which a court order in respect of the demutualisation becomes effective. [Table 1;item 9]

5.63 Table 2, item 7 proposes parallel provisions where an amount would be included in the assessable income of a policyholder/member as a consequence of a disposal by a sale trustee.

5.64 Table 1, item 10 ensures that no CGT consequences will apply to the trustee on the distribution by the trustee of a share to a policyholder/member.

Other taxation consequences for the trustee of a voting trust

5.65 Under demutualisation methods 2 or 4 the trustee of a voting trust may hold a small number of special shares (10 or less) for the benefit of the policyholder/member group. Once ordinary shares are issued, the special shares may be replaced by ordinary shares or the rights attaching to the special shares may be modified and become the same as those attaching to the ordinary shares. Table 1, item 8 ensures that Part IIIA will not apply in relation to any disposal (for example a notional disposal under Division 19B of Part IIIA of the Act) constituted by the disposal and replacement of the special shares or a change in rights attaching to the special shares. The deemed acquisition cost of ordinary shares issued to the trustee of a voting trust will be calculated in accordance with the rules described at paragraphs 5.33 to 5.44 above.

Application to trustees of superannuation funds

5.66 It is possible that the policyholder/member group may include the trustee of a superannuation fund where the fund holds policies in the demutualising company on behalf of its members. Where in the course of a demutualisation, ordinary shares are distributed to the trustee of a superannuation fund as a member of the policyholder/member group, the trustee may hold the shares on behalf of a beneficiary of the fund.

5.67 In order for such shares to benefit from the deemed acquisition cost calculated by reference to the applicable company valuation amount, table 2; item 11 provides that, on payment by the trustee of an ETP or a superannuation pension or annuity to a member of the fund, the undeducted contribution amount in relation to the payment will be increased to reflect the deemed acquisition cost of the shares.

Application to holding and other companies interposed between member/policyholders and the insurance company

5.68 Demutualisation methods 3, 4 and 5 propose that companies may be interposed between the policyholder/member group and the demutualising insurance company. Table 1, items 5 and 7 set out the method for determining the consideration for the acquisition of shares in the mutual insurance company or another interposed company where these demutualisation methods apply.

5.69 The deemed cost of acquisition of the shares is calculated in the same way that the deemed cost of acquisition of shares by policyholder/members is determined and which is described at paragraphs 5.33 to 5.44 above. Prior to the listing date, the applicable company valuation amount (being the pre-listing day company valuation amount) is determined by reference to the embedded value of a life insurance company or the net tangible asset value of a general insurance company. Following the listing day the lesser of the pre-listing day company valuation amount and an amount calculated by reference to the last published traded price of ordinary shares on the first day of trading is the applicable company valuation amount.

5.70 No capital loss is available where a share is disposed of by a holding company or other interposed company prior to the listing date. [Table 1; items 5 and 7] .

5.71 Table 1;item 6 proposes parallel rules for shares issued to holding companies where demutualisation method 7 applies and the demutualising entities comprise a mutual insurance company and a mutual affiliate company.

Bonus shares

5.72 The modifications proposed by [table 1, items 5, 6 and 7] operate so that the rules relating to bonus shares in Division 8 of Part IIIA will apply appropriately. The applicable company valuation amount will be spread across the original demutualisation shares as well as any subsequent non demutualisation bonus shares.

The demutualising company

Imputation credits

5.73 Section 160APKA of the Act provides that, from 22 August 1990, mutual life insurance companies cannot maintain dividend franking accounts. Following demutualisation, franking accounts can be maintained by former mutual life insurance companies.

5.74 In relation to general insurance companies, table 2; item 12 provides that any existing class A, B or C franking account balance held by the general insurance company, a wholly-owned subsidiary of a general insurance company, or (where demutualisation method 7 applies), mutual affiliate companies and their subsidiaries, will be reduced to nil at the demutualisation resolution day. The same rule will apply to companies whose shares are beneficially owned by the general insurance company and the mutual affiliate company.

Application in relation to dividends declared prior to the demutualisation resolution day

5.75 In relation to dividends declared before the demutualisation resolution day, to be paid to:

•

a life insurance company;

•

a general insurance company;

•

a wholly-owned subsidiary of a life or general insurance company;

•

a mutual affiliate company; or

•

a company all of whose shares are owned by the mutual affiliate company and the general insurance company

and which are paid on or after the demutualisation resolution day, no franking account credit arises in relation to the dividend in the accounts of the company. [Table 2; item 13]

Transfer of life insurance business

5.76 A demutualisation may proceed under demutualisation method 6 whereby all of the life insurance business of a company is transferred to another company under a scheme confirmed by the Federal Court of Australia. Table 1;item 2 deems the second company to be related to the insurance company for the purposes of the application of section 160ZZO of the Act to the transfer of the assets. Section 160ZZO generally provides a capital gains tax rollover for assets transferred between related companies.

5.77 Following the transfer of the life insurance business, the second company, will be deemed to carry on the same business (i.e. the transferred life insurance business) as the mutual life insurance company. [Table 2, item 9]

Calculating the embedded value or net tangible assets value

5.78 The Commissioner of Taxation and the Australian Government Actuary were asked by the Government to consult with the Institute of Actuaries of Australia on the details of the appropriate method of calculating the 'embedded value' of life insurance companies in the case of demutualisations. Following those discussions the following method of calculating the 'embedded value' of a life insurance company is to be adopted in cases of demutualisations.

5.79 In calculating the 'embedded value' of a life insurance company an actuary is to apply normal actuarial practice to the calculation, having regard to the Institute of Actuaries of Australia Professional Standard PS 201 - Determination of Life Insurance Policy Liabilities and Guidance Note GN 252 - Actuarial Appraisals of Life Insurance Business. The 'embedded value' should relate to existing business only, calculated on a going concern basis and assuming no major changes in the company circumstances. No value is to be placed on future new business and no value is to be placed on transactions occurring in association with the demutualisation.

5.80 The calculation of 'embedded value' is to be the sum of the life insurance company's existing business value and its adjusted net worth (see paragraphs 5.84 to 5.86 below) on the applicable accounting day. The calculation is to be performed by a Fellow or Accredited Member of the Institute of Actuaries of Australia according to Australian actuarial practice. Such an actuary is not to be an employee of the life insurance company, a mutual affiliate company or a subsidiary of either the mutual insurance or mutual affiliate companies. [New subsections 121AM(1), (2), (5) and 121 AP]

5.81 The calculation of the 'embedded value' or the 'net tangible assets value' is to use the most recent financial accounts applicable to the demutualisation resolution day. The particular day is referred to as the 'applicable accounting day'. [New subsections 121AM(3) and 121AN(4)]

5.82 Where a significant change has occurred in values between the applicable accounting day and the demutualisation resolution day such a change is to be incorporated into the calculation of the 'embedded value' or the 'net tangible assets value'. [New subsections 121AM(4) and 121AN(5)]

5.83 The above formulae for 'embedded value' consists of 2 of the 3 components of an actuarial calculation known as the appraisal value of a life company. Guidance Note GN 252 (issued by the Institute of Actuaries of Australia) is concerned with all three components. The third component (value of future new business) is specifically excluded from the 'embedded value' calculation for the purposes of calculating the cost base of shares obtained as a result of demutualisation.

Adjusted net worth and existing business value

5.84 The terms 'adjusted net worth' and 'existing business value' are specific Australian actuarial terms and form the basic concepts for an actuarial calculation of 'embedded value'. Both terms are explained in detail in Guidance Note GN 252.

5.85 Generally, 'adjusted net worth' can be explained as the sum of the following:

(a)

the net balance of shareholders' funds;

(b)

the proprietors' share of any unappropriated surplus that is disclosed in the statutory funds; and

(c)

the proprietors' share of any market value excess.

5.86 Generally, 'existing business value' can be explained as the present value of distributable profits expected to emerge from existing business in the future.

Assumptions in calculating embedded value

Continued business

5.87 In calculating the 'embedded value' of a life insurance company it will be assumed that the organisation will continue to carry on the same business after demutualisation as it did before demutualisation. It is also assumed that the organisation will not conduct any new business after demutualisation. These assumptions are based on the 'going concern' concept and are used to value the organisation as at the date of demutualisation as if the demutualisation were not to occur. [New subsections 121AM(5)]

5.88 The concept of a 'going concern' business includes the following assumptions:

(a)

the valuation should not take account of changes to the company's business plans which are contingent on the demutualisation proceeding;

(b)

the valuation should not take into account changes in experience that might be expected as a result of the demutualisation (an example would be a reduction in the policy surrender rates of the company due to increased consumer confidence in the company); and

(c)

the valuation should not take into account any expected major business changes (eg, the sale of assets) as a consequence of the demutualisation not proceeding.

Distributable profits

5.89 It is assumed that capital just sufficient to meet statutory capital adequacy standards is maintained at all times, and all remaining profits are distributed. The capital adequacy standards are about to be strengthened following the passage of the Life Insurance Act 1995. The phase-in arrangements have not been determined. [New subsection 121AM(10)]

5.90 To the extent that a company does not meet the standards at the present time, it is to be assumed that the phase-in arrangement is such that a company can continue to operate, but that it cannot distribute any profits until it meets the new final capital adequacy standard. This will require the use of a higher discount rate during any period when the new capital adequacy standard is not met. The new capital adequacy standard will be published by the Life Insurance Actuarial Standards Board. The capital reserve adequacy standard is to be the standard published after 1 July 1995. Until those standards are published the capital reserve adequacy level will be the level of reserves necessary to provide adequate capital for the conduct of the life insurance business and other activities of the company. This level will be calculated by the eligible actuary according to Australian actuarial practice. [New subsection 121AO(2)]

Treasury bond rate

5.91 The Treasury bond rate is to be the yield on the 10 year Treasury bond as published by the Reserve Bank of Australia in the monthly Reserve Bank of Australia Bulletin. The rate published in the August 1995 Bulletin for the July 10 year Treasury bond yield was 9.42%. The Treasury bond is the Treasury bond issued by the Commonwealth of Australia. [New subsection 121AO(1)]

Discount rate

5.92 The discount rate is to be set at the 10 year Treasury bond rate plus 4.5 per cent. Where a company does not meet the capital adequacy standard, the discount rate should be increased by 0.2 per cent for each full 1 per cent by which the reserves available fall below the capital adequacy standard. The discount rate would, in these circumstances, be expected to fall each year into the future, as the company moves closer to the capital adequacy standard. [New subsection 121AM(6)]

5.93 The capital adequacy shortfall is to be calculated having regard to the average of the capital adequacy position of the company over the year rather than at any particular time during the year. The use of an average will smooth any fluctuations that may occur during the year.

5.94 For example, assume company ABC has an average capital adequacy shortfall of 10% and that the Treasury bond rate is the rate for July 1995 as published in the Reserve Bank of Australia's Bulletin (i.e. 9.42%). In this circumstance the discount rate to be used in the calculation of ABC company's embedded value would be as follows:

Discount Rate = 9.42% + 4.5% + 2% = 15.92%


5.95 The 'embedded value' of a life office represents the present value of the future distributable earnings calculated on an after-tax basis. The usual actuarial approach would apply an after-tax discount rate to the net of tax earning stream. For the purposes of the actuarial calculations the discount rate is to be an after-tax discount rate.

Inflation rate

5.96 The inflation rate is to be set at the 10 year Treasury bond rate less 4 per cent. This rate is to be used for all purposes where inflation is an assumption, for example, inflation in expenses, CPI growth etc. [New subsection 121AM(7)]

5.97 In the above example (at paragraph 94) ABC's inflation rate would be 5.42%.

Expenditure assumption

5.98 In calculating the 'embedded value' of a life assurance organisation actual maintenance and investment management expenses of the preceding accounting period excluding clearly identifiable non-recurring items (eg, redundancy costs) are to be assumed. The preceding accounting period's expenses of the same kind and amounts (increased by the inflation rate) are to be used in this calculation. Anticipated future improvements in expenses are not to be included in any calculations. [New subsection 121AM(8)]

5.99 In applying the expenditure assumption to the embedded value calculation it is anticipated that the eligible actuary should exclude non-recurring expenditure and divide the company's total expenditure between acquisition and maintenance (recurring) and then express the maintenance expenditure as some combination of rates per unit of assets, rates per unit of premium income and dollar amounts per policy. Those rates are then to be held constant into the future and the dollar amounts are to be inflated at the prescribed inflation rate.

Investment return

5.100 In calculating the existing business value or adjusted net worth, it is to be assumed that future investment distribution will remain in line with the company's investment policy and returns on investments are to be as follows:

5.101 The term of a security will be ascertained with reference to the period from the applicable accounting day to the date of maturity of the security. For example, a 10 year bond that from the applicable accounting day only has 14 months to maturity will be treated as a short term security.

5.102 The term 'securities' is to have the meaning as contained in subsection 159GP(1), Division 16E, of the Act with the exception that it does not refer to stock and as if paragraph (d) of subsection 159GP(1) had not been enacted.

5.103 The term 'security' then for the purpose of these provisions will mean:

(a)

a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(b)

a deposit with a bank, building society or other financial institution; or

(c)

a secured or unsecured creditor. [New subsection 121AO(4)]

Assumptions in calculating net tangible assets value

5.104 The 'net tangible asset value' of a general insurance company or mutual affiliate company is to be the amount of its assets as at the 'demutualisation resolution day' reduced by the amount of its liabilities including its future liabilities arising from business conducted by the company before the 'demutualisation resolution day'. [New subsection 121AN(1)]

5.105 The value of a company's assets and liabilities (excluding future liabilities) is to be calculated in accordance with Australian accounting practice. [New subsection 121AN(2)]

5.106 An eligible actuary will be required to calculate the amount of future liabilities (the outstanding claims) in relation to business conducted before the demutualisation. The other components of the 'net tangible asset value' will normally be ascertained by the company in conjunction with the actuary's calculations and its external auditors. The calculation of net tangible assets is to be made at the applicable accounting day and adjusted for any significant changes between the applicable accounting day and the demutualisation resolution day. [New subsections 121AN(3), (4) and (5)]

5.107 When calculating the 'net tangible assets' of a general insurance company the requirement that the calculation be performed on the basis of the continued business assumption is to apply. The continued business assumption is discussed in paragraphs 5.87 and 5.88 above. [New subsections 121AN(6)]

Chapter 6 - Establishment costs of horticultural plants

Overview

6.1 The proposed amendments contained in Part 1 of Schedule 4 of the Bill will introduce new Division 10F into the Income Tax Assessment Act 1936 (the Act) to allow capital expenditure incurred in establishing horticultural plants to be written off where the plants are used in a business of horticulture. [Item 1]

Summary of amendments

Purpose of amendments

6.2 The purpose of these amendments is to give horticultural plantations and perennial crops comparable tax treatment to other industries. Business is able to depreciate the capital cost of the plant and equipment with which it produces, or is ready to produce, its assessable income. Similarly, the original capital cost of buildings and structural improvements is written off over time, once they begin to be used to produce income.

6.3 Accordingly, this Bill inserts new Division 10F into the Act to allow for the write-off of the original capital expenditure incurred in establishing horticultural plants used in a business of primary production. The write-off begins when the plants begin to produce assessable income. The period over which the cost is written off is based on the effective life of the plants, and gives the same rate of deduction as prime cost (or 'straight line') depreciation on plant and equipment.

Date of effect

6.4 The amendments will apply to expenditure incurred after 9 May 1995 on establishing horticultural plants.

Background to the legislation

6.5 The Act contains a number of measures under which otherwise non-deductible capital costs may be written off, such as the depreciation of plant and articles and the capital allowance for income-producing buildings and structural improvements.

6.6 Generally, there is no write-off available for the capital cost of establishing or acquiring live plants which crop more than once in the plant's life. However, the cost of planting annual crops, such as wheat and barley, is deductible at the time the expenditure is incurred, because their production cycle is annual and the expenditure on grain for planting is considered recurrent.

6.7 In its report on Horticulture (released in May 1993), the Industry Commission concluded that the taxation treatment of horticultural plantations is anomalous and discriminates against investment in perennial crops relative to other industries. The Horticultural Task Force was established to review the Industry Commission's recommendations; the Task Force recommended the taxation treatment of horticultural plantations should be reviewed in the light of the concessional treatment afforded to grape vines. On 28 November 1994, the Government announced that it would provide a taxation write-off for new expenditure incurred in establishing horticultural plantations.

Explanation of the amendments

6.8 Item 1 will introduce new Division 10F into the Act. These amendments will provide for a write-off of the original establishment costs of horticultural plants which are used in a business of horticulture in Australia. The proposed write-off allows the taxpayer to commence writing off the expenditure once the plants are used, or are held ready to use, to produce assessable income in a business of horticulture.

6.9 The deduction goes to the taxpayer who owns and uses the plants, or holds them ready for use, to produce assessable income in a business of horticulture from time to time.

6.10 A lessee or licensee of land who carries on a business of horticulture will be taken to own plants in the land and so will get the deduction in preference to the lessor or licensor.

6.11 The period over which the establishment expenditure of horticultural plants is written off is based on their effective lives, and is accelerated in exactly the same way as the rates of prime-cost (straight line) depreciation of plant and equipment for tax purposes.

Outline

6.12 The new Division contains a simplified outline and index [new Subdivision A, new section 124ZZE] . The simplified outline provides a summary of the provisions and framework to assist the reader in understanding them. The index helps the reader to locate relevant provisions.

6.13 The simplified outline sets out the major criteria which must be satisfied for eligibility for the write off.

6.14 The expenditure for which deductions may be given must be capital in nature and incurred in establishing a horticultural plant. The expenditure should be incurred on or after 10 May 1995 and should not be otherwise deductible.

6.15 The taxpayer must own the plant, which must be used for the purpose of producing assessable income from a business of horticulture. The taxpayer can get the deduction whoever incurred the relevant expenditure.

