Senate

Supplementary Explanatory Memorandum

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

Glossary

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

General outline and financial impact

Thin capitalisation

Schedules 1 to 4 to this bill amend the ITAA 1997 and the ITAA 1936 to implement changes to the thin capitalisation regime contained in Division 820-D of the ITAA 1997. The amendments ensure that the policy objectives of the thin capitalisation regime are achieved, promote equity between taxpayers, generally reduce compliance costs and clarify the operation of the law.

Date of effect: The amendments in Schedule 1 will apply from the start of a taxpayer's first income year commencing on or after 1 July 2001. Amendments in Schedule 2 (except Part 5) and Schedule 4 will apply for income years commencing on or after 1 July 2002, with Schedule 2 (Part 5) amendments not applying for the purposes of working out a capital gain made from a CGT event happening before 1 July 2002. Schedule 3 amendments are applicable to income years commencing on or after 1 July 2003.

Proposal announced: The amendments were announced in Minister for Revenue and Assistant Treasurer's Press Release No. C125/02 of 4 December 2002.

Financial impact: Nil.

Compliance cost impact: Overall, the amendments will involve a net reduction in compliance costs as compared with the operation of the existing thin capitalisation rules.

Fringe benefits tax - certain exemptions for public hospitals

Schedule 5 to this bill amends the FBTAA 1986 to ensure that fringe benefits provided to employees whose duties are performed in, or in connection with, a public hospital will continue to be subject to the $17,000 capped FBT exemption, whether or not the hospital is a PBI.

This measure forms part of the Government's response to the Report of the Inquiry into the Definition of Charities and Related Organisations. It will ensure that public hospitals of the Commonwealth, a State or a Territory will have access to the $17,000 capped FBT exemption, whether or not they are a PBI.

Housing fringe benefits are FBT exempt where provided in a remote area. This Schedule also amends the FBTAA 1986 so that for a public hospital, a remote area will be one that is at least 100 kilometres from a population centre of 130,000 or more, whether or not the hospital is a PBI. The amendment to the housing fringe benefit provision will ensure consistent treatment for public hospitals with that provided under the $17,000 capped FBT exemption.

Date of effect: These amendments apply from 1 April 2003.

Proposal announced: The Government's response to the Report of the Inquiry into the Definition of Charities and Related Organisations was announced in Treasurer's Press Release No. 49 of 29 August 2002.

Financial impact: The amendments are expected to have an insignificant effect on revenue.

Compliance cost impact: The amendment will not involve additional compliance costs.

Reducing tax on the excessive component of ETPs

Schedule 6 to this bill amends relevant taxation legislation to reduce the effective rate of tax on the excessive component of an ETP paid by a superannuation fund. The amendments also provide a reduction in the amount of surchargeable contributions reported by the fund paying the excessive ETP in that year, in respect of the relevant member.

The Acts that are amended are the:

•

Income Tax Rates Act 1986;

•

Superannuation Contributions Tax (Assessment and Collection) Act 1997; and

•

Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997.

Date of effect: The amendments will apply to ETPs made on or after 1 July 2002.

Proposal announced: This measure was announced in the Government's policy statement A Better Superannuation System on 5 November 2001, and confirmed in the 2002-2003 Federal Budget.

Financial impact: The revenue cost of this measure is expected to be $5 million in each of 2003-2004, 2004-2005 and 2005-2006.

Compliance cost impact: The proposed amendments impose additional administrative and compliance costs on the ATO. However, it is expected that any additional compliance costs on superannuation funds or taxpayers will be minimal.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure will impact on those taxpayers who receive an ETP with an excessive component. Such taxpayers will benefit from the tax rate and superannuation surcharge reduction for ETPs made on or after 1 July 2002.

Main points:

•

Superannuation funds currently provide information to the ATO regarding the components of an ETP when one is paid to a member. As such, it is expected that superannuation funds will incur minimal additional compliance costs.

•

Superannuation funds currently report surchargeable contributions for each member to the ATO each year. This information, together with information on the amount of the excessive ETP will be used by the ATO to ascertain by how much the surchargeable contributions should be reduced. As such, it is expected that superannuation funds will incur minimal additional compliance costs for this aspect of this measure.

Application of same business test

Schedule 7 to this bill amends Division 165 of the ITAA 1997 to remove an anomaly that prevents a company from accessing the SBT to determine its eligibility to deduct a tax loss incurred in a previous year, or write off a bad debt, in circumstances where the company has failed the COT but is unable to identify the precise date on which that failure occurred.

Date of effect: The amendments made by Part 1 of Schedule 8 to this bill apply to assessments for the 1997-1998 income year and later income years. The amendments made by Part 2 of Schedule 8 to this bill apply to assessments for the 1998-1999 income year and later income years.