6.16 Where the effective life of a plant is less than 3 years, the first taxpayer to use the plant for the purpose of producing assessable income in a business of horticulture can then write-off the establishment expenditure in full.

6.17 Where the effective life of the plant is 3 years or more, the taxpayer can write-off the establishment expenditure on a prime cost basis during the maximum write-off period for the plant. The write-off period and the rate of write-off are the same as for prime cost depreciation of plant and equipment with the same effective life.

6.18 If a plant with an effective life of 3 years or more is destroyed before the end of its maximum write-off period, there is a special deduction for the balance of the establishment expenditure after allowing for the part of the maximum write-off period already gone. There is no deduction for recouped establishment expenditure.

6.19 The Index of the Division enables the reader to locate the provisions which are of immediate relevance and alerts the reader to any other provisions which may also be of use. [New section 124ZZE]

What is horticulture?

6.20 Primary production is defined for taxation purposes as being any of several distinct kinds of production. Each of those kinds of production is distinct from the others.

6.21 Horticulture is defined in subsection 6(1) of the Act in terms which show that it includes both the cultivation and the propagation of plants, of fungi, and of their seeds, bulbs, spores or the like. Horticulture is apt to include cultivation for such produce as fruits, flowers, foliage or fruiting bodies. It is apt to include propagation, producing like growing plants and fungi or their seeds, bulbs, or spores. However, it is commonly distinguished from operations such as grain growing involving the cropping of annual plants.

6.22 Horticulture does not encompass forestry operations as defined in subsection 6(1) which, broadly, includes the planting and tending of trees in a forest or a plantation where the trees are intended for felling, as well as the felling of trees and their transport by the feller to the place where they will be first milled.

6.23 The definition of horticulture encompasses an activity which can precede the planting of trees or plant. It includes the propagation or cultivation of plants and their products such as fruit, flowers and vegetables. Where trees are not planted for felling, then the activity for which they are planted will fall within the definition of horticulture; for example, planting and tending of tea-trees for the production of oil. The definition of horticulture is sufficiently wide to cover the growing of plants etc in pots or by hydroponic means and will allow other means of growing plants to come within the definition when those means are developed.

6.24 Horticulture also includes the growing of fungi such as truffles and mushrooms. The growing of these falls within this legislation.

What is a 'horticultural plant'?

6.25 The term 'horticulture' as used in this Division has the meaning prescribed in subsection 6(1) of the Act.

6.26 The term 'plant' is specifically defined in this Division to mean 'any live member of the plant kingdom, and includes fungi'. [New subsection 124ZZR]

Plant or plantation?

6.27 The provisions apply to each horticultural plant. Such a plant includes any plant, fungus, seed, bulb, spore or the like capable of use in horticulture.

6.28 In practice, horticultural plants are rarely established individually, and their establishment expenditure is likely to be aggregated too. The provisions can accommodate this readily, as plants established together will generally begin to be used for the purpose of producing assessable income (or be held for that use) together.

6.29 The provisions provide simple legislation for the case where, say, an orchard or plantation is later divided between different horticultural businesses. Because the provisions apply plant by plant, deductions follow the divisions accordingly. This is no more complicated for horticulturists than the much more complex legislative option of defining the deduction in terms of plantations, orchards or the like and seeking to provide complex rules governing their division.

Eligible taxpayer

6.30 A taxpayer who owns horticultural plants is eligible for a deduction for the capital expenditure in establishing those plants provided the taxpayer uses them for the purpose of producing assessable income while carrying on a business of horticulture. [New section 124ZZF]

6.31 However, the expenditure must not already be deductible under other provisions of the ACT and must be incurred after 9 May 1995. [New paragraph 124ZZJ(1)(b) and subsection 124ZZJ(3)]

6.32 To own horticultural plants, the taxpayer may be the owner of the land on which the plants are established, the lessee of that land (under a Crown lease as defined in section 54AA of the ACT or otherwise) or a licensee in relation to the land. A lease can include a sublease. [New section 124ZZQ]

6.33 Where the taxpayer who originally established the plants no longer carries on (or never carried on) the business of horticulture using the plants, and another taxpayer has succeeded the original taxpayer in using the plants in carrying on their own business of horticulture then the second taxpayer can claim the deduction provided all the eligibility criteria are met.

6.34 If a landowner leases land on which the lessee establishes horticultural plants which are fixtures in the land and which the lessee uses for producing assessable income in a business of horticulture and the lease comes to an end, any further deductions will be available only to the next taxpayer to use the plants for the producing assessable income in a business of horticulture. That could be the landowner.

6.35 If the landowner grants another lease over the land to another tenant who then uses the plants for producing assessable income from a business of horticulture then that tenant may claim any outstanding amounts of the write-off expenditure provided all the eligibility criteria are met.

6.36 At any one time only one taxpayer may claim the write-off amount. The taxpayer who can claim this amount must be the owner or deemed owner of the plant. A lessee or licensee will be deemed to be the only owner of the plant if the plant is a fixture on the land, the lease or licence enables the lessee or licensee to carry on a business of horticulture on the land, and there is no holder of an inferior lease or licence in the land whose lease or licence enables them to carry on a business of horticulture on the land. In effect, the only owner of a plant that is a fixture on land is the holder of the most inferior interest in the relation to the land that entitles its holder to carry on a business of horticulture.

Meaning of 'establishment expenditure'

6.37 Establishment expenditure in respect of a horticultural plant is capital expenditure incurred by a person after 9 May 1995 on the establishment of horticultural plants for use in a business of primary production.

6.38 There is no definition of what constitutes the cost of establishing a horticultural plantation, however, costs of establishing horticultural plants may include the following:

•

the cost of acquiring the plants or the seeds;

•

the cost of planting the plants or seeds;

•

any costs incurred preparing to plant. These do not include the initial clearing of the land, but may in some cases include part of the costs of ploughing, contouring, top dressing, fertilising, stone removal, top soil enhancement, and so on that is attributable to the establishment of the plant;

•

the costs of pots and potting mixtures (for potted plants);

•

the costs incurred in grafting trees;

•

the costs of replacing existing plants and trees, because of loss of fair economic return or because of declining popularity of a particular existing variety.

6.39 Establishment expenditure is limited to capital expenditure, because it is capital expenditure that needs to be written off by analogy with the cost of plant and equipment or the original cost of building work or structural improvements. Revenue expenditure will be dealt with like other revenue expenditure, and will be a matter for the taxpayer who incurs it. So taxpayers for whom expenses that might otherwise be establishment expenditure are matters of revenue must look to the revenue deductibility of these expenses.

6.40 Some costs of replacing plants in an existing plantation, because of disease or damage, are likely to be revenue expenditure. Similarly, a nursery may incur revenue expenditure in planting seeds in beds or punnets to produce stock for sale.

6.41 Establishment expenditure expressly excludes expenditure incurred on draining swamp or low-lying land or the clearing of land. This resolves any possible doubt that such expenditures might be taken to be attributable to the later establishing of horticultural plants on the land [new subsection 124ZZJ(2)] . Establishment expenditure incurred on establishing horticultural plants does not include expenditure on other plants. However, where plants are used for associated purposes, such as demonstration purposes or for companion planting, in a business of horticulture, then expenditure incurred in establishing those plants will fall within the operation of this Division. Plants used for the purpose of producing assessable income in a business of horticulture may be accepted as horticulture plants in other own right, rather than as establishment expenditure on other plants.

6.42 The establishment expenditure provisions are to be treated as provisions of last resort. If expenditure is allowable either totally or partially as a deduction under another provision of the ACT not within this Division, then that provision will operate before the provisions of this Division and so will exclude the expenditure to that extent from establishment expenditure deductible under this Division. [New subsection 124ZZJ(3)]

6.43 Where depreciation is allowable as a deduction in relation to expenditure, it cannot be included as part of the establishment expenditure of a plant [new subsection 124ZZJ(4)] . Also, if expenditure is for buildings or structural improvements (and is qualifying expenditure under Division 10D), then that expenditure is also excluded from establishment expenditure. This resolves any possible doubt that such expenditures, including the costs of constructing greenhouses, dams or retaining structures, might be taken to be attributable to the later establishing of horticultural plants [new subsection 124ZZJ(5)] .

6.44 Where the taxpayer replaces a diseased or dead plant with a new one, then the expenditure incurred in establishing the plant will be immediately deductible under section 51(1) and so will not be part of establishment expenditure.

Availability of deductions

6.45 Establishment expenditure begins to be written off once the plants begin to be used, or held ready for use, to produce assessable income in a business of horticulture.

6.46 If for any reason, plants are never used or held ready for use, their establishment expenditure will not begin to be written off. This does not mean that dead plants represent dead deductions. Take the case where many seedlings are planted, so that there will be survivors to cull to form a productive orchard. The establishment expenditure of the plants in the orchard includes the costs of all the original seedlings.

6.47 As a general rule, plants may be said to be so used or held ready for use from the beginning of what is expected to be their first commercial season or period.

6.48 This is comparable to the treatment of plant and equipment, for which depreciation begins with first use or installation ready for use and holding in reserve. Some horticultural plants may take time, perhaps several growing seasons, to be ready for use in a business of horticulture. Similarly, some plant and equipment takes time, perhaps several years, before it is ready for use (after a period of manufacture and installation, say). Other horticultural plants, like plant and equipment, may be more quickly ready for use. [New paragraphs 124ZZF(c) and 124ZZG(c)]

What is the effective life of a plant

6.49 The Commissioner may issue a Taxation Ruling setting out 'safe harbour' effective life rates for a variety of horticultural plants; if the original taxpayer elects to adopt this rate, that election is irrevocable. The beginning of the effective life of the plant will be measured from the time that it became capable of being used in a business of horticulture for the purpose of producing assessable income. The original taxpayer is the one who owns the plant at that time. [New subsection 124ZZK(2)]

6.50 Such an election is irrevocable. This ensures that complex provisions adjusting the maximum write-off period and related calculations are not needed where different effective life estimates are made by horticulturists using the same plants. Instead, other provisions ensure that a purchaser is entitled to know the expenditure and basis to the deduction of a purchaser. [New subsection 124ZZK(4)]

6.51 Where the original taxpayer does not elect to adopt the effective life period specified by the Commissioner, the effective life of a plant will be measured by its capacity to produce assessable income whilst being used in a business of horticulture as from the time it was first capable of that use. This measure of effective life is an objective one, and takes account of all relevant commercial and other circumstances. It measures the period for which it is reasonable to expect that the plant could be used. The measure of effective life will take account of commerciality and practicality, not just of some theroretical botanical possibility. [New subsection 124ZZK(3)]

Commissioner's determination of effective life

6.52 Where the Commissioner has made a determination on the effective life of horticultural plants, the Commissioner must make this determination in writing and it must be available to the public. If the determination is to be revoked or varied, the revocation or variation must also be made in writing. [New section 124ZZL]

6.53 Where a determination has been made by the Commissioner, that determination may be made conditionally or unconditionally. Where the Commissioner does specify conditions, plants may have more than one effective life prescribed depending on the different conditions that apply when the plant first becomes capable of horticultural use. [New subsections 124ZZL(2) and (3)]

6.54 In practice, the Commissioner is likely to make such "safe harbour' determinations in consultation with the members of the horticultural industry concerned or their representatives. Because the Commissioner may well set 'safe harbour' rates based on the shortest likely effective lives in the range of possible effective lives for a particular kind of horticultural plant, taxpayers may seek retrospective application. A determination on the period of effective life may be made retrospectively when the determination works to the advantage of taxpayers. [New subsection 124ZZL(5)]

Effective life of less than 3 years

6.55 Where a plant has an effective life of less than 3 years, the taxpayer who owns the plant when it is first used or held ready for use for the purpose of producing assessable income from a business of horticulture will have an amount that can be written off immediately. This may be later than the first time the plant was capable of being used for such a purpose. [New section 124ZZF]

Effective life of 3 years or more

6.56 Where someone has incurred establishment expenditure on a horticultural plant and the effective life of the plant is 3 years or more, there may be an annual amount to be written off in each year that includes part of the maximum write-off period for the plant.

Calculation of deductions

6.57 The amount that can be written off is calculated by using the effective life and multiplying that by the proportion of a particular year that was eligible for deductions. The available deduction will be that percentage of the establishment expenditure.

6.58 A taxpayer determines the number of days for which establishment expenditure of a plant can be written off - the write-off days in the year - by determining how many days in a year of income the taxpayer used the plant or held it in readiness for use for the purpose of producing assessable income in a business of horticulture, owned the plant (or is deemed to have owned it), and was within the maximum write-off period. [New section 124ZZH]

6.59 The effect of this provision is that establishment expenditure is written-off only once, over the maximum write-off period of the relevant plant. Deductions lost during that period, say to a taxpayer who does not use the plants in a business of horticulture, are not carried forward for later taxpayers to claim. A taxpayer who buys plants and uses them in a business of horticulture during the maximum write-off period is entitled to the same deductions, whatever use the vendor or some predecessor made of the plants. This is similar to the effect of Divisions 10C and 10D.

6.60 New section 124ZZI sets out the appropriate prime cost rate for the different lengths of effective lives.

6.61 Because accelerated depreciation rates are being used, the period of time over which a taxpayer can write off the establishment expenditure is shorter than the effective life of the plant. See column 3 in the above table.

6.62 If a horticultural plantation is sold part way through a year of income before the end of its maximum write-off period, each taxpayer will be able to qualify for deductions based on their write-off days in the year.

Write-off on destruction

6.63 Where an eligible taxpayer's horticultural plants are destroyed and there is some part of the maximum write-off period remaining, the taxpayer can claim an outstanding amount as a deduction. The amount of the deduction is determined by deducting, from the establishment expenditure, a proportion based on the proportion of the maximum write-off period expiring before the destruction, and then deducting from the balance any amount recovered or recoverable in respect of the destruction. If there is any excess of establishment expenditure, this amount is deductible. These provisions will apply whether the destruction is either voluntary or involuntary. [New section 124ZZM]

6.64 Amounts recovered or recoverable in respect of the destruction include insurance payments, but are not limited to them. If these amounts exceed the remaining establishment expenditure, there is no additional deductions, but these provisions do not make the excess taxable. [New subsection 124ZZM(2)]

Recoupment of expenditure

6.65 Where a taxpayer receives or is entitled to receive reimbursement for any establishment expenditure a deduction will not be allowable for so much of the expenditure that is reimbursed as is not assessable income in the hands of the taxpayer. [New subsection 124ZZN(1)]

6.66 Taxpayers can opportion a reasonable amount out from the reimbursed sum where only part of the reimbursed sum relates to the establishment expenditure, but the extent to which it does so is unspecified. [New subsection 124ZZN(2)]

Transfer of ownership of plants - provision of tax information

6.67 Where a taxpayer transfers ownership in horticultural plants to another entity and there is some part of the maximum write-off period remaining, then the transferee can write off part of the establishment expenditure too provided the eligibility criteria are met. When a transfer occurs, if the transferee does not get the information from the transferor to know what deduction to claim for the establishment expenditure the transferee may give the transferor a written request for that information. [New subsection 124ZZO(1)]

6.68 The written notice may seek information on:

•

the amount of establishment expenditure;

•

the effective life;

•

whether the transferor made an election to use the Commissioner's safe harbour rate of write-off; and

•

when the maximum write-off period began. [New subsection 124ZZO(2)]

6.69 Where a request for information is made, it must be given within 60 days of the transfer, or within 60 days after the commencement of the section, which ever comes last. The transferee must give not less than 60 days for reply. [New subsection 124ZZO(2)]

6.70 If a transferor will not give the information sought, this is an offence with a penalty of 10 penalty units under the penalty unit system, in relation to a natural person. [New section 124ZZO(4)]

6.71 The transferee may only give one notice per transfer. [New subsection 124ZZO(3)]

6.72 This section applies to transfers that occur on or after 10 May 1995. [New subsection 124ZZO(6)]

6.73 Since early 1993 Commonwealth legislation has adopted the term penalty unit when imposing pecuniary penalties or fines. A penalty unit is currently worth $100. The transferee's notice must warn the transferor of this possible offence. A body corporate may have up to 5 times the penalty imposed on it as a natural person. [Crimes Act 1914, sections 4AA and 4B]

Partnerships

6.74 For the purposes of supplying establishment expenditure information to a transferee, where the transferor is a partnership the obligations imposed on it by proposed section 124ZZO can be discharged by any of the partners even though the obligations are imposed on all partners. [New subsection 124ZZP(1)]

6.75 Where a notice is given to a partner of a partnership, then the document is taken to be given to the partnership. [New subsection 124ZZP(2)]

Definitions

6.76 New section 124ZZR contains a number of definitions of words and terms used in the new Division 10F. Several definitions provide cross references to other sections. More substantial definitions are given for 'entity', 'plant', and 'producing assessable income'.

Chapter 7 - Forestry plantations

Overview

7.1 The amendments contained in Part 2 of Schedule 4 of the Bill amend the Income Tax Assessment Act 1936 (the Act) to ensure that where a taxpayer who conducts timber operations purchases an established forest or plantation and sells that forest or plantation before the trees are felled, the taxpayer only pays tax on the net proceeds from the sale of the trees.

Summary of the amendments

Purpose of the amendments

7.2 The purpose of the amendments is to remove an anomaly in the income tax law that may operate to disadvantage taxpayers who purchase an established but immature plantation or immature forest and subsequently sell it with the timber still standing. At present, these taxpayers may be taxed on the gross profits of such a sale of standing timber.

7.3 The amendments will tax only the net proceeds from the sale of the immature plantation or forest.

Date of effect

7.4 Applies to sales of standing timber after 9 May 1995.

Background to the legislation

7.5 In preparing its ruling TR95/6, Income Tax: primary production and forestry, the Australian Taxation Office (ATO) became aware that there was a taxation anomaly affecting sales of immature forests and plantations. This anomaly operates to disadvantage some of those taxpayers who purchase a pre-existing forest or plantation and subsequently sell it with the timber still standing.

7.6 In most circumstances, only the net proceeds of the sale of timber are taxed. The proceeds from the sale of timber are taxed, and related costs are allowed, either when incurred or against the proceeds of the sale.

7.7 Where a grower plants and tends trees in a plantation, an immediate deduction is available for the costs of establishing the plantation (IT 2296). Where a grower buys an established plantation or a forest and subsequently fells the timber for sale, a deduction of the original price of the trees is available at the time of felling them (section 124J).

7.8 But, it is possible for the seller of an immature plantation or forest to be taxed on the gross value of the standing timber rather than the net profit. This occurs when a grower has bought an established plantation or forest and then disposes of it without having felled the timber. In these circumstances, the grower is taxed on the total value of the timber (under subsection 36(1) of the Act) and is permitted no deduction for any part of the original purchase price of the plantation.

7.9 This differential tax treatment between taxpayers in essentially similar activities is inequitable.

Explanation of the amendments

7.10 The anomaly arises through the interaction between subsection 36(1) and section 124J which apply to the sale of an immature plantation outside the ordinary course of business and the sale of felled timber where a taxpayer has purchased an established forest or plantation respectively.

7.11 Section 36 brings trading stock to account as income on a revenue basis at the trading stock's market value when the unsold trading stock is being disposed of outside the carrying on of the taxpayer's normal business. For this section's purposes trees which have been planted and tended for sale are treated as trading stock.

7.12 The amendment to correct the anomaly has been inserted into section 36 because this continues the trading stock-like treatment accorded to the sale of immature plantations. This treatment is the most appropriate for these plantations and fits within the structure of the Act.

7.13 A taxpayer who satisfies all the criteria listed below will have any profits on the sale of an immature plantation or forest taxed on a net basis. These criteria are:

•

the taxpayer must acquire land on which there are trees;

•

within the purchase price of the land, there must be an amount attributable to the value of the trees;

•

the trees must be tended for the purposes of sale by the taxpayer, and held by the taxpayer in connection with timber operations. Those operations are defined in section 124E, and mean the planting or tending of trees for felling, felling of standing timber, removing felled timber, or milling or processing felled timber;

•

the trees were assets of the taxpayer's business;

•

the taxpayer disposed of the trees, after 9 May 1995; and

•

the disposal of the trees was not in the ordinary course of carrying on the taxpayer's business.

The anomaly does not arise for other taxpayers. [Item 2, new subsection 36(7A)]

7.14 If all these criteria are satisfied, then the original acquisition costs of trees plus any associated acquisition costs are allowed as deductions (to the extent they are not already deductible) in the income year in which the standing trees are disposed of. [Item 2, new subsection 36(7A)]

7.15 There are three safeguards in this legislation. Firstly, if any capital expense is allowed or is allowable as a deduction, then that capital expense is not taken into account in determining the net profit from the sale of the land and trees. [Item 2, new subsection 36(7B)]

7.16 Secondly, in circumstances where the vendor and taxpayer (purchaser) are not dealing with each other at arm's length and the price paid for the land was greater than was reasonable, the price will be one that is reasonable if the parties were dealing with each other at arm's length. [Item 2, new subsection 36(7C)]

7.17 Finally, where the vendor and the taxpayer (purchaser) are again not dealing with each other at arm's length, and the amount spent on acquiring the trees was greater than what should have been reasonable, the price will be at a level which is reasonable between the parties. [Item 2, new subsection 36(7D)]

7.18 An additional subsection is being added to section 124J. This additional subsection provides that where a taxpayer acquires land on which there are trees, or a right to cut trees, and the parties were not dealing with each other at arm's length and the price paid by the taxpayer for either the land or right is greater than was reasonable, the price will be taken to be one that is reasonable. [Item 3, new subsection 124J(2)]

7.19 This reflects new subsection 36(7C) and insures that section 124J is not now to be read as having a different effect to section 36 because of these amendments.

Application

7.20 The amendments to section 36 will apply to disposals of standing timber which occur after 9 May 1995.

7.21 The amendment to section 124J will apply to timber which is felled after the date of introduction of the Bill. [Item 4]

Chapter 8 - Research and development

Overview

8.1 The proposed amendments contained in Part 4 of Schedule 4 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to deny deductions under section 73B of the Act for expenditure incurred to a private tax exempt entity, if that expenditure is not fully at risk.

Summary of the amendments

Purpose of the amendments

8.2 The proposed amendments will ensure that companies receive the same taxation treatment for expenditure incurred to private tax exempt entities as presently applies for expenditure incurred to public tax exempt entities under section 73CB.

Date of effect

8.3 The proposed amendments will apply to expenditures incurred at or after 7.30 pm Australian eastern standard time on 9 May 1995. Transitional rules apply to companies relying on a finance scheme approved by the Industry Research and Development Board before that time. [Item 14]

Background to the legislation

8.4 The R&D tax concession is available to an eligible company for expenditure incurred, on or after 1 July 1985, on qualifying R&D activities. The concession is in the form of a deduction up to 150 per cent of the expenditure incurred on qualifying R&D activities.

8.5 Where a company incurs expenditure in relation to R&D activities carried out on its behalf, the arrangements are often structured in such a way that the company receives a guaranteed return for its expenditure. Where a company incurs expenditure in relation to R&D on the basis that the company receives a guaranteed return, the rate of allowable deduction for such expenditure is reduced to 100 per cent of that expenditure as the return rises to 100 per cent of the expenditure, under section 73CA.

8.6 A company incurring R&D expenditure, that has a guaranteed return arrangement, to a tax exempt researcher will derive a tax benefit from the tax exempt status of that researcher. For example, a company might obtain a deduction for R&D expenditure incurred to a researcher. A taxable researcher will be assessed on the amount received for the R&D. If the researcher is exempt from income tax, the amount received for the R&D will not be taxable. An arrangement with a tax exempt researcher will therefore have more funds to return (in a guaranteed return arrangement) to the company. If the project fails, the company has obtained a tax deduction of all its expenditure on R&D activities (including core technology and plant) and later received a return for that expenditure. The company has in effect done little more than buy tax deductions from a entity that does not have them to sell. The tax exempt researcher is left with funds to cover direct costs related to the research, for example wages. If the project fails, both the company and the tax exempt researcher have been advantaged. The Commonwealth revenue has been disadvantaged. That is, the cost of the failed R&D project has been supported by the Commonwealth's income tax exemption of the researcher. The Bureau of Industry Economics Research Report 60, dated October 1994, on Syndicated R&D gives a detailed analysis of the operation, and the costs and benefits, of tax exempt entities in relation to R&D.

8.7 Section 73CB was introduced in 1992 to deny deductions under section 73B for expenditure on R&D activities incurred to a government authority or an associate of a government authority ( public tax exempt entities ) where there is a direct or indirect guaranteed return to the owner of the research. Expenditure incurred on R&D activities to private tax exempt entities that has a guaranteed return to the owner of the research may still be eligible for a deduction under section 73B.

8.8 Section 73CB does not apply to expenditure incurred to government authorities and their associates if they are listed on a Register of Commercial Government Bodies kept by the Industry Research and Development Board under the Industry Research and Development Act 1986. Listing is only available to bodies which meet a range of criteria, including being liable to income tax.

Explanation of the amendments

8.9 Section 73CB currently operates to deny deductions for expenditure incurred on R&D activities to a government authority or an associate of a government authority (public tax exempt entities) where that expenditure is not fully at risk. The proposed amendments will extend the operation of section 73CB to apply to expenditure incurred to both public and private tax exempt entities by repealing the current section 73CB and substituting a new section 73CB that will apply to all tax exempt entities or associates of tax exempt entities. [Item 13; new subsection 73CB(5)]

8.10 The new section 73CB will deny a company a deduction for expenditure incurred in connection with R&D activities that would otherwise be allowable under section 73B where the following conditions are satisfied:

•

the expenditure was incurred to a tax exempt entity or an associate of a tax exempt entity; and

•

at the time the expenditure was incurred there was at least some part of the expenditure for which the company was not at risk; and

•

at the time the expenditure was incurred, it was not incurred to an entity or associate that was on the Register of Commercial Government Bodies that is kept under section 39HA of the Industry Research and Development Act 1986. That Register is relevant only to taxable government bodies, continuing the effect of the former paragraph 73CB(2)(c). [Item 13; new subsection 73CB (4) and (5)]

8.11 New section 73CB will continue to be construed as part of section 73B, which is the provision under which the R&D tax concession is provided. [Item 13; new subsection 73CB(4)]

8.12 Where the operation of new section 73CB is attracted, the Commissioner is able to go back at any time and amend an assessment under section 170 of the Act. This provision will remain unchanged under the new section 73CB. This is necessary, because the tax status of the entity to which expenditure was incurred may not be known for some time. [Section 170(10)]

All expenditure in connection with R&D may be affected

8.13 New section 73CB applies to all expenditure in connection with R&D which is deductible under section 73B. It includes actual expenditures on 'R&D expenditure', 'core technology expenditure', plant expenditure and building expenditure that relate to qualifying R&D activities on behalf of the company incurring the expenditure. 'R&D expenditure' includes contract expenditure, salary expenditure and other expenditure directly in relation to R&D activities. 'Core technology expenditure' is expenditure incurred in acquiring core technology or the right to use it for the purposes of R&D activities. [Item 13; new subsection 73CB(4)]

Meaning of 'not at risk'

8.14 Proposed section 73CB will apply to deny a deduction for all expenditures which are at least partly not 'at risk'. The current section 73CB ties in the concept of not being 'at risk' (for the company incurring the expenditure) to the same criteria as those under subsection 73CA(5), which generally reduces deductions to 100 per cent of expenditure to the extent that the company incurring the expenditure is certain of recouping its expenditure. [Item 13; new subsection 73CB(5) and (6)]

8.15 To avoid any confusion that may be caused by adopting the subsection 73CA(5) definition of 'at risk' to section 73CB, the definition of 'at risk' has been inserted into the new section 73CB . The meaning of 'at risk' remains unchanged. [Item 13; new subsection 73CB(6)]

8.16 The company is taken not to have been 'at risk' in relation to expenditure incurred to a tax exempt entity or its associate, if, in the Commissioner's opinion, the company or any associate of the company would receive or could be expected to receive any consideration as a direct or indirect result of incurring the R&D expenditure. The Commissioner must form such an opinion reasonably, and is subject to the normal avenues of review and appeal. [Item 13; new subsection 73CB (5) and (6)]

8.17 Subsection 73CB(6) does not ask whether the consideration is given expressly in relation to particular expenditure, it asks whether the consideration is given practically in relation to the expenditure. This continues the effect of the present law. [Item 13; new subsection 73CB(6)]

8.18 If the Commissioner is of the opinion that the amount of consideration received by a taxpayer, nominally on only some of the taxpayer's expenditure, is designed to ensure a minimum return on expenditure incurred on all its R&D projects, section 73CB will apply to deny a deduction for all that expenditure incurred. That is, as long as it can clearly be determined, from the facts of the case, that the guaranteed return also relates to expenditure incurred to the tax exempt entity in relation to another project, then this provision will apply to deny a deduction for the expenditure that has a direct guarantee and for the expenditure that is guaranteed indirectly. (The term 'guaranteed return' is used in respect of a company not being 'at risk' for its expenditure on R&D activities in terms of new section 73CB(6)) . [Item 13; new subsection 73CB(6)]

8.19 Where the consideration to be received is formally related to only part of a project's expenditure, for example core technology expenditure, section 73CB(5) may operate to deny a deduction for all the expenditure, not just on core technology, but on the R&D activities of the whole project. The company claiming deductions is not at risk in respect of part of its expenditure in connection with the R&D activities carried out on behalf of the company. So a deduction is not allowable to the company under section 73B for any part of the expenditure. The new wording reflects the former subsection 73CB(2). [Item 13; new subsection 73CB(5)]

8.20 New section 73CB may apply to expenditure incurred by both the company and its associate, where the R&D expenditure is incurred by the company to the associate, and the associate incurs expenditure which is not fully at risk to a tax exempt entity. In these cases, if the Commissioner is able to conclude that the associate incurred expenditure that was not fully at risk to a tax exempt entity in the expectation that the company will incur expenditure to it for the R&D, then section 73CB will apply to the expenditure incurred by the company and the associate. For example Company A incurs expenditure on core technology to a tax exempt entity and is to receive consideration as a result of that expenditure. Company A incurred that expenditure in the expectation that an associate will incur expenditure to acquire the core technology from it. Later, an associate, Company B, does so. Section 73CB will apply to deny a deduction for the core technology expenditure of both Company A and B. The same result follows where the company incurs expenditure to its associate in the expectation that the associate will incur expenditure to a tax exempt entity that is not fully at risk. [Item 13; new subsection 73CB(5) and (6)]

Tax exempt entity

8.21 New section 73CB applies to R&D expenditures to all tax exempt entities. For the purpose of new section 73CB a tax exempt entity is a person, a body or association (whether incorporated or unincorporated), or a fund, that is not liable to income tax. This includes the Commonwealth, State or Territory governments and any authorities of the Commonwealth, State or Territory governments that are not liable to income tax. [Item 13; new subsection 73CB(1)]

8.22 A body is an authority of the Commonwealth, State or Territory if the Commonwealth, State or Territory has a controlling interest in that body; or if the Commonwealth, State or Territory has an interest in the body and the only other persons having an interest in the body are the Commonwealth, States or Territories or authorities of the Commonwealth, States or Territories. For example section 73CB will apply to R&D expenditures incurred to a tax exempt entity that is owned one third by a State government, one third by a Commonwealth authority and one third by a Territory authority. [Item 13; new subsection 73CB(2)]

Meaning of agreement

8.23 Under the current section 73CB the term 'agreement' takes its meaning from section 73CA(6) because 'not at risk' takes its meaning from section 73CA(5).

8.24 In the proposed section 73CB, the concept of 'not at risk' is separately defined in section 73CB(6) for clarity of reading, and therefore the meaning of 'agreement' is also separately defined in the new section 73CB . [Item 13; new subsection 73CB(6)]

8.25 The meaning of 'agreement' remains unchanged from the existing meaning to that appearing in new section 73CB(1) . It means any agreement, arrangement, understanding or scheme, whether formal or informal, whether express or implied, and whether or not intended to be legally enforceable. [Item 13; new subsection 73CB(1)]

Meaning of associate

8.26 The meaning of the term 'associate' remains unchanged from the current section 73CB. It is defined in section 73B(3) to have the same meaning as in 26AAB and is extended in the present section 73CB to include government bodies. Hence, Commonwealth, State and Territory authorities will be taken to be associates of their respective governments (which include government departments, commissions etc) and of other authorities of the same government. In the same way, the respective governments will be associates of the respective Commonwealth, State or Territory authorities. [Item 13; new subsection 73CB(3)]

Transitional arrangements

8.27 The Government announced an amnesty period for companies relying on a finance scheme approved by the Industry, Research and Development Board (IR&D Board) before 7.30 pm Australian eastern standard time on 9 May 1995. For those companies, the proposed amendments will not apply if the expenditures incurred on or after 9 May 1995:

•

are incurred in accordance with the terms of the finance scheme; and

•

are incurred under a contract evidenced in writing that was entered into on or before 3 August 1995, and

•

are incurred by members of syndicates (one or more eligible companies) which lodged an application for joint registration with the IR&D Board on or before 3 August 1995. [Item 14]

8.28 These transitional rules reflect the long lead times of R&D syndication. Because detailed contracts, and incurring of expenditure, only follow the approval of the finance scheme, there could be syndication arrangements which had not reached the stage of finalising contracts or registering the syndicate when the changes were announced. The Government decided to allow the former rules to apply to all those syndication arrangements which had finance scheme approval before the announcement, provided the syndicates concluded the necessary contracts and applied for registration as syndicates no later than 3 August 1995 - more than 12 weeks after the announcement. [Item 14]

Chapter 9 - Sales tax - exemption for rice milk

Overview

9.1 Schedule 5 of the Bill will amend the sales tax law to exempt rice milk from sales tax.

Summary of the amendments

Purpose of the amendments

9.2 The amendments will provide a sales tax exemption for certain beverages consisting principally of rice milk [Item 1] . This will ensure that rice milk is treated for sales tax purposes the same as other similar milk and soy milk beverages. Flavoured beverages that consist principally of rice milk will be taxed at the concessional rate, currently 12 per cent.

Date of effect

9.3 The amendments will apply from the date of introduction of the Bill. [Item 5]

Background to the legislation

9.4 Rice milk is subject to the general rate of sales tax, currently 22 per cent, while milk products and beverages consisting principally of soy milk are exempt from sales tax. Flavoured beverages containing 90 per cent or more milk or consisting principally of soy milk are currently taxed at the concessional rate of 12 per cent.

9.5 Rice milk is generally regarded as a substitute for both milk and soy milk. The inconsistent treatment of these very similar beverages has adverse consequences for those people who are allergic to both dairy products and soy milk.

9.6 The proposed amendments will ensure that rice milk is treated for sales tax purposes the same as other similar milk and soy milk beverages.

Explanation of the amendment

9.7 Schedule 1 to the Sales Tax (Exemptions and Classification) Act 1992 identifies goods which are exempt from sales tax.' 71 of Schedule 1 currently provides an exemption for beverages consisting principally of soy milk and this will be amended to also include rice milk. [Items 2 and 3]

9.8 Schedule 2 to the Sales Tax (Exemptions and Classification) Act 1992 identifies goods which are taxed at the concessional rate of sales tax, currently 12 per cent. Subitem 12(2) of Schedule 2 currently covers flavoured beverages that consist principally of soy milk. This subitem will be extended to include beverages consisting principally of rice milk. [Item 4]

Chapter 10 - Trust losses

Overview

10.1 Part 1 of Schedule 7 of the Bill will insert a new Schedule 2C into the Income Tax Assessment Act 1936 (the Act) to provide new rules that have to be satisfied by trusts before prior and current year losses can be deducted. The new Schedule is inserted in a way to fit within the proposed new structure of the income tax law.