Proposal announced: The measure was announced on 14 May 2002 as part of the 2002-2003 Federal Budget.

Financial impact: The financial impact of the amendments is expected to be negligible.

Compliance cost impact: Overall, the amendments will involve a net reduction in compliance costs.

Tax losses

Schedule 8 to this bill will amend the ITAA 1997 so that corporate tax entities will be able to choose the amount of prior year losses they want to deduct in an income year. This will ensure prior year losses are not used up against franked dividend income. Also, to ensure corporate tax entities are not required to deduct 'current year' losses against franked dividend income, the current year loss will be treated as a tax loss for the income year and carried forward for deduction in a later year of income.

Date of effect: The amendments will apply in respect of the 2002-2003 and later income years.

Proposal announced: 2002-2003 Federal Budget on 14 May 2002.

Financial impact: The measure has a cost to revenue of nil in 2002-2003, $15 million in 2003-2004, $40 million in 2004-2005 and $70 million in 2005-2006.

Compliance cost impact: Nil.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure will potentially apply to all corporate tax entities who will benefit as they will no longer be required to use up losses that could be deductible in a later year of income against franked dividend (effectively tax free) income.

Main points:

•

Corporate tax entities will now be allowed to choose the amount of prior year losses they wish to deduct in a later year of income, again avoiding such losses being used up against franked dividend income.

•

Corporate tax entities will identify the otherwise wasted current year loss by reference to the amount of any unused franking tax offset as part of the calculation of income tax payable for a year of income.

•

The excess franking tax offset will be converted back to the equivalent amount of tax loss, allowed to be carried forward as a prior year loss and considered for deduction in a later year of income.

Chapter 1 - Thin capitalisation

Outline of chapter

1.1 Schedule 1 to 4 to this bill explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997 and amendments to the ITAA 1936. Legislative references are to ITAA 1997 unless otherwise stated. The amendments ensure that the policy objectives of the thin capitalisation regime are achieved, promote equity between taxpayers, generally reduce compliance costs and clarify the operation of the law.

Context of amendments

1.2 The policy underlying the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. A number of outstanding thin capitalisation policy issues are addressed in these amendments. In addition, there are technical amendments and integrity measures to ensure the legislation operates as intended.

Summary of new law

1.3 This bill will amend the ITAA 1997 and the ITAA 1936 to:

•

exclude certain special purpose entities from the operation of the thin capitalisation regime;

•

allow qualifying financial entities to use the risk weighting rules that apply to ADIs;

•

align the definition of 'equity capital' for ADIs and non-ADIs;

•

vary the rules for the revaluation of assets;

•

amend the treatment of reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements;

•

clarify the definition of assets and liabilities;

•

amend the definition of financial entity;

•

amend record keeping requirements for permanent establishments; and

•

introduce a number of technical amendments and integrity measures.

Detailed explanation of new law

Exemption of certain special purpose entities

1.4 The zero capital amount provides a carve out of certain assets from the thin capitalisation regime and as a consequence allows full debt funding of those qualifying assets. Assets held by a securitisation vehicle are included in the zero capital amount provided that the definition of securitised asset and securitisation vehicle as set out in section 820-942 are satisfied.

1.5 This treatment reflects that securitisation vehicles are tax neutral entities established to pool assets and are generally funded entirely through the issue of debt interests without the need to hold equity.

1.6 The securitisation industry is complex and dynamic. Many securitisation programs are not able to avail themselves of the benefits of the zero capital treatment provided under the current thin capitalisation legislation. In particular, the current definitions do not contemplate origination, warehousing, two-tiered securitisation or synthetic securitisation. Nor do the current rules allow any residual equity holding in a securitisation vehicle. As a consequence, many bona fide securitisation vehicles will inappropriately have a proportion of their interest deductions denied under the thin capitalisation rules.

1.7 To address this, amendments will exclude special purpose entities from the thin capitalisation rules for all or part of the income year provided that the following conditions are met:

•

the entity is established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself);

•

At least 50% of the entity's assets are funded by debt interests; and

•

the entity is an insolvency remote special purpose entity according to the criteria of an internationally recognised rating agency applicable to the entity's circumstances.

[Schedule 1, item 2, subsections 820-39(1) to (3)]

1.8 The first condition is a purpose test that seeks to exclude entities that are not specifically established for what might be commonly referred to as securitisation or origination activity. It also seeks to exclude entities that undertake any activities not related to the process of securitisation or origination. The first condition seeks to cover items and risks that could be securitised or originated. For example, it covers a straightforward arrangement where assets are purchased by a special purpose entity. It also covers more complex arrangements, for example, where the risk associated with the assets is acquired by a special purpose entity but the underlying assets remain on the balance sheet of the originating entity.