10.2 The proposed rules, other than an income injection test, will not apply to family trusts.

10.3 With the exception of the income injection test, the rules that will apply will depend on the type of trust being considered. The three basic types of trusts are fixed trusts (including widely held unit trusts), non-fixed trusts and excepted trusts.

10.4 The new regime will contain an income injection test which applies to deny a deduction to the trust for losses. In very broad terms, the test will apply where, in connection with a scheme, the losses are used to shelter assessable income from tax.

10.5 Consequential amendments will also be made to the Act. These will integrate the new measures into the income tax law.

Summary of the amendments

Purpose of the amendments

10.6 The amendments will insert rules into the Act to restrict the recoupment of current and prior year losses of trusts in order to prevent trafficking of trust losses. Under loss trafficking, a person who did not bear the economic loss at the time it was incurred by the trust obtains a benefit from the trust being able to deduct the loss. The following tables provide a broad summary of the various rules in the trust losses proposals.

Date of effect

10.7 Subject to certain transitional arrangements, the proposed measures will apply to all trafficking in trust losses from 7.30 pm AEST and the equivalent time elsewhere on 9 May 1995.

10.8 However, the pattern of distributions test (see paragraphs 10.91 to 10.102 below), one of the tests that applies to non-fixed trusts for prior year losses, will apply from the date of introduction of the Bill into the Parliament.

Background to legislation

10.9 Under the Act a tax loss incurred by a taxpayer in a year of income may generally be carried forward and deducted from the taxpayer's assessable income in a later year. Losses incurred in the 1989/90 and later income years may be carried forward indefinitely until recouped. There are special rules for the carry forward and deduction of losses arising from foreign income deductions. The relevant provisions are sections 79D, 79E and 80. Film losses are treated in a similar way (sections 79F and 80AAA). In the case of companies there are provisions in the Act which limit the deductibility of prior and current year losses.

10.10 The provisions which limit carry-forward of prior year losses are sections 80A-80E. These provisions contain tests that need to be satisfied by a company before losses can be recouped in a later income year. These tests have the effect that a company can carry forward a loss if there is continuity of beneficial ownership of certain dividend, capital and voting rights of the company. Where there is a change in the beneficial ownership of shares in the company or another company which has resulted in that continuity not being satisfied, the company can carry forward a loss if it carries on the same business as when the loss was incurred. There are also additional rules to prevent the carry forward of a loss in certain circumstances.

10.11 The provisions which limit deductibility of current year losses are sections 50A-50N. Under these provisions a company may not be able to offset deductions incurred by the company which are attributable to one part of an income year against assessable income of the company which is attributable to another part of the income year. This would be the result where an event or circumstance occurs during the income year which is similar to those events or circumstances which result in the company not being able to deduct a prior year loss (see paragraph 10.10 above).

10.12 There are no provisions in the Act similar to sections 80A-80E or 50A-50N which prevent the deduction of prior and current year trust losses. This Bill will insert Schedule 2C into the Act which will place restrictions as to when prior year or current year losses can be deducted by trusts. The rules differ from those currently applicable to companies and reflect the different features of trusts as compared to companies.

Explanation of the amendments

10.13 The Bill, and the explanatory memorandum, are divided into the following divisions:

Division 265 - Overview of trust loss provisions

10.14 The provisions dealing with trust losses are intended to prevent trafficking in tax losses or other deductions which are incurred by trusts. They mainly do this by looking at whether there is a relevant change in the individuals who will benefit from any deduction for the tax losses or other deductions compared to the individuals who actually incurred and economically suffered the loss or deduction. The discussion below outlines in broad terms how the measures will apply. This is followed by a detailed explanation of the proposed amendments.

10.15 The proposed rules that are to apply to trusts will differ from those that apply to companies, reflecting the different characteristics of trusts. Accordingly, the particular rules which apply to a trust will depend on the type of trust. The three basic types of trusts which are dealt with differently in the legislation are fixed trusts (including listed and unlisted widely held trusts), non-fixed trusts and excepted trusts. Excepted trusts include family trusts.

10.16 The Bill, and this explanatory memorandum, deal with each kind of trust in a different part. While this leads to some repetition of common rules, it means that the reader can see the rules which apply to each kind of trust in one place.

10.17 Fixed trusts (other than listed widely held trusts) that are not family or other excepted trusts will have to satisfy a continuity of ownership test and an income injection test before losses can be deducted.

10.18 Special rules will apply to family trusts. In general, these rules will permit the carry forward of losses so long as distributions from the trust are only capable of flowing to members of the family. Family trusts will also be subject to the income injection test.

10.19 A fixed trust that is a listed widely held trust, but not an excepted trust, will be able to deduct prior year losses only if the trust satisfies a continuity of ownership test or the continuity of business test, and an income injection test.

10.20 Special rules for testing changes in ownership will apply to widely held trusts that are fixed trusts.

10.21 Listed widely held trusts or unlisted widely held trusts with at least 1000 unit holders and which also satisfy certain other requirements only need to test for continuity of ownership where an abnormal dealing (trading) in units occurs.

10.22 An unlisted widely held trust that has less than 1000 unit holders or does not satisfy the necessary requirements has to test for a continuity of ownership not only when there is an abnormal dealing in units but also at the end of each accounting period.

10.23 The Bill specifies some of the factors to be taken into account in deciding whether a dealing is abnormal or not. It also specifies the circumstances in which an abnormal dealing will be deemed to have occurred.

10.24 A non-fixed trust that is not a family or other excepted trust will have to satisfy a pattern of distributions test, a continuity of ownership test, a continuity of control test and an income injection test before prior year losses can be deducted. However, the pattern of distributions test and continuity of ownership test may not be applicable to the circumstances of some non-fixed trusts in which case they will not have to be met. The continuity of ownership test will only have to be satisfied by a non-fixed trust in which there are fixed entitlements to more than 50% of the income or capital of the trust.

10.25 The continuity of ownership test for fixed trusts requires that more than 50% of fixed entitlements in the income and capital of the trust be held, directly or indirectly, by the same individuals (i.e. natural persons), other than as a trustee, from the loss year to the recoupment year. Indirect entitlements can only be traced through fixed entitlements in interposed companies, trusts and partnerships.

10.26 The pattern of distributions test for non-fixed trusts, will, broadly, examine the pattern of distributions of income and capital of the trust over a period to determine whether there has been an effective change in those who benefit under the trust.

10.27 The Bill contains an income injection test which applies equally to fixed trusts, non-fixed trusts and family trusts. This test operates to disallow a deduction for a prior year loss where certain schemes are entered into. The scheme involves the trust deriving assessable income and a person obtaining a benefit which effectively represents consideration for the shelter of the assessable income from tax by the loss.

10.28 There will also be corresponding rules to restrict the deductibility of current year losses and accounting rules to determine a trust's net income or tax loss where necessary.

10.29 The new rules will not apply to complying superannuation funds, complying approved deposit funds, pooled superannuation trusts and deceased estates (within a reasonable administration period). These are all excepted trusts. However, if these trusts make investments in other trusts, the rules will apply to the deductibility of losses of those other trusts.

Division 266 - Income tax consequences for fixed trusts of abnormal trading or change in ownership

10.30 Division 266 sets out the circumstances in which a fixed trust will not be able to deduct a prior year loss or will have to calculate its net income or tax loss for the current year in a special way.

10.31 The rules that apply depend on the kind of fixed trust being considered. There are four kinds of fixed trust for the purposes of the legislation, as follows:

•

fixed trusts (other than widely held unit trusts);

•

listed widely held trusts;

•

unlisted very widely held trusts; and

•

unlisted widely held trusts.

10.32 The characteristics of each of these kinds of trust is defined in Division 271, which deals with interpretation. This is discussed at paragraphs 10.230 to 10.283 below. Broadly, a fixed trust is a trust where all of the income or capital is the subject of a fixed entitlement.

10.33 A family trust (a type of 'excepted trust') that is also a fixed trust will, however, not be affected in any way by the tests in Division 266. The rules in Division 266 will not, therefore, prevent a family trust from deducting prior or current year losses. Also, other excepted trusts (as defined - see paragraphs 10.267 to 10.269 below) are not affected by Division 266.

10.34 The tests that apply to fixed trusts to determine whether a prior or current year loss can be deducted look at three different things. They are abnormal trading of units in a trust, change in fixed entitlements and whether there is continuity of business. The last of these, continuity of business, applies only to listed widely held trusts.

10.35 The abnormal trading concept is central to determining whether listed widely held trusts and unlisted very widely held trusts can deduct losses. It is normal for units in these kinds of trusts to be traded. Trading is defined in the legislation to include all dealing in units, including redemption and issue. The rules will, therefore, only test for a change in the individuals who can benefit from the losses when there is abnormal trading. The abnormal trading concept is also used for unlisted widely held trusts.

10.36 At the heart of the tests for fixed trusts is whether there is a significant change in those individuals who have direct or indirect fixed entitlements in the trust. Fixed entitlements are readily quantifiable and will give an accurate picture of those who will receive income or capital of the trust. This in turn will be a reliable indicator of whether there has been a change in the individuals who can benefit from the losses of a fixed trust. Indirect entitlements can only be traced through fixed entitlements in interposed entities.

Subdivision 266-B - Fixed trusts (other than widely held unit trusts)

When can't a fixed trust (other than a widely held unit trust) deduct a tax loss of an earlier income year?

10.37 The Bill sets out rules to determine when a fixed trust (other than a widely held unit trust) cannot deduct a prior year tax loss. These trusts are called fixed trusts in the discussion below. The following flow chart outlines, in broad terms, when such a trust cannot deduct a prior year loss.

10.38 A fixed trust is affected by the proposed rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible;

•

it was a fixed trust at all times in the 'test period';

•

it was not a widely held unit trust at all times in the 'test period'; and

•

it was not an excepted trust at all times in the 'test period'.

10.39 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years [subsection 266-25(1)] . For example, a fixed trust incurs a loss in Year 1. In Year 3 it seeks to recoup that loss. The test period in this case is Year 1 (the loss year), Year 3 (the current income year) and Year 2 (the intervening income year).

10.40 If the rules in paragraph 10.38 are met then the fixed trust cannot deduct the prior year tax loss unless it meets the condition set out in the Bill [subsection 266-25(2)] . This condition is explained at paragraphs 10.44 and 10.45 below.

When does a fixed trust (other than a widely held unit trust) have to work out its net income or tax loss in a special way? (current year losses)

10.41 The Bill also sets out rules to determine when a fixed trust (other than a widely held unit trust) cannot deduct a current year tax loss. These trusts are called fixed trusts below. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year. The following flow chart outlines, in broad terms, when such a trust has to work out its net income or tax loss in a special way.

10.42 A fixed trust is affected by the proposed rules, as they relate to current year losses, if:

•

it was a fixed trust at all times in the income year being examined (called the test period);

•

it was not a widely held unit trust at all times in the 'test period'; and

•

it was not an excepted trust at all times in the 'test period'. [Section 266-30]

10.43 If the rules in paragraph 10.42 are met then the fixed trust must work out its net income or tax loss in a special way unless it meets the condition set out in the Bill [section 266-30] . This condition is explained at paragraphs 10.44 and 10.45 below.

What is the condition for fixed trusts (other than widely held unit trusts)?

10.44 The condition is that the same individuals must have more than 50% of the fixed entitlements (called a stake) in the trust at all times in the test period. [Paragraph 266-35]

10.45 The meaning of the 50% stake concept is set out in Division 269 and is discussed below at paragraphs 10.181 to 10.193.

When can part of a prior year tax loss be deducted by a fixed trust (other than a widely held trust)?

10.46 If a fixed trust cannot deduct a prior year tax loss because it does not meet the condition set out above (see paragraph 10.44), then it may still be able to deduct part of the tax loss which is properly attributable to part of the loss year [subsection 266-40(1)] . This will only apply if the change in ownership that leads to the inability of the trust to deduct the loss occurs in the loss year.

10.47 The trust can only deduct part of the tax loss if, assuming the part of the loss year was a whole loss year, it meets the condition discussed in paragraph 10.44. [Subsection 266-40(2)]

10.48 The following example illustrates the application of this rule. In Year 1, a fixed trust incurs a tax loss. During that year there is a change in ownership of the trust. It is thus prevented from carrying forward all the loss. During the period after the change in ownership to the end of Year 2 (the current income year) the trust meets the condition that would allow it to carry forward a tax loss. The trust may deduct the part of the loss that is attributable to the period of the loss year that occurs after the change in ownership.

Subdivision 266-C - Unlisted widely held trusts

When can't an unlisted widely held trust deduct a tax loss of an earlier income year?

10.49 The Bill sets out rules to determine when an unlisted widely held trust cannot deduct a prior year tax loss. The following flow chart outlines, in broad terms, when such a trust cannot deduct a prior year loss.

10.50 An unlisted widely held trust is affected by the proposed rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible;

•

it was an unlisted widely held trust at all times in the 'test period' but not an unlisted very widely held trust at those times (see paragraph 10.276); and

•

it was not an excepted trust at all times in the 'test period'.

10.51 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years. [Subsection 266-55(1)]

10.52 If the rules in paragraph 10.50 are met then the unlisted widely held trust cannot deduct the prior year tax loss unless it meets the condition set out in the Bill [subsection 266-55(2)] . This condition is explained at paragraphs 10.56 and 10.57 below.

When does an unlisted widely held trust have to work out its net income or tax loss in a special way? (current year losses)

10.53 The Bill also sets out rules to determine when an unlisted widely held trust cannot deduct a current year tax loss. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year. The following flow chart outlines, in broad terms, when such a trust has to work out its net income or tax loss in a special way.

10.54 An unlisted widely held trust is affected by the proposed rules, as they relate to current year losses, if:

•

it was an unlisted widely held trust at all times in the income year being examined (called the test period) but not an unlisted very widely held trust at those times; and

•

it was not an excepted trust at all times in the 'test period'. [Section 266-60]

10.55 If the rules in paragraph 10.54 are met then the unlisted widely held trust must work out its net income or tax loss in a special way unless it meets the condition set out in the Bill [section 266-60] . This condition is explained at paragraphs 10.56 and 10.57 below.

What is the condition for unlisted widely held trusts?

10.56 The condition is that the same individuals must have more than 50% of the fixed entitlements (called a stake) in the trust at the start of the test period and also every time a specified event occurs. The specified events are:

•

an abnormal trading in the trust's units in the test period; and

•

the end of the trust's accounting period in the test period. [Section 266-65]

10.57 The meaning of important concepts used in determining whether this condition is satisfied are set out in Division 269 and are discussed below at paragraphs 10.168 to 10.193. The concepts are abnormal trading and 50% stake.

When can part of a prior year tax loss be deducted by an unlisted widely held trust?

10.58 The Bill contains a provision to allow an unlisted widely held trust to deduct part of a tax loss [section 266-70] . This provision works in the same way as the corresponding provision applying to fixed trusts (see paragraphs 10.46 to 10.48 above).

Subdivision 266-D - Listed widely held trusts

When can't a listed widely held trust deduct a tax loss of an earlier income year?

10.59 The Bill sets out rules to determine when a listed widely held trust cannot deduct a prior year tax loss. The following flow chart outlines, in broad terms, when such a trust cannot deduct a prior year loss.

10.60 A listed widely held trust is affected by the proposed rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible;

•

it was a listed widely held trust at all times in the 'test period'; and

•

it was not an excepted trust at all times in the 'test period'.

10.61 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years. [Subsection 266-85(1)]

10.62 If the rules in paragraph 10.60 are met then the listed widely held trust cannot deduct the prior year tax loss unless it meets one of two conditions set out in the Bill [subsection 266-85(2)] . These conditions are explained at paragraphs 10.66 and 10.67 below.

When does a listed widely held trust have to work out its net income or tax loss in a special way? (current year losses)

10.63 The Bill also sets out rules to determine when a listed widely held trust cannot deduct the whole or a part of a current year tax loss. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year. The following flow chart outlines, in broad terms, when such a trust has to work out its net income or tax loss in a special way.

10.64 A listed widely held trust is affected by the proposed rules, as they relate to current year losses, if:

•

it was a listed widely held trust at all times in the income year being examined (called the test period); and

•

it was not an excepted trust at all times in the 'test period'. [Section 266-90]

10.65 If the rules in paragraph 10.64 are met then the listed widely held trust must work out its net income or tax loss in a special way unless it meets one of two conditions set out in the Bill [section 266-90] . These conditions are explained at paragraphs 10.66 and 10.67 below.

What are the two conditions for listed widely held trusts?

10.66 The two conditions are:

•

there must not be any 'abnormal trading' in the trust's units during the test period [subsection 266-95(1)] ;

•

if there is abnormal trading, then either

-

the same individuals must have more than 50% of the fixed entitlements (called a stake) in the trust at the start of the test period and also immediately after each abnormal trading [paragraph 266-95(2)(a)] ; or

-

if the same individuals do not have more than a 50% stake after an abnormal trading, the trust must satisfy the continuity of business test (in relation to the time immediately before the abnormal trading) in the part of the test period that occurs after the abnormal trading [paragraph 266-95(2)(b)] .

10.67 The meaning of important concepts used in determining whether these two conditions are satisfied are set out in Division 269 and are discussed below at paragraphs 10.168 to 10.206. The concepts are abnormal trading, 50% stake and continuity of business.