1.9 The second condition recognises that while the overall objective of a securitisation or origination program is to fund the assets of the special purpose entity entirely through the issue of debt interests, there is the possibility that this may take some time to achieve or that there may be some residual equity holding in the vehicle or some other form of credit enhancement.

1.10 The third condition seeks to ensure that the special purpose vehicle meets or would meet an internationally recognised rating agency's requirements for an insolvency remote special purpose entity. A rating agency would attempt to ensure that the entity is unlikely to be subject to voluntary or involuntary insolvency proceedings. A rating agency may be satisfied where the entity can demonstrate that it:

•

is restricted to activities necessary to its role in the transaction;

•

is restricted from incurring additional indebtedness;

•

cannot be subject to reorganisation, merger or change of ownership; and

•

holds itself out to the world as a separate entity.

1.11 Some rating agencies publish general criteria whereas others have specific criteria for particular types of special purpose entities. For example, Standard and Poors have published Structured Finance Criteria for Australian and New Zealand Special Purpose Entities.

1.12 To take advantage of the exclusion from the thin capitalisation rules an entity must be able to demonstrate that it meets the criteria of an internationally recognised rating agency most applicable to its circumstances. This might be the criteria that is specific to that type of entity or that was relevant at the time the entity was established. It is not a requirement that the entity must have been rated by a rating agency. [Schedule 1, item 2, subsection 820-39(4)]

1.13 It is also possible for several legal entities to demonstrate that they meet the criteria of an internationally recognised rating agency where they are taken to be a single notional entity. [Schedule 1, item 2, subsection 820-39(5)]

1.14 The three conditions in subsection 820-39(3) seek to cover a broad and ever expanding range of securitisation activity and structures. For example, the conditions seek to include a warehousing type entity where securitised assets are temporarily placed pending their transfer to another entity. The conditions also seek to cover a two tiered securitisation structure where one entity holds the securitised assets and the other entity issues the debt interests.

1.15 A note has also been added signposting that if an entity does not qualify as a special purpose entity it may still be a securitisation vehicle under subsection 820-942(2) [Schedule 1, item 2, note 2 in section 820-39]. A similar note also covers the reverse situation where an entity may be exempt under section 820-39 even though it is not considered to be a securitisation vehicle for thin capitalisation purposes [Schedule 1, item 5, note in subsection 820-942(2)].

1.16 Where a special purpose entity is a member of a resident TC group it is not treated as part of that group for purposes of applying the thin capitalisation rules [Schedule 1, item 3, subsection 820-552(3)]. It does however remain part of the group for the purposes of maintaining the resident TC group's structure and to cover periods when it is a special purpose vehicle for part of the year but not at the end of the year. While it is considered a part of the group for these purposes, its presence will not affect the classification of the resident TC group [Schedule 1, item 3, subsections 820-552(1) and (2)].

1.17 Similarly, for the period that an entity is considered to be an exempt special purpose entity it is not part of a consolidated group or MEC group. [Schedule 1, item 4, section 820-584]

1.18 A note signposting this treatment for exempt special purpose entities has also been included. [Schedule 1, item 2, note 1 in section 820-39]

1.19 It should be noted that equity provided to a special purpose entity that meets the condition of subsection 820-39(3) will be treated as associate entity equity under section 820-915. Whereas a loan provided to a special purpose entity will not be treated as associate entity debt. [Schedule 1, item 32, paragraph 820-910(2)(c)]

1.20 This amendment applies in relation to income years commencing on or after 1 July 2001.

Choice by some financial entities to be treated as an ADI

1.21 The thin capitalisation methodology for banks is based on risk weighting assets and a minimum capital requirement. The methodology uses the approach that banking regulators use for prudential purposes. Under the existing law, the methodology is only available to ADIs.

1.22 The amendments extend this treatment to non-bank financial entities that meet certain conditions and elect to apply the ADI rules. This provides the opportunity for equivalent treatment for banks and non-banks that may be undertaking similar activities.

What are the conditions for making a choice to apply the ADI rules?