Example

10.68 Fifty individuals have, between them, a 100% stake in a listed widely held trust at the start of a test period. During the test period, the trust has two abnormal tradings. After the first abnormal trading, the fifty individuals hold a 65% stake in the trust. After the second, the fifty individuals hold only a 40% stake. In this case, the trust fails the 50% stake (continuity of ownership) test after the second abnormal trading.

10.69 However, the trust carries on the same business from the time after the 50% stake test is failed until the end of the test period as it carried on immediately before the second abnormal trading. The trust is, therefore, not affected by the rules preventing the deduction of prior and current year losses.

When can part of a prior year tax loss be deducted by a listed widely held trust?

10.70 The Bill contains a provision to allow a listed widely held trust to deduct part of a tax loss [section 266-100] . This provision works in the same way as the corresponding provision applying to fixed trusts (see paragraphs 10.46 to 10.48 above).

Subdivision 266-E - Unlisted very widely held trusts

When can't an unlisted very widely held trust deduct a tax loss of an earlier income year?

10.71 The Bill sets out rules to determine when an unlisted very widely held trust cannot deduct a prior year tax loss. The following flow chart outlines, in broad terms, when such a trust cannot deduct a prior year loss.

10.72 An unlisted very widely held trust is affected by the proposed rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible;

•

it was an unlisted very widely held trust at all times in the 'test period'; and

•

it was not an excepted trust at all times in the 'test period'.

10.73 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years. [Subsection 266-115(1)]

10.74 If the rules in paragraph 10.72 are met then the unlisted very widely held trust cannot deduct the prior year tax loss unless it meets one of two conditions set out in the Bill [subsection 266-115(2)] . These conditions are explained at paragraphs 10.78 and 10.79 below.

When does an unlisted very widely held trust have to work out its net income or tax loss in a special way? (current year losses)

10.75 The Bill also sets out rules to determine when an unlisted very widely held trust cannot deduct a current year tax loss. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year. The following flow chart outlines, in broad terms, when such a trust has to work out its net income or tax loss in a special way.

10.76 An unlisted very widely held trust is affected by the proposed rules, as they relate to current year losses, if:

•

it was an unlisted very widely held trust at all times in the income year being examined (called the test period); and

•

it was not an excepted trust at all times in the 'test period' [section 266-120] .

10.77 If the rules in paragraph 10.76 are met then the unlisted very widely held trust must work out its net income or tax loss in a special way unless it meets one of two conditions set out in the Bill [section 266-120] . These conditions are explained at paragraphs 10.78 and 10.79 below.

What are the two conditions for unlisted very widely held trusts?

10.78 The two conditions are:

•

there must not be any 'abnormal trading' in the trust's units during the test period [subsection 266-125(1)] ;

•

if there is abnormal trading, then the same individuals must have more than 50% of the fixed entitlements (called a stake) in the trust at the start of the test period and also immediately after each abnormal trading [subsection 266-125(2)] .

10.79 The meaning of important concepts used in determining whether these two conditions are satisfied are set out in Division 269 and are discussed below at paragraphs 10.168 to 10.193. The concepts are abnormal trading and 50% stake.

When can part of a prior year tax loss be deducted by an unlisted very widely held trust?

10.80 The Bill contains a provision to allow an unlisted very widely held trust to deduct part of a tax loss [section 266-130] . This provision works in the same way as the corresponding provision applying to fixed trusts (see paragraphs 10.46 to 10.48 above).

Division 267 - Income tax consequences for non-fixed trusts of change in ownership or control

10.81 Division 267 sets out the circumstances in which a non-fixed trust will not be able to deduct a prior year loss or will have to calculate its net income or tax loss in a special way.

10.82 Since non-fixed trusts are different in nature to fixed trusts, different rules apply to determine whether a non-fixed trust can deduct a prior year or current year loss. Non-fixed trusts are different to fixed trusts because it is not possible to determine who has a vested interest in the income or capital of the trust. This is because the trustee or some other person will generally have a discretion as to who will benefit under the trust and/or what the amount of the benefit will be. Alternatively, the interests of persons in the trust may change because the vesting of the interests is conditional. It is not, therefore, possible to apply the same traditional continuity of ownership test that applies to fixed trusts. Instead, the pattern of distributions or control of the trust are tested to give a picture of who can benefit from the trust.

10.83 Some non-fixed trusts, however, have both fixed and discretionary elements. In these circumstances it is possible to examine the fixed entitlements to determine some of those who will benefit under the trust.

10.84 A family trust (a type of 'excepted trust') that is also a non-fixed trust will not be affected in any way by the tests in Division 267. The rules in Division 267 will not, therefore, prevent a family trust from deducting prior or current year losses. Also, other excepted trusts (as defined - see paragraphs 10.267 to 10.269 below) are not affected by Division 267.

Subdivision 267-B - Non-fixed trusts and tax losses of earlier years

When can't a non-fixed trust deduct a tax loss of an earlier income year?

10.85 The Bill sets out rules to determine when a non-fixed trust cannot deduct a prior year tax loss. The following flow chart outlines, in broad terms, when a non-fixed trust cannot deduct a prior year loss.

10.86 A non-fixed trust is affected by the proposed rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible; and

•

it was a non-fixed trust at any time in the 'test period'; and

•

it was not an excepted trust at all times in the 'test period'.

10.87 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years. [Subsection 267-20(1)]

10.88 If the rules in paragraph 10.86 are met then the non-fixed trust cannot deduct the prior year tax loss unless it meets all three conditions set out in the Bill. Two of the conditions may not be applicable to a particular trust for a particular period. If this is the case, the trust does not need to meet the condition that is not applicable. [Subsection 267-20(2)]

10.89 The three conditions relate to:

•

the pattern of distributions of the trust - this test will not be applicable if relevant distributions have not been made by the trust [section 267-25] ;

•

fixed entitlements to income or capital of the trust - this test will not be applicable if the fixed entitlements in the trust were never above 50% of the total income or capital of the trust in the test period [section 267-30] ;

•

control of the trust - this condition will apply to all non-fixed trusts [section 267-35] .

10.90 The details of the three conditions are set out below. The meaning of important concepts used in determining whether the second two conditions are satisfied are set out in Division 269 and are discussed below at paragraphs 10.181 to 10.198. The concepts are 50% stake and control of a non-fixed trust.

What is the pattern of distributions condition?

10.91 The first condition in paragraph 10.89 is applicable to a non-fixed trust, and therefore must be satisfied by the trust, if the trust distributed income and/or capital in the income year and at least one of the six previous income years. [Subsection 267-25(1)]

10.92 If the condition applies, the trust cannot deduct the loss unless:

•

the same individuals between them receive, directly or indirectly, and for their own benefit, more than 50% of every 'test year distribution' of income; and

•

the same individuals between them receive, directly or indirectly, and for their own benefit, more than 50% of every 'test year distribution' of capital. [Subsection 267-25(2)]

When does a person receive income or capital for their own benefit?

10.93 A person receives something for his or her own benefit if the person receives the thing otherwise than in the capacity of a trustee.

When is a person taken to receive income or capital indirectly?

10.94 A person receives something indirectly for the purposes of the pattern of distributions condition if the person receives the thing through a chain of one or more interposed companies, trusts or partnerships (all called entities below). The amount of a 'test year distribution' of income or capital received by a person through interposed entities is determined by ascertaining what is fair and reasonable having regard to the entitlements of each successive entity in the other, and the actual distributions made by each successive entity.

What is a 'test year distribution' of income or capital?

10.95 A test year distribution of income is the total of all distributions of income made by the trust in a relevant income year. A relevant income year is:

•

the income year being examined (the end year);

•

the earlier of:

-

the income year in which the trust distributed income that is before the loss year but closest to the loss year;

-

the loss year, if the trust distributed income in that year; or

-

the income year in which the trust distributed income that is not before the loss year but is closest to the loss year;

(The earlier of these three years is called the start year below).

•

each intervening income year between the start year and the end year. [Subsection 267-25(4)]

10.96 The test applies in the same way to distributions of capital to determine what is a 'test year distribution' of capital. [Subsection 267-25(5)]

10.97 The percentage of any test year distribution of income or capital received by an individual in an income year is the total income or capital distribution received by the individual in that year as a percentage of the total income or capital distributions made by the trust in that year.

10.98 The percentage of a test year distribution that a person is taken to receive is the smallest percentage that the person received in the period being tested [subsection 267-25(3)] . This rule is necessary because each test year distribution will not necessarily be of the same value. The rule will, therefore, ensure some comparability between the distributions that are being tested.

An example of how the pattern of distributions condition is applied

10.99 Year 7 is the current income year. A trust has losses incurred in Year 6. The trust has made one distribution of income in Years 1, 2, 3 and 4 and two distributions in Year 7. No distributions of capital have been made in Year 7. This means it is not possible to apply the test for any distributions of capital by the trust.

10.100 In accordance with the test discussed in paragraph 10.95, the end year is Year 7 (i.e. the current income year) and the start year is Year 4. Year 4 is the start year because it has a distribution made before the loss year that is closest to that loss year. To work out the test year distribution for each year, each distribution of income made to each beneficiary in the year is totalled. The percentage of the total received by each beneficiary is that beneficiary's share of the test year distribution.

10.101 The test year distributions made by the trust are as follows:

10.102 In this example, the trust does not satisfy the pattern of distributions condition. This is because only 30% of each test year distribution has been received by the same persons, having regard to the fact that each beneficiary is taken to receive the smallest distribution for each test year distribution. In essence, if the total worked out by adding the smallest distribution of each person is more than 50%, the test is passed (in the above example, the smallest distributions are those in the far right column).

What is the 50% stake condition?

Income

10.103 The 50% stake condition applies for income if individuals have fixed entitlements (called a stake ) to more than 50% of the income of the trust at any time in the test period (called the test time ). If this is the case, then at all times in the period after the test time, the same individuals must continue to hold more than a 50% stake in the income of the trust. [Subsection 267-30(1)]

Capital

10.104 A 50% stake condition in the same terms applies for capital of the trust. [Subsection 267-30(1)]

Commissioner's discretion

10.105 The Commissioner has a discretion to treat a non-fixed trust as having met the 50% stake condition in certain circumstances. This discretion is intended to provide a mechanism to prevent any harsh results in particular cases.

10.106 The discretion can be exercised where:

•

some or all of the individuals cease to have a stake in more than 50% of the income or capital of the trust (whichever is applicable); and

•

the Commissioner considers it fair and reasonable to treat the trust has having met the 50% stake condition having regard to the likely way in which the trustee or any other person will exercise any discretion to distribute income or capital and to any other matter. [Subsection 267-30(2)]

Example

10.107 At the start of a test period, a non-fixed trust has fixed entitlements to income of 51% and fixed entitlements to capital of 100%. These are all held by Jack. The other 49% of income is the subject of a discretion of the trustee. During the test period, Jack sells 2% of his fixed entitlement to income to Jill. As a result, the trust fails the 50% stake condition because the same individuals no longer hold fixed entitlements to more than 50% of the income of the trust.

10.108 In this set of circumstances, the Commissioner could exercise his or her discretion to treat the trust as having met the 50% stake condition. This could be, for example, if the Commissioner was satisfied that Jill would not receive, in connection with a scheme under which the fixed entitlement was purchased, any distributions of income from the share of the trust's income that is subject to a trustee's discretion.

What is the control condition?

10.109 The control condition is that no group (i.e. a person and/or his or her associates, either alone or together) must begin to control the trust in the test period (whether directly or indirectly). [Section 267-35]

When can part of a tax loss be deducted by a non-fixed trust?

10.110 If a non-fixed trust cannot deduct a tax loss because it does not meet the 50% stake or control conditions, then it may still be able to deduct part of the tax loss attributable to part of the loss year [subsection 267-40] . This provision works in a similar way as it works for fixed trusts (see the discussion above at paragraphs 10.46 to 10.48).

Subdivision 267-C - Non-fixed trusts and current year deductions

When does a non-fixed trust have to work out its net income or tax loss in a special way? (current year losses)

10.111 The Bill also sets out rules to determine when a non-fixed trust cannot deduct a current year tax loss. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year. The following flow chart outlines, in broad terms, when a non-fixed trust has to work out its net income or tax loss in a special way.

10.112 A non-fixed trust is affected by the proposed rules, as they relate to current year losses, if:

•

it was a non-fixed trust at any time in the income year being examined (called the test period); and

•

it was not an excepted trust at all times in the 'test period'. [Section 267-50]

10.113 If the rules in paragraph 10.112 are met then the non-fixed trust must work out its net income or tax loss in a special way unless it meets both conditions set out in the Bill. One of the conditions may not be applicable to the circumstances of the trust in question. If this is the case, the trust does not need to meet that condition. [Section 267-50]

10.114 The two conditions relate to:

•

fixed entitlements to income or capital of the trust - this test will not be applicable if the fixed entitlements in the trust were never above 50% of the total income or capital of the trust in the test period [section 267-55] ;

•

control of the trust - this condition will apply to all non-fixed trusts [section 267-60] .

10.115 These two conditions apply in exactly the same way for the relevant test period as they apply for the prior year loss rules for non-fixed trusts (see paragraphs 10.103 to 10.109 above).

Division 268 - How to work out a trust's net income and loss for the income year

10.116 The following discussion sets out the provisions that apply where a trust is required to work out its net income or tax loss in a special way (i.e. the current year loss rules). In very broad terms, these provisions work by:

•

dividing the trust's income year into periods on the basis of when a specified event (e.g. change in ownership or control) occurs;

•

allocating to each period that assessable income and those deductions which can be allocated to periods and working out a notional net income or notional loss for each period; and

•

calculating the net income (if any) and the tax loss taking into account the notional net income and notional loss for each period and any income or deductions that cannot be allocated to periods.

Subdivision 268-B - Dividing the income year into periods

10.117 A trust that is required to calculate its net income or loss under the current year loss provisions will have its income year divided into two or more periods. An explanation of how the income year is divided into periods for the different types of trusts is set out below.

How is the income year of a fixed trust (other than a widely held unit trust) divided into periods?

10.118 The beginning of the first period will be the start of the income year. Any subsequent period starts immediately after the end of the previous period. [Subsection 268-10(2)]

10.119 The last period will end at the end of the income year. Any other period will end when, after the start of the period, the individuals who had a stake in the trust (i.e. ownership) at the start of the period no longer have more than a 50% stake. [Subsection 268-10(3)]

How is the income year of an unlisted widely held trust divided into periods?

10.120 The beginning of the first period will be the start of the income year. Any subsequent period starts immediately after the end of the previous period. [Subsection 268-15(2)]

10.121 The last period will end at the end of the income year. Any other period will end the first time after the start of the period that the individuals who had a stake in the trust at the start of the period no longer have more than a 50% stake. This will be tested at the end of an accounting period and at the time of an abnormal trading. [Subsection 268-15(3)]

10.122 In cases where a trust's accounting period is the same as the income year, a period will only ever end when there is an abnormal trading in units and the trust fails the 50% stake test. This is because, in these cases, the end of the last period will also be the end of the accounting period.

How is the income year of a listed widely held trust divided into periods?

10.123 The beginning of the first period will be the start of the income year. Any subsequent period starts immediately after the end of the previous period. [Subsections 268-20(2)]

10.124 The last period will end at the end of the income year. Any other period will end when there is an abnormal trading in units after the start of the period and the individuals who had a stake in the trust at the start of the period no longer have more than a 50% stake. [Subsection 268-20(3)]

10.125 If a trust's income year is split up into periods, successive periods will be treated as a single period if throughout these periods the trust passes the continuity of business test in relation to the time immediately before the end of the first of them [subsection 268-20(4)] . The current year loss provisions do not apply if the trust carries on at all times during the income year, the same business as the business which it carried on just before an abnormal trading. As a consequence, this provision will only ever have application where the income year is split up into at least three periods (i.e. there has been two changes in ownership which has resulted in the trust failing the continuity of ownership test).

Example

10.126 This example illustrates how what would otherwise be two or more periods would be treated as one period where the same business is carried on throughout the two or more periods. As discussed above, this situation is unlikely to arise in practice but this example is provided in order to explain how the circumstance would be dealt with.

10.127 A listed widely held trust fails the continuity of ownership test two times in the income year (shown as events (1) and (2) in the time line below). However, the trust continued to carry on the same business throughout the period of the income year between (1) and (2) as it had throughout the period from the start of the income year to (1). The trust's income year is split into two periods as shown on the time line below. If the continuity of business test did not apply, the trust's income year would have been split up into three periods, each beginning on a change in ownership (except the first which commences at the start of the income year). However, what would otherwise be periods 1 and 2 are treated as one period because the trust carried on at all times during those periods the same business before both (1) and (2).

How is the income year of an unlisted very widely held trust divided into periods?

10.128 The beginning of the first period will be the start of the income year. Any subsequent period starts immediately after the end of the previous period. [Subsections 268-25(2)]

10.129 The last period will end at the end of the income year. Any other period will end when there is an abnormal trading in units after the start of the period and the individuals who had a stake in the trust at the start of the period no longer have more than a 50% stake. [Subsection 268-25(3)]

How is the income year of a non-fixed trust divided into periods?

10.130 The beginning of the first period will be the start of the income year. Any subsequent period starts immediately after the end of the previous period. [Subsections 268-30(2)]

10.131 The last period will end at the end of the income year [subsection 268-30(3)] . The point in time that any other period will end will depend on whether there are individuals who have more than 50% fixed entitlements to the income or capital of the non-fixed trust at any time during the income year.

10.132 If a non-fixed trust is one in which persons have more than 50% fixed entitlements to income or capital at any time in the income year the 50% stake (continuity of ownership) condition will apply to the trust. If this is the case, a period (except the last) will end the first time after the start of the period that:

•

the individuals who had a stake in the trust at the start of the period no longer have more than a 50% stake; or

•

a group begins to control the trust (i.e. a change of control occurs). [Subsection 268-30(4)]

10.133 If the 50% stake condition does not apply to the non-fixed trust, a period (except the last) will end when, after the start of the period, there is a change of control of the trust. [Subsection 268-30(5)]

Subdivision 268-C - other steps in working out the net income or loss

How do you work out the trust's notional net income or notional tax loss for a period?

10.134 A notional loss or net income of a trust has to be calculated for each period of the income year [subsection 268-35(1)] . These calculations have to be made in respect of each period in the income year as if it were itself a year of income.

10.135 If there is no notional loss in any of the periods these provisions do not apply and the net income of the trust is calculated in the usual way [subsection 268-35(4)] . There is no mischief in these cases because there are no current year deductions that can be utilised by new owners or controllers of a trust in the current income year.

10.136 A notional loss will arise where certain deductions attributable to the period exceed the assessable income attributable to the same period [subsections 268-35(2)] . The notional loss may be able to be carried forward to a later year of income. If the relevant deductions do not exceed the relevant assessable income, the trust will have a notional net income for the period [subsection 268-35(3)] .

How are deductions attributed to a period?

10.137 For the purpose of allocating deductions to respective periods there are three types:

•

deductions that are attributed to each period in proportion to the length of the period (i.e. pro-rated);

•

deductions that are attributable to periods as if each period were an income year;

•

full year deductions.

Pro-rated deductions

10.138 The first type of deduction is one that can be pro-rated over the income year according to the length of the period being considered. These kinds of deductions are listed in subsection 268-40(2) and include, for example, depreciation which is deductible under section 54 of the Act and some deductions for expenditure which are spread over 2 or more years. [Subsection 268-40(2)]

Example 1

10.139 A fixed trust has depreciation expenses of $3000 for an' of capital equipment in the current year of income. As a result of section 268-10, the current income year of the trust is divided into 3 periods of 4 months. Depreciation expenses of $1000 are allocated to each of the 4 month periods.

Example 2

10.140 A fixed trust has taken out a three year loan. The borrowing expenses that are deductible under section 67 of the Act are $600. Pro-rated on a daily basis, $200 of this expense is applicable to the year of income. As a result of section 268-10, the income year of the fixed trust is divided into 4 periods of 3 months. The amount of deduction that is attributed to each of the periods is

$50*($200*(91.25/365))


Deductions attributed to periods as if each period were an income year

10.141 The second type of deduction is a deduction that is attributed to a period as if the period were an income year. [Section 268-40(3)]

Example 1

10.142 A non-fixed trust disposes of an' of depreciable property during a year of income. As a result of the disposal an amount of $2000 is available for deduction under subsection 59(1) of the Act. Under section 268-30, the income year of the non-fixed trust is to be divided into 2 periods. The $2000 deduction is to be allocated to the period in which the disposal took place.

Example 2

10.143 As a result of section 268-30, a non-fixed trust is required to divide its income year into 2 periods. A stock take of trading stock is carried out at the end of the first period. The value of the opening stock exceeds the value of the closing stock by $2000. A deduction for the excess is allowable under subsection 28(3) of the Act. This deduction is allocated to the first period.

Example 3

10.144 A fixed trust prepares its accounts on an accruals basis. As a result of section 268-10, the income year of the fixed trust is to be divided into 2 periods. The trust incurs a deductible expense in the first period but it is not paid for until the second period. The expense is allocated to the first period.

Full year deductions

10.145 The third type of deduction is a full year deduction. These deductions are not allocated to a particular period or dissected between the relevant periods but are brought to account in the final calculation of the trust's net income for the year. [Subsection 268-40(4)]

10.146 Full year deductions are listed fully in the Bill and include, for example, deductions allowable for bad debts, gifts, and tax losses for earlier years. [Subsection 268-40(5)]

How is assessable income attributed to a period?

10.147 For the purpose of spreading assessable income over periods of the income year there are five classes of income that are attributed to periods as set out below.

Income from other trusts

10.148 The first class is income that is included in the assessable income of the trust under section 97 (i.e. the trust's share in the net income of another trust as a presently entitled beneficiary) or section 98A (i.e. the trust is a non-resident beneficiary). This income is reasonably attributed to periods in the income year where possible. [Subsection 268-45(2)]

Pro-rated assessable income

10.149 The second class is these items of assessable income that can be pro-rated over the income year according to the length of the period being considered. These kinds of income are listed in subsection 268-45(3) and include, for example, insurance pay outs for loss of livestock or trees which, under section 26B of the Act, can be spread in equal instalments over 5 years. [Subsection 268-45(3)]

Wool clips

10.150 The third class is amounts included in the trust's assessable income under section 26BA (double wool clips). These are attributed to the period when the wool would ordinarily have been shorn. [Subsection 268-45(4)]

Assessable income attributed to periods as if each period were an income year

10.151 The fourth class is income that is attributable to periods as if each period were an income year. This income is attributed accordingly. [Subsection 268-45(5)]

Example

10.152 As a result of section 268-30, a non-fixed trust is required to divide its income year into 2 periods. A stock take of trading stock is carried out at the end of the first period The value of the closing stock exceeds the value of the opening stock by $2000. This amount is to be included in assessable income under subsection 28(2) of the Act. This income is allocated to the first period as this is the period the income would have been attributed to if the period were an income year.

Full year amounts

10.153 The fifth class is full year amounts. This is income that is included in the assessable income of the trust in the year of income under section 97 (i.e. the trust's share in the net income of another trust as a presently entitled beneficiary) or section 98A (ie. the trust is a non-resident beneficiary) but where the income cannot be reasonably attributed to a particular period. As with full year deductions, these amounts are not attributed to a period but are brought to account in the final calculation of the trust's net income for the year. [Subsection 268-45(6)]

Example

10.154 A non-fixed trust receives income as a beneficiary of a trust estate which is assessable under section 97 of the Act. As a result of section 268-30, the trust is required to divide its income year into 2 periods. It is not possible to reasonably attribute any of this trust income to a particular period of the income year. The amount is treated as a full year amount which at a later stage is added on to the trust's total net income.

How do you work out the trust's net income for the income year?

10.155 If the income year of a trust has been divided into periods under Subdivision 268-B, the net income of the trust is calculated as follows:

•

the sum of the notional net incomes for the relevant periods; plus

•

any 'full-year amounts' that are to be included in the assessable income of the trust (i.e. the income of a trust that cannot be reasonably attributed to any period);

less

•

certain full year deductions (those listed in paragraphs 268-40(5)(a), (b) and (c));

•

if any amount remains, other full year deductions in the order shown in subsection 268-40(5). [Section 268-50]

10.156 An example of how the net income of the trust is calculated is shown at paragraph 10.161 below.

How do you work out the trust's section 79E loss for the income year?

10.157 Section 79E is the general provision in the Act that allows the carry forward of losses for post-1989 income years. If the income year of a trust has been divided into periods under Subdivision 268-B, the section 79E loss of the trust is:

•

the sum of the notional losses of any of the periods; plus

•

the amount by which any full year deductions listed at paragraphs 268-40(5)(a), (b) and (c) exceed:

-

the total of the notional net incomes (if any); and

-

the full-year amounts referred to in 268-45 (i.e. trust income that is not reasonably attributable to any period in the income year).

less

•

if the trust has derived any exempt income, the net exempt income. [Section 268-55]

How do you work out the trust's film loss for the income year?

10.158 As a result of subsection 79E(4) of the Act film losses incurred in a post-1989 year of income (i.e. a year of income commencing on 1 July 1989 or subsequent year of income) are effectively quarantined and can only be deducted in a later year of income against film income.

10.159 A trust's section 79F film loss is essentially worked out in the same way as a general section 79E loss except only the assessable film income, net exempt film income and film deductions are taken into account. The trust's film loss is the amount worked out in this way to the extent that it does not exceed the amount of the overall section 79E loss (including film losses) incurred in the year of income. The terms 'film deductions', 'assessable film income' and 'net exempt film income' are terms defined in subsection 79F(12). [Section 268-60]

Example

10.160 A trust's section 79E losses (including film losses) from the whole of its activities, calculated under section 268-55 are $8m. A trust's losses from its film activities calculated under subsections 268-60(1),(2) and (3) are $10m. Since the section 79E losses are less than the losses from its film activities the amount of the film loss for the year is $8m.

An example of how to calculate a trust's net income or loss for an income year

10.161 The trust's income year is divided into two periods with notional net income and notional losses as follows:

The amount remaining, $28,500, is the trust's net income for the income year.

The amount is assessable under Division 6 of the Act.

The amount remaining, $21,800, is the trust's tax loss for the income year.

The loss may be able to be carried forward for deduction in a later year of income.

Subdivision 268-D - Supplementary rules for partnerships

How does the trust calculate its notional loss or net income for a period when the trust is a partner in a partnership?

10.162 Subdivision 268-D applies where a trust is a partner in a partnership from which it derives a share of the net income of the partnership or is entitled to a deduction for its share of the partnership loss.

10.163 The broad aim of the Subdivision is to attribute a share of the partnership's net income or loss to the trust. To do this, a notional net income of the partnership or a notional partnership loss is calculated on the same basis as if that partnership were a trust for which a notional net income or notional loss were being ascertained in relation to a period into which the trust's income year has been divided.

10.164 The trust's share of the partnership's notional loss or notional net income is added in to the trust's notional loss and notional net income for each of the periods. [Section 268-65]

10.165 If a trust has the same accounting period as the partnership the notional income and the notional loss of the partnership is to be allocated to the relevant periods of the trust on a percentage basis, i.e. according to the percentage interest of the trust in the partnership. If the trust has no net income or loss under Division 6 of the Act, ie. breaks even in the income year, the trust's share is a percentage that is fair and reasonable, having regard to the trust's interest in the partnership. [Section 268-70]

10.166 If the trust has a different accounting period from the trust, the partnership's notional net income or notional loss will be that which can be reasonably attributed to the income year of the trust. The trust's share is then calculated on a percentage basis as set out in paragraph 10.165 above. [Section 268-75]

10.167 If the trust and the partnership have the same accounting period, the full year deductions of the partnership are allocated to the trust on a percentage basis, depending on the trust's share in the partnership. If the trust and the partnership have a different accounting period the trust's share of full year deductions is to be what ever is fair and reasonable, having regard to any relevant circumstances. If the partnership had neither a net income nor partnership loss, the percentage is to be what is fair and reasonable having regard to the percentage interest of the trust in the partnership. [Section 268-80]

Division 269 - Tests applied in determining abnormal trading, 50% stake, control and continuity of business

10.168 Division 269 defines certain important concepts used in determining whether a trust can deduct a prior year or current year loss [section 269-5] . The meaning of each of these concepts is set out below.

Subdivision 269-B - When is there abnormal trading of units in a widely held unit trust?

10.169 The abnormal trading concept is used in determining when widely held unit trusts can deduct prior or current year losses. Whether there is an abnormal trading will be determined in one of two ways.

Where the trading is abnormal on balance having regard to certain factors

10.170 The first method is a general factual test where a number of factors must be weighed to determine whether the trading is, on balance, abnormal. Trading in this context means an issue, redemption or transfer of units in the widely held unit trust or other dealing in the trust's units [section 269-10] . All relevant factors (including the four factors specified in the Bill) must be taken into account in determining whether a trading is abnormal (e.g. the price paid for units). The specific factors in the Bill are:

•

the timing of the trading when compared to the normal timing for trading in units of the trust;

•

the number of units traded by comparison to the normal number of units traded (e.g. voluminous trading in units may indicate the possibility of a significant change in the underlying beneficial ownership of the trust);

•

any connection between the trading in units and any other trading (e.g. two or more lots of trading may be linked and may indicate a meaningful change in underlying beneficial ownership of the trust); and

•

any connection between the trading and a tax loss or other deduction of the trust (e.g. where units are bought because the trust has prior year losses). [Subsection 269-15(1)]

Where abnormal trading is deemed to have occurred

10.171 Abnormal trading will automatically be taken to have occurred in four sets of circumstances, as explained below. [Subsection 269-15(2)]

Trading of 5% or more in one transaction

10.172 Firstly, there is abnormal trading if 5% or more of the units in the trust are traded in one transaction [section 269-20] . The size of such a transaction is enough to indicate that there may have been a significant change in the underlying beneficial ownership of the trust.

More than 5% trading over 2 or more transactions

10.173 Secondly, there is abnormal trading if a person and/or associates of the person have acquired and/or redeemed 5% or more of the units in the trust in two or more transactions. However, this is only where the trustee of the trust knows or reasonably suspects that the acquisitions or redemptions have occurred and that they would not have been made if the trust did not have a tax loss or other deduction. This rule is similar in nature to the first (paragraph 10.172) but looks to the situation where the possibility of a significant change in underlying ownership is disguised in a number of transactions. [Subsection 269-25(1)]

10.174 If an abnormal trading is deemed to have taken place by the rule in paragraph 10.173, the time of the trading is the time of the transaction that pushes the trading over 5%. [Subsection 269-25(2)]

Suspected acquisition or merger

10.175 Under this category, there is an abnormal trading in units where the trading is part of a proposed take over of the trust or a proposed merger with another trust. However, the trading will only be abnormal where the trustee knows or reasonably suspects this to be the case. The abnormal trading will be taken to occur at the time of the trading. [Section 269-30]

More than 20% change in a 60 day period

10.176 Lastly, there is abnormal trading if:

•

ownership of more than 20% of the units changes in a 60 day period [subsection 269-35(1)] ;

•

units are issued to new unit holders and at the end of a 60 day period they have more than 20% of the units on issue [subsection 269-35(2)] ; or

•

more than 20% of the trusts units are redeemed in a 60 day period [subsection 269-35(3)] .

10.177 Again, these facts are enough to indicate that there may have been a significant alteration in the underlying beneficial ownership of the trust.

10.178 If an abnormal trading is deemed to have taken place by the rule in paragraph 10.176, the time of the trading is the end of the 60 day period. [Subsection 269-35(4)]

Example

10.179 An unlisted widely held trust has 100 units owned, directly and indirectly, by 30 individuals. On a day, 50 new units are issued to Jack, Jill, Mary and Bill, none of whom are existing unit holders.

10.180 There is an abnormal trading at the time of issue because, in the sixty days to that time, the new unit holders have gained, through issue, 40% of the units on issue after that time.

Subdivision 269-C - When are there persons who have more than a 50% stake in a trust or in the income or capital of a trust? (continuity of ownership)

10.181 The 50% stake concept is used in determining whether there has been a change in ownership of a trust with fixed entitlements. Whether persons have a 50% stake in a trust is determined by looking at both fixed entitlements to income and capital of the trust.

10.182 The 'more than 50% stake in income or capital' concepts are specifically used in the 50% stake condition that applies to non-fixed trusts (see paragraphs 10.103 to 10.108 above). They are also used in the 'more than 50% stake in a trust' concept (paragraph 10.186) and also in the definition of control (see paragraph 10.195 below).

10.183 The 'more than 50% stake in a trust' concept is specifically used in the 50% stake condition that applies to all fixed trusts, whether widely held unit trusts or not (see paragraphs 10.44, 10.56, 10.66 and 10.78 above).

When do individuals have more than a 50% stake in income?

10.184 Individuals have more than a 50% stake in the income of a trust at a time if the individuals between them have fixed entitlements, directly or indirectly, and for their own benefit, to more than 50% of the income of the trust. [Subsection 269-40(1)]

When do individuals have more than a 50% stake in capital?

10.185 Individuals have more than a 50% stake in the capital of a trust at a time if the individuals between them have fixed entitlements, directly or indirectly, and for their own benefit, to more than 50% of the capital of the trust. [Subsection 269-40(2)]

When do individuals have more than a 50% stake in a trust?

10.186 Individuals have more than a 50% stake in a trust at a time if the individuals have both:

•

more than a 50% stake in the income of the trust; and

•

more than a 50% stake in the capital of the trust. [Subsection 269-40(3)]

When does a person have a fixed entitlement in income or capital?

10.187 The meaning of a fixed entitlement in the income or capital of a trust is explained at paragraphs 10.232 to 10.238 below. Broadly, a person has a fixed entitlement where he or she has a vested and indefeasible interest in the income or capital of the trust (whichever is relevant). Some interests can be included as fixed entitlements where the Commissioner makes a determination to that effect.

When does a person have a fixed entitlement to income or capital for their own benefit?

10.188 A person receives something for his or her own benefit if the person receives the thing otherwise than in the capacity of a trustee.

When does a person have a fixed entitlement to income or capital indirectly?

10.189 Fixed entitlements will be taken to be held by an individual indirectly where the entitlements are held through one or more interposed companies, trusts or partnerships. Paragraphs 10.243 to 10.253 below set out the detailed rules that apply in determining whether a fixed entitlement is taken to be held indirectly.

An example of when the individuals have a 50% stake in a trust

10.190 Trust A, a fixed trust, has a prior year loss from Year 1. In Year 2, the Trust seeks to deduct that loss. Throughout Year 1 and part of Year 2 the following persons hold the fixed entitlements set out:

•

Jack has a 50% fixed entitlement to income and a 30% fixed entitlement to capital on winding up;

•

Jill has a 50% fixed entitlement to income and a 30% fixed entitlement to capital on winding up;

•

Mary has a 20% fixed entitlement to capital on winding up;

•

Bill has a 20% fixed entitlement to capital on winding up.

10.191 During Year 2, both Jack and Jill sell half of their fixed entitlements in Trust A to James. As a result, from the time of sale, James has a 50% fixed entitlement to income and a 30% fixed entitlement to capital on winding up.

10.192 Before the sale, Jack, Jill, Mary and Bill have, between them, 100% of the fixed entitlements to both income and capital of Trust A. After the sale, Jack, Jill, Mary and Bill have, between them, a fixed entitlement to income of 50% and a fixed entitlement to capital of 70%.

10.193 Trust A fails the 50% stake test. This is because there has been a 50% change in the natural persons who hold fixed entitlements to income of the trust for their own benefit. That is, the original owners of the fixed entitlements no longer hold more than 50% of the fixed entitlements to income of Trust A.

Subdivision 269-D - When does a group control a non-fixed trust?

10.194 The concept of control of a non-fixed trust is relevant to determining whether a non-fixed trust can deduct a prior or current year loss. The relevant rules are triggered if a person and/or his or her associates (called a group), either alone or together, begin to control a non-fixed trust in the test period.

10.195 A group is to be taken to be in a position to control a non-fixed trust if the group:

•

had the power, by whatever means, to obtain the beneficial enjoyment of the income or capital of the trust (e.g. through obtaining a fixed entitlement to that income or capital or by ensuring the exercise of a trustee discretion in their favour);

•

was able to control, directly or indirectly, the application of the income or capital of the trust;

•

was capable, under a scheme, of gaining the enjoyment or control referred to in the first two dot points;

•

was in a position such that the trustee of the trust was accustomed or under a formal or informal obligation, or might reasonably be expected to act in accordance with the directions, instructions or wishes of the group;

•

had the ability to remove or appoint the trustee or any of the trustees of the trust;

•

acquired more than a 50% stake in the income or capital of the trust (i.e. gained fixed entitlements to more than 50% of the income or capital). [Section 269-45]

10.196 Whether the trustee of the trust was accustomed or might reasonably be expected to act in accordance with the directions, instructions or wishes of a group is to be determined having regard to all the circumstances of the case. For example, the mere presence in the trust deed of a requirement that the trustee should have no regard to such directions, instructions or wishes would not prevent the examination of the actual circumstances to determine whether the group controls the trust.

10.197 Some examples of the factors which might be considered are:

•

the way in which the trustee has acted in the past;

•

the relationship between the group and the trustee;

•

the amount of any property or services transferred to the trust;

•

any arrangement or understanding between the group and a settlor or persons who have benefited under the trust in the past.

Example: A group takes a 50% stake in a trust

10.198 Trust A has a tax loss in Year 1 which it seeks to deduct in Year 2. At the start of Year 1 it is a purely discretionary trust (i.e. none of the income or capital is the subject of a fixed entitlement). During Year 2, under an arrangement between the original settlor of the trust and a group, 60% of the income of the trust becomes the subject of a fixed entitlement held by the group. In this case, the group begins to control the trust in the 'test period' and the loss is not deductible (see paragraph 10.109 above).

Subdivision 269-E - When does a trust pass the continuity of business test?

10.199 The continuity of business test is relevant to determining whether a listed widely held trust can deduct a prior or current year loss. The test is split up into two parts. The first part is those rules that apply to determine whether the trust passes the continuity of business test for both prior year and current year loss purposes. The second part applies only in determining whether the trust passes the continuity of business test for current year losses.

10.200 Thus, for prior year loss purposes, the trust needs to satisfy the first part of the continuity of business test. For current year loss purposes, the trust needs to satisfy both the first and second parts of the continuity of business test.

The rules of the test that apply for both prior and current year loss purposes

10.201 A trust satisfies this part of the continuity of business test if it meets three cumulative conditions [subsection 269-50(1)] . The conditions are as set out below.

10.202 The first condition is that the trust must, at all times in the period being considered, carry on the same business as it carried on immediately before the particular time being considered. [Subsection 269-50(2)]

10.203 The mere status of a trust as a trust does not mean that it cannot carry on a business [subsection 269-50(3)] . This ensures that a trust will be taken to carry on a business where it has the usual elements of a business (e.g. profit motive, regular transactions, business records, etc.).

10.204 The second condition is that the trust must not, at any time in the period being considered, derive income from:

•

a business of a kind that it did not carry on before the particular time being considered; or

•

a transaction of a kind that it had not entered into in the course of its business operations before the particular time being considered. [Subsection 269-50(4)]

10.205 The third condition is that the trust must not, before the particular time being considered, do certain things for the purpose, or for purposes including the purpose, of being taken to have carried on, at all times in the period being considered, the same business as it carried on immediately before the particular time [subsection 269-50(5)] . The things that the trust must not do are:

•

start to carry on a business it had not previously carried on; or

•

in the course of its business operations, enter into a transaction of a kind that it had not previously entered into.

The rules of the test that apply for current year loss purposes only

10.206 A trust satisfies this part of the continuity of business test if it does not, at any time in the period being considered:

•

incur expenditure in carrying on a business of a kind that it did not carry on before the particular time being considered; or

•

incur expenditure as a result of a transaction of a kind that it had not entered into in the course of its business operations before the particular time being considered. [Subsection 269-50(6)]

Division 270 - Schemes to take advantage of tax loss and other deductions

10.207 The purpose of Division 270 is to disallow a trust a deduction for prior year losses or losses or outgoings incurred in the current year where certain schemes are involved. The test that is applied under this Division is referred to as the income injection test . The test operates objectively and does not have a tax avoidance motive as one of its elements.

10.208 The test is designed to ensure that a trust cannot deduct prior year losses or current year expenses in certain circumstances. These are where, although a trust has technically satisfied the tests set out in Divisions 266 and 267 (eg. it has continuity of ownership), the benefits from the allowance of the deductions flows to persons (or certain associates) who have, in effect, given a benefit to a trustee or beneficiary of a trust (or associates of those persons) in return for the benefit of the deductions. The test can also apply where an allowable deduction is injected into a trust to offset assessable income derived by a trust in the income year being examined. The income injection test does not apply to complying superannuation funds, complying approved deposit funds, pooled superannuation trusts and deceased estates within a reasonable administration period (see paragraph 271-50(c) of Schedule 2C).

When does the income injection test apply?

10.209 The following flow charts set out, in broad terms, the two sets of circumstances in which a deduction for a prior year loss or a current year deduction will be disallowed under the income injection test.

The first test (subsection 270-10(1))

The second test (subsection 270-10(2))

Elements of the income injection test

10.210 There are a number of elements that need to be met before the test applies. The first is that the trust has a deduction for a prior year loss or a loss or outgoing that is deductible in the income year being examined. The other elements are that, under a scheme:

•

the trust derives assessable income in the income year;

•

a person not connected with the trust (the outsider), directly or indirectly provides a benefit to the trustee or a beneficiary (or their associates) and the trustee or a beneficiary (or associates) directly or indirectly provides a benefit to the outsider (or an associate who is not a family beneficiary of the trust other than under the scheme); and

•

it can reasonably be concluded that if the particular deduction was not available either one or both of the following events would have occurred:

-

the trust would have derived a different amount of assessable income or the value of the benefit provided to the trustee or beneficiary (or their associates) would have been different, or both; or

-

the value of the benefit provided by the trustee or a beneficiary (or associate) would have been different. [Subsection 270-10(1)]

10.211 The test set out in paragraph 10.210 can also apply where the only advantage given to the trust is assessable income or an allowable deduction and a benefit is given to any outsider. [Subsection 270-10(2)]

10.212 Where the income injection test applies, the particular deduction mentioned in the third dot point of paragraph 10.210 is not allowable in the income year being examined. However, if the deduction is a prior year loss, it may still be able to be deducted in a later year of income.

10.213 The test as outlined in paragraph 10.210 has regard to the value of any benefit provided to the trustee or a beneficiary (or associates) and the value of any benefit provided by the trustee or beneficiary (or associates) to another person. The value of benefits provided will be affected by the availability of losses or deductions in the trust. For example, a person would have to transfer a larger income stream into a non-loss trust, to be able to receive in return from the trustee the same distribution that would have been received by that person had losses been available to shelter the income stream from tax.

10.214 The overall benefit provided by the trustee or a beneficiary (or associates) will generally be an effective reduction in the outsider's (or associates') tax liability. However, the broad nature of the test ensures that the test will also apply in circumstances where benefits apart from tax benefits are received.

Terms used in the income injection test

What is a scheme?

10.215 For the purposes of this test the term scheme takes on the same meaning as in Part IVA of the Act (see paragraph 10.281 below).

What is an 'outsider'?

10.216 A person is an outsider where that person is not a trustee or specified beneficiary of the trust or is a person who became a trustee or specified beneficiary under the scheme [subsection 270-10(3)] . For this purpose, a specified beneficiary means a person who has a fixed entitlement in the income or capital of the trust or, if the trust is a family trust, a family member who is a beneficiary of the trust. Thus, the income injection test will apply where the person (the outsider) who has obtained, or whose affected associates have obtained, a benefit is unconnected to the trust or became connected to the trust under the scheme. Where income or a deduction is injected into a trust by a connected person (non-outsider), Part IVA of the Act may nevertheless be applicable to deny a deduction.

What is a benefit?

10.217 The term benefit is broadly defined. It includes any benefit within the ordinary meaning of that expression. However, it is defined to specifically include money or other property (whether tangible or intangible), rights (whether proprietary or not), services and the extinguishment, forgiveness, release or waiver of a debt or other liability. [Subsection 270-10(4)]

Examples of how the income injection test applies

Example 1

10.218 A is the trustee of a discretionary trust that has carry forward losses of $1m. Under a scheme, B:

•

pays a $200,000 fee to the trustee of the trust;

•

leases an income producing property to the trust; and

•

is made a discretionary object of the trust.

The income derived from the property is sheltered from tax by the losses and the trust income is distributed to B free of tax.

10.219 The trust loss is not allowable as a deduction to the trust. In terms of subsection 270-10(1) (paragraph 10.210 above) the benefit provided by B is the $200,000 fee and the income gained by leasing the income producing property for a higher rental and the benefit provided by A is the distribution of income to B. If it were not for the losses, B would have had to provide a greater benefit to A to obtain the same distribution of income from A in return and the fee would not have been paid.

Example 2

10.220 A company becomes a partner in a leveraged leasing partnership which is formed for the purpose of acquiring depreciable assets with borrowed funds and leasing the assets. In the early years of the arrangement taxable income is nil as deductions exceed assessable income (e.g. because of depreciation expenses). However, in the later years the assessable income will be much greater than the allowable deductions.

10.221 Once there is taxable income, the company assigns most of its interest as a partner by way of an Everett assignment to a unit trust. Units in that trust are then sold to trusts with losses. The taxable income flows through the unit trust to the trusts with losses to be absorbed by the losses.

10.222 The loss trusts receive a benefit, i.e., a small accounting profit derived by the unit trust from the leasing partnership. This benefit is smaller than that which would have been given at arm's length under the arrangement if there were no trust losses. This is because the trusts would have had to pay tax on the taxable income from the leases if the losses were not available. The trusts would have had to be given a higher benefit to take account of the tax payable. The income injection test, as set out in subsection 270-10(2) (paragraph 10.210 above) will apply to deny the deduction to the trust.

Example 3

10.223 A father transfers income into a family trust with losses that has the father, mother and children as beneficiaries. The trust loss will be able to be carried forward to be offset against the injected income. The transfer of the income is merely gratuitous. The income injection test will not apply to deny deductions to the trust. This will apply only in the context of a family trust.

Example 4

10.224 Two brothers, A and B, have family trusts whose beneficiaries consist of their respective families. Brother A's trust has losses while Brother B's trust is profitable.

10.225 Under a scheme Brother B's trust becomes a beneficiary of Brother A's trust. Brother B's trust then provides services through that trust. The income generated by the services is sheltered from tax by the losses. The income from Brother A's trust is distributed to the Brother B's trust free of tax (this is the return benefit). Subsection 270-10(1) (paragraph 10.211 above) will apply to deny the loss deduction to Brother A's trust.

Example 5

10.226 The same group of persons control and benefit from two non-family discretionary trusts. One trust has carry forward losses. The other trust trades profitably. The profitable trust makes a low interest loan to the loss trust. The trust with profits is made a beneficiary of the trust with losses. The loss trust derives income as a result of the low interest loan and a tax-free distribution is made to the profitable trust.

10.227 Subsection 270-10(1) (paragraph 10.210 above) will apply so that the loss trust is denied the loss deductions. The benefit provided to the loss trust is the low interest loan and the benefit provided to the profitable trust is the interest and the distribution of income. If it were not for the losses the profitable trust would have had to provide a greater benefit to the trust to obtain the same distribution of income.

Example 6

10.228 A trust has earned assessable income in the income year. Under a scheme a person transfers to the trust a subsection 51(1) deduction which reduces the trust's net income.

10.229 In return the person who transferred the deduction receives a tax-free distribution from the trust. The amount of the tax-free distribution would normally be a percentage of the tax saving made by the trust. Under subsection 270-10(1) the trust will be denied the injected deduction.

Division 271 - Interpretation

Subdivision 271-A - What is a fixed entitlement to income or capital?

10.230 The concept of a fixed entitlement is central to the operation of the trust loss measures. A fixed entitlement to income or capital is defined for each of the following:

•

trusts;

•

companies; and

•

partnerships.

10.231 Fixed entitlements in trusts are used to determine whether a trust is a fixed trust or a widely held unit trust, whether a trust has continuity of ownership and control and for tracing indirect entitlements in other trusts. Fixed entitlements in companies and partnerships are used in the legislation to trace whether a person has an indirect fixed entitlement to the income or capital of a trust.

What is a fixed entitlement to income or capital of a trust?

10.232 A person (the beneficiary) will have a fixed entitlement to either income or capital of a trust (whichever is applicable) where the beneficiary has a vested and indefeasible interest in a share of the income of the trust that the trust derives from time to time (i.e. current and future income), or a share of capital of the trust. [Subsection 271-5(1)]

10.233 The share that the person has an interest in is expressed as a percentage of the total income or capital (whichever is applicable) of the trust. Note that a beneficiary's vested interest in income or capital of a unit trust will not be taken to be defeased because new units are issued, or existing units cancelled.

What is a vested interest?

10.234 A person has a vested interest in something if the person has an immediate right relating to the thing. In traditional legal analysis, a person can be either said to be 'vested in possession' or 'vested in interest'.

10.235 A person is vested in possession where the person has a right to immediate possession of the thing in question. On the other hand, a person is vested in interest where the person has a present right to the future possession of the thing. In the definition of fixed entitlement, 'vested' means vested in possession or vested in interest. If an interest of a beneficiary in income or capital is the subject of a condition precedent, so that an event must occur before the interest becomes vested, the beneficiary does not have a vested interest to the income or capital.

When is a vested interest indefeasible?

10.236 A vested interest is indefeasible where, in effect, it is not able to be lost or varied. A vested interest is defeasible where it is subject to a condition subsequent that may lead to the entitlement being divested. A condition subsequent is an event that could occur after the interest is vested that would result in the entitlement being defeated, for example, on the occurrence of an event or the exercise of a power. For example, where a beneficiary's vested interest is able to be varied by the exercise of a power by the trustee or any other person, the interest will not be a fixed entitlement.

Commissioner's discretion to treat an entitlement as not being able to be varied

10.237 The Bill gives the Commissioner a discretion to determine that an interest of a beneficiary to income or capital that is not vested and indefeasible can be treated as vested and indefeasible. This in turn would mean the interest could be treated as a fixed entitlement. The Commissioner could exercise this power having regard to:

•

the circumstances in which the beneficiary's interest would not be vested or is not indefeasible;

•

the likelihood of the interest not vesting or not being indefeasible; and

•

the nature and type of the trust. [Subsection 271-5(2)]

10.238 This provision is intended to provide for special circumstances where there is a low likelihood of a beneficiary's vested interest being changed and, having regard to the scheme of the trust loss provisions to prevent trafficking in losses, it would be unreasonable to treat the trust as having to satisfy the additional tests required of a non-fixed trust.

What is a fixed entitlement to income or capital of a company?

10.239 A fixed entitlement in a company is defined for both income and capital.

10.240 A person has a fixed entitlement to income of a company if the person is the beneficial owner of shares in the company that carry any right to receive dividends that might be paid by the company. The extent of the entitlement is expressed as a percentage of the total dividends that might be paid by the company. [Subsection 271-10(1)]

10.241 A person has a fixed entitlement to capital of a company if the person is the beneficial owner of shares in the company that carry the right to receive any return of capital in the company to all shareholders (e.g. in the event of winding-up, or of a reduction in the capital, of the company). The extent of the entitlement is expressed as a percentage of the total capital that would be distributed. [Subsection 271-10(2)]

What is a fixed entitlement in a partnership?

10.242 A person will have a fixed entitlement to either income or capital of a partnership (whichever is applicable) where the following conditions are met:

•

the beneficiary is entitled to a share of the income of the partnership that the partnership derives from time to time (i.e. current and future income), or a share of capital of the partnership; and

•

the share is not able to be varied. [Subsection 271-15(1)]

10.243 As with trusts, the Commissioner will have a discretion to treat an entitlement to income or capital of a partnership as a fixed entitlement in special circumstances notwithstanding that the partner's share is able to be varied. [Subsection 271-15(2)]

When is a fixed entitlement held indirectly?

10.244 The concept of a fixed entitlement being held indirectly through one or more interposed companies, trusts or partnerships (all called entities for this purpose) is used in determining whether:

•

individuals have more than a 50% stake in the income or capital of a trust (see paragraph 10.181 to 10.193);

•

an individual is taken to hold units in a unit trust for the purposes of the widely held unit trust definition (paragraph 10.270 to 10.273).

Tracing through fixed entitlements in companies, partnerships and trusts

10.245 A person will be taken to have a fixed entitlement in the income or capital of a trust if the person is indirectly entitled to the income or capital through fixed entitlements in a chain of one or more interposed entities [subsection 271-20(1)] . The income or capital that a person is entitled to through interposed entities is determined by multiplying the entitlements of the person in each successive entity.

10.246 When tracing fixed entitlements to income of the loss trust, the fixed entitlements to income of the interposed entities are taken into account. When tracing fixed entitlements to the capital of the loss trust, the fixed entitlements to capital of the interposed entities are taken into account.

10.247 All relevant fixed entitlements of one entity in another are expressed as a percentage of the total fixed entitlements to income or capital of the entity concerned (whichever is applicable).

10.248 To determine one entity's fixed entitlement in an entity immediately above it, the entitlement of the lower entity in the higher entity is multiplied by the entitlement of the higher entity in the loss trust. If the higher entity is the loss trust being considered, the entitlement of the lower entity is multiplied by its fixed entitlement in the loss trust.

Example 1: A simple example of how fixed entitlements are traced

10.249 Trust A has prior year losses. Company B has a 40% fixed entitlement to the income of the trust and a 40% fixed entitlement to capital. Jack holds 60% of the shares in Company B all of which are of the same class.

10.250 Jack's fixed entitlement to the income of Trust A is 60% (his fixed entitlement to income (dividends) of Company B) multiplied by 40% (Company A's fixed entitlement in the income of Trust A). This gives Jack a 24% fixed entitlement in the income of Trust A for the purposes of the 50% stake test. Jack's fixed entitlement to capital of Trust A is worked out in the same way (also 24%) except that it is traced through Jack's fixed entitlement to capital.

Example 2: A more complex example of how fixed entitlements are traced

10.251 Jill holds an indirect fixed entitlement to the income of Trust A through the structure set out in the following diagram.

10.252 The following steps are taken in working out Jill's fixed entitlement in Trust A.

Step 1: Partnership B's fixed entitlement to the income of Trust A is ascertained. This is 60%.

Step 2: Company C's fixed entitlement to the income of Partnership B (50%) is multiplied by Partnership B's fixed entitlement to the income of Trust A (60%). This equals 30%.

Step 3: Trust D's fixed entitlement to income (dividends) of Company C (100%) is multiplied by Company C's indirect fixed entitlement to the income of Trust A (30%). This equals 30%.

Step 4: Jill's fixed entitlement to the income of Trust D (50%) is multiplied by Trust D's indirect fixed entitlement to the income of Trust A (30%). This equals 15%.

The result is that Jill is taken to have a fixed entitlement to 15% of the income of Trust A.

Tracing through non-fixed interests in trusts

10.253 If a fixed entitlement to income or capital of a trust (the head trust) is held by a non-fixed trust in which no persons have a fixed entitlement to income or capital, there will not be individuals who have a fixed entitlement to any of the income or capital of the head trust to which the trustee of the interposed non-fixed trust has a fixed entitlement. This is because it is only possible to trace through fixed entitlements in a non-fixed trust in order to determine if an individual has a fixed entitlement to the whole or part of the income or capital of the head trust to which the trustee of the interposed non-fixed trust has a fixed entitlement.

10.254 However, where there are persons who have fixed entitlements to income or capital of a non-fixed trust which is interposed between the head trust and an individual, a fixed entitlement to income or capital of the head trust will be able to be traced through the interposed non-fixed trust to the extent of the fixed entitlement.

What if a fixed entitlement is held through a family trust?

10.255 A special rule will apply to circumstances where a fixed entitlement to the income or capital of an entity (the head entity) is held by a family trust. The trustee of the family trust will be taken to have that fixed entitlement to the income or capital of the head entity for its own benefit if the family trust is a family trust at all times being tested. [Subsection 271-20(2)]

Avoidance arrangements

10.256 The Bill contains a provision to deal with avoidance arrangements designed to ensure that persons have a fixed entitlement in a trust of a certain level. The Commissioner will be allowed to treat a fixed entitlement held by a person as not having been held by the person if certain conditions are met.

10.257 The conditions are that an arrangement must have been entered into and:

•

the arrangement is in some way related to, affected or dependent for its operation, whether directly or indirectly, on the fixed entitlement or the value of the fixed entitlement - this condition makes the necessary link to the entitlement that the Commissioner would treat as not being held by a person; and

•

the purpose, or one of the purposes, of the arrangement was to ensure that persons would have more than a 50% stake in the trust or that the trust would be a widely held unit trust - this makes it clear that the arrangement has been entered into to ensure the trust passes the continuity of ownership test or is treated under the more favourable rules applying to widely held unit trusts. [Section 271-25]

What happens if a beneficial owner of an entitlement dies?

10.258 The Bill makes special provision for the situation where the beneficial owner of a fixed entitlement in a trust dies. This is necessary to prevent a trust failing the 50% stake (continuity of ownership) test or the widely held unit trust definition merely because a stakeholder in the trust dies. Where the individual dies, the fixed entitlement is taken to continue to be owned by the individual as long as:

•

the entitlement is held by the trustee of the dead person's estate; or

•

the entitlement is held by a person who is a beneficiary of the dead person's estate. [Section 271-30]

Subdivision 271-B - Fixed trusts and non-fixed trusts

What is a fixed trust?

10.259 A fixed trust is a trust where all of the income or capital of the trust is the subject of fixed entitlements held by persons. A person in this context includes a natural person, a company, a trustee or the partners in a partnership. Thus, for example, a trust where some part of the income or capital may be distributed on the discretion of the trustee or another person is not a fixed trust. [Section 271-35]

What is a non-fixed trust?

10.260 A non-fixed trust is any trust which is not a 'fixed trust'. Thus a non-fixed trust could include a large range of trusts from those that are purely discretionary to those that are fixed but where some or all of the entitlements in the trust are defeasible. Trusts that have both fixed and non-fixed elements (hybrid trusts) are also non-fixed trusts for the purposes of the proposed legislation. [Section 271-40]

Subdivision 271-C - What is a family trust?

10.261 The definition of 'family trust' is crucial to the operation of the provisions. Family trusts will not be affected by the proposed amendments, other than the income injection test.

10.262 A trust is a family trust if an individual and his or her family are the only persons who are capable of receiving income or capital from the trust. That is, the individual and his or her family must be the only persons to whom the trustee of the trust may directly or indirectly make a distribution of income or capital of the trust whether during the life of the trust or on its vesting. However, special provision is made to ensure a family trust retains its status as such where certain bodies, such as charitable institutions, can benefit under the trust on the death of family members. [Subsection 271-45(1)]

10.263 An individual's family is defined broadly as:

•

a spouse or former spouse of the individual;

•

a parent, brother, sister, child, nephew or niece of the individual or of the individual's spouse or former spouse;

•

a child of any of the individuals mentioned above who could benefit under the trust on the death of the individual;

•

a grandparent or great-grandparent, grandchild, aunt or uncle of the individual; or

•

a spouse or former spouse of any of the above. [Subsection 271-45(2)]

(A reference to an individual in any of the above categories does not include an individual in the capacity of trustee).

10.264 The fact that on the death of all the beneficiaries there is a religious, scientific, charitable or educational institution which is exempt from income tax under paragraph 23(e) of the Act or a body listed in certain gift provisions of the Act that would benefit under the trust would not prevent the trust from being a family trust. [Subsection 271-45(3)]

10.265 In determining whether an individual's family are the only persons who are capable of receiving distributions indirectly from the trust, it will be possible to look through interposed companies, trusts and partnerships. If the only persons who can receive income or capital from any of the interposed entities are family members (as defined), then the trust will still be treated as a family trust. The following examples illustrate this idea.

Example 1

10.266 Trust A (a discretionary trust) has as a class of possible beneficiaries Jill (an individual), her spouse and children and Company B. Half the shares in Company B are held by Jill and the other half are held by Jill's business associate, Mary. Mary is not a family member as defined. Trust A is not a family trust because someone other than a family member (Mary) is capable of receiving distributions, indirectly, from the trust.

Example 2

10.267 The facts are the same as in Example 1 except Mary is Jill's sister. Trust A is a family trust because only family members are capable of receiving distributions, directly and indirectly, from the trust.

Subdivision 271-D - What is an excepted trust?

10.268 There are five kinds of trusts that are excepted trusts . They are family trusts (as defined above), complying superannuation funds, complying approved deposit funds, pooled superannuation trusts and deceased estates within a reasonable administration period. [Section 271-50]

10.269 The definitions of a complying superannuation fund, a complying approved deposit fund and a pooled superannuation trust are taken from sections 45, 47 and 48 of the Superannuation Industry (Supervision) Act 1993 respectively. [Paragraph 271-50(b)]

10.270 The term 'deceased estate' has its ordinary meaning. It is generally a trust formed on the death of a person, either by a will or codicil of that person or under rules applying to a person who dies intestate. For the purposes of the legislation, a deceased estate will only be treated as an excepted trust during a reasonable administration period. This period is the part of the income year from the date of death of the person and the next five full income years [paragraph 271-50(c)] . This will give the trustee of the deceased estate ample opportunity to complete the administration of the estate.

Subdivision 271-E - What is a widely held unit trust?

10.271 Listed widely held trusts, unlisted very widely held trusts and unlisted widely held trusts are all widely held unit trusts with particular characteristics.

10.272 A widely held unit trust is a fixed trust in which more than 20 individuals hold, directly or indirectly, 75% or more of the fixed entitlements to income and capital of the trust (the 20-75 test). The entitlements of the beneficiaries in the trust are evidenced by unit holdings. In addition, at least some of the units in the trust must be prescribed interests which have been offered for subscription or purchase within the meaning of Part 7.12 of Chapter 7 of the Corporations Law. This generally requires the unit trust to issue a prospectus on the sale of some units in the trust. [Subsection 271-55(1)]

10.273 For the purposes of the definition of a widely held unit trust a person and his or her relatives and nominees are treated as being one individual. This will prevent an individual circumventing the intent of the 20-75 rule by having family members or nominees holding units on his or her behalf. [Subsection 271-55(2)]

10.274 The rule that 20 or fewer persons must not hold 75% or more of the interests in income and capital of the trust is affected by an anti-avoidance provision which is similar to those contained in section 102G of the Act. This provision looks to the rights attached to units and at any arrangement, contract, etc. that would affect those rights in a way that would circumvent the 20-75 rule. If the rights attaching to units are capable of being varied or abrogated in such a way that less than 20 individuals would, directly or indirectly, hold 75% or more of the fixed entitlements to the trust's income and capital, the trust will not be a widely held unit trust. [Subsection 271-55(3)]

Subdivision 271-F - Listed and unlisted widely held trusts

What is an unlisted widely held trust?

10.275 An unlisted widely held trust is a widely held unit trust whose units are not listed for quotation in the official list of an approved stock exchange within the meaning of section 470 of the Act. [Section 271-60]

What is a listed widely held trust?

10.276 A listed widely held trust is a widely held unit trust whose units are listed for quotation in the official list of an approved stock exchange within the meaning of section 470 of the Act. [Section 271-65]

Subdivision 271-G - What is an unlisted very widely held trust?

10.277 An unlisted very widely held trust is an unlisted widely held unit trust with at least 1,000 unit holders. All of the units in the trust must carry the same rights and be redeemable at any time. The redemption price must be a true reflection of the trust's market value, i.e. based on its net asset value according to Australian accounting principles. [Subsection 271-70(1)]

10.278 The trust must engage only in investment or business activities that are set out in the trust instrument or deed and prospectus of the trust. All these activities must be carried out at arm's length. Thus, if any of the activities are not at arm's length, the trust will not be an unlisted very widely held trust. [Subsection 271-70(2)]

Subdivision 271-H - Other definitions not previously dealt with [section 271-75]

What is an associate?

10.279 The term associate has the same meaning as in section 318 of the Act. This kind of definition is commonly used in the income tax law to define who an associate of another person is.

What is an income year?

10.280 The term income year is used throughout the provisions dealing with trust losses. It is a short hand way of saying 'year of income'. The term 'year of income' is defined in subsection 6(1) of the Act.

What is a loss year?

10.281 A loss year is simply a year of income in which a tax loss was incurred.

What is a scheme?

10.282 The term 'scheme' is used mainly in the income injection test. It has the same meaning as that term has in Part IVA of the Act. Part IVA is the general anti-avoidance provision in the income tax law.

10.283 In Part IVA a scheme is defined as:

'(a)

any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b)

any scheme, plan, proposal, action, course of action or course of conduct.'

What is a tax loss?

10.284 A tax loss is defined as a loss within the meaning of sections 79E, 80 or 80AA or a film loss within the meaning of sections 79F or 80AAA. Those sections are the provisions of the Act which deal with the deductibility of losses. In general terms, a tax loss arises when a taxpayer's non-loss allowable deductions exceed assessable income and net exempt income.

Consequential amendments (Part 2 of Schedule 7)

10.285 Part 2 of Schedule 7 of the Bill makes a number of amendments consequential on the insertion in the Act of Schedule 2C. The consequential amendments integrate Schedule 2C into the loss and net income calculation rules in the Act. [Items 2, 3 and 4]

10.286 Amendments are made to sections 79E and 79F of the Act. These amendments will ensure that, before a prior year loss or film loss of a trust is deductible by the trust in calculating net income, the rules proposed in the Bill must be satisfied. [Subsections 79E(2A) and 79F(5A)]

10.287 An amendment is also made to section 95 of the Act. Section 95, among other things, outlines the method by which a trust's net income is calculated. The amendment made by the Bill to section 95 will make it clear that a trust may be required to work out its net income or loss in a special way if the relevant rules in the Bill are triggered. This integrates the proposed current year loss rules for trusts into the Act. [Subsection 95(1A)]

Application and transitional (Part 3 of Schedule 7)

10.288 Part 3 of Schedule 7 of the Bill deals with application and transitional matters. The amendments are of two kinds:

•

application arrangements; and

•

transitional arrangements for trusts that become family trusts after 1995 Budget time.

Application arrangements

10.289 In general terms, the provisions dealing with trust losses (Schedule 2C) inserted in the Income Tax Assessment Act 1936 by the Bill will apply to all trafficking in trust losses after 1995 Budget time. 1995 Budget time means 7.30 pm, by legal time in the Australian Capital Territory (i.e. Australian Eastern Standard Time), on 9 May 1995. [Item 5]

10.290 The provisions in Schedule 2C will apply where the income year in question is the 1994-95 income year or later income years [subitem 6(1)] . This provision, in part, ensures that the trust loss provisions can apply to any events that may occur between 1995 Budget time on 9 May 1995 and the end of the 1994-95 income year on 30 June 1995 (or substituted accounting period ending after 1995 Budget time).

Application of prior year loss rules

10.291 For the prior year loss provisions, the Bill ensures that the proposed measures will apply only from 1995 Budget time for the 1994-95 and later income years by saying that the 'test period' for any trust applying those measures will commence just before the Budget time [subitem 6(2)] . This will be the case where the loss was incurred in the 1994-95 income year or an earlier year. The 'test period' is the period used in determining whether certain events that will prevent the deduction of a prior year loss have occurred.

10.292 There is also a provision to ensure that the pattern of distributions test that applies for non-fixed trusts (see paragraphs 10.91 to 10.102 above) will, in effect, only apply from the date of introduction of the Bill into the Parliament. The application of this test is different because the details of the test, as they are presented in the Bill, have not previously been announced. This special application provision will ensure no retrospective operation of the test. It does this by saying at least part of the test year distribution in the 1995-96 income year must occur after the date of introduction. [Subitem 6(3)]

Application of current year loss rules

10.293 The Bill also makes similar provision for the current year loss rules by saying the following about the events that may lead to a trust having to calculate its net income or tax loss in a special way:

•

no abnormal trading in a trust's units and no accounting period of a trust is taken to have occurred, in the 1994-95 income year, before 1995 Budget time; and

•

the fixed entitlements of persons to income or capital of a trust and the control of a trust that existed just before 1995 Budget time are taken to have existed throughout the 1994-95 income year to the Budget time. [Subitem 6(4)]

Application of income injection test

10.294 The income injection test will only apply where the following happens:

•

the benefit (if applicable) provided to the trust, beneficiary or associates under an income injection scheme is provided after 1995 Budget time; and

•

the assessable income derived under the scheme is derived after 1995 Budget time. [Subitem 6(5)]

Transitional arrangements for family trusts

10.295 A special transitional provision will apply for family trusts. This provision will give some trusts which are not strictly family trusts the opportunity to alter their arrangements so that they can benefit from the concession in the proposed rules for family trusts. Essentially, these trusts will be given from 1995 Budget time to the start of the 1996/97 income year to make the necessary alterations.

10.296 The trusts affected are those that were predominantly family trusts at 1995 Budget time (i.e. 7.30 pm AEST on 9 May 1995 and equivalent time elsewhere). The provision will apply to such a trust that:

•

becomes a family trust after 1995 Budget time but before the start of the 1996/97 year of income; and

•

between 1995 Budget time and the time the trust becomes a family trust, satisfies the ordinary tests for deductibility of losses that will apply to trusts that are not family trusts (this would be the tests for fixed trusts if the trust is a fixed trust or the tests for non-fixed trusts if the trust is a non-fixed trust).

10.297 If the provision applies, the trust will be treated as having been a family trust at all times between 1995 Budget time and the time the trust became a family trust. In turn this will mean the trust cannot be prevented from deducting a prior or current year loss except by the income injection test. [Item 7]

Chapter 11 - Non-compulsory uniforms or wardrobes

Overview

11.1 Part 3 of Schedule 4 of the Bill makes a minor amendment to the taxation law.

Explanation of the amendment

Non-compulsory uniforms or wardrobes

11.2 The amendment gives effect to the Government's 1995-96 Budget announcement that it will transfer responsibility for the maintenance of the Register of Approved Occupational Clothing from the Textiles, Clothing and Footwear Development Authority to the Secretary of the Department of Industry, Science and Technology. Included in the amendment are transitional arrangements to ensure taxpayers' rights and the smooth transfer of responsibility.

11.3 The amendment will apply from 1 March 1996.

Finding table portions of Index

* No specific reference to clause or' in the Explanatory Memorandum because of their minor nature.