1.23 An entity must be a financial entity to qualify to be able to choose to apply the ADI rules. In addition, at least 80% of its assets must meet the definition of on-lent amount. (See paragraph 1.64 for discussion of changes to the definition of financial entity.) [Schedule 1, item 6, subsection 820-435(1)]

1.24 Where a financial entity's financial services licence covers dealing in derivatives, the total value of its on-lent amount plus the net unrealised gains from its derivative trading must be at least 80% of the value of its assets. This also applies to entities exempted from the requirement to hold a financial services licence covering dealings in derivatives by virtue of paragraph 911A(2)(h) or (l) of the Corporations Act 2001. The head company of a consolidated group or MEC group must also satisfy this requirement where the group contains a financial entity that meets these same licensing conditions. [Schedule 1, item 6, subsections 820-435(2) and (3)]

1.25 Where a financial entity's assets include precious metals, the value of the precious metals can be added to the on-lent amount in determining whether the 80% test is met. This also applies to the head company of a consolidated group or MEC group where the group contains a financial entity. [Schedule 1, item 6, subsections 820-435(4) and (5); item 12, definition of 'precious metal' in subsection 995-1(1)]

1.26 These conditions are referred to as the 80% rule in subsequent discussions.

How do the ADI rules apply to a non-ADI entity?

1.27 Where a financial entity elects to use the ADI methodology and the entity is an outward investor (financial) or an inward investment vehicle (financial), Division 820 applies as if the entity were an outward investing entity (ADI). Specifically, the entity would apply Subdivision 820-D. [Schedule 1, item 6, subsection 820-430(1)]

1.28 Where a financial entity elects to use the ADI methodology and that entity is an inward investor (financial) Division 820 applies as if the entity were an inward investing entity (ADI). Specifically, the entity would apply Subdivision 820-E. For the purposes of applying Subdivision 820-E all of the entity's business is considered to be its banking business. [Schedule 1, item 6, subsections 820-430(1) and (3)]

1.29 Where an entity elects to use the ADI methodology, this will not affect the calculation of an associate entity's associate entity debt. A loan that qualifies as associate entity debt will continue to be associate entity debt irrespective of whether a choice is made by the borrower to apply the ADI rules for thin capitalisation purposes. [Schedule 1, item 6, subsection 820-430(4)]

1.30 Similarly, where an entity elects to use the ADI methodology, this will not affect the calculation of an associate entity's associate entity equity. However, there will be no mechanism available to transfer any excess debt capacity back to the associate. Specifically, the associate will not be able to utilise section 820-920 - associate entity excess amount in relation to its equity investment in an entity that elects to apply the ADI rules.

How does the entity make the choice?

1.31 Provided that an entity meets the necessary conditions it may make the choice to apply the ADI rules. No formal notification of the choice is required. The choice will be evident in the entity's tax return. The choice will cease to have effect only in certain circumstances as discussed in paragraphs 1.32 to 1.34. [Schedule 1, item 6, subsection 820-430(2)]

Having made the choice can an entity revert back to the non-ADI rules?

1.32 Once having made the choice to apply the ADI rules, the taxpayer can only revert to using the non-ADI rules in 2 circumstances:

•

it no longer meets the 80% rule when tested at the end of the third year; or

•

the Commissioner approves a revocation of the choice.

1.33 Having satisfied the 80% rule, and made the choice to apply the ADI methodology, an entity is required to test for and satisfy the 80% rule every 3 years. Where the 80% rule is not satisfied in the third year, the entity must revert to using the non-ADI rules in the following year. Apart from the exception discussed in the following paragraph, the entity is not forced, nor does it have the option, to revert to the non-ADI rules in the intervening 3 years. This is irrespective of whether the entity would fail the 80% rule in those intervening years. [Schedule 1, item 6, subsections 820-430(6) and (7)]

1.34 Where an entity having qualified and made the choice to use the ADI methodology, wants to revert to the non-ADI rules it must demonstrate to the Commissioner that its business has substantially changed. An example of this might include situations where merger, acquisition or sale activity significantly modifies the operations of the entity. In such circumstances the Commissioner may approve the revocation of the choice. Where the Commissioner revokes the choice it has effect from that date or a date specified by the Commissioner. [Schedule 1, item 6, section 820-440]

1.35 Having made the choice to apply the ADI methodology at one point in time, an entity that reverts back to the non-ADI rules is prohibited from applying the ADI rules again at any point in the future. Specifically, an entity reverting to the non-ADI rules as prescribed in the 2 previous paragraphs cannot apply the ADI rules again. [Schedule 1, item 6, subsection 820-430(5)]

1.36 Notes signposting the availability of the ADI methodology for financial entities have been added to the definitions of inward investing entity (ADI), inward investment vehicle (financial), inward investor (financial), outward investing entity (ADI) and outward investor (financial). [Schedule 1, items 7 to 11]

ADI election interaction with resident TC grouping rules

1.37 Generally where an entity has made an election under section 820-430 to be treated as an ADI that choice will not flow into the classification process for resident TC groups as set out in section 820-550. The one exception to this is where the resident TC group could have made that same choice under section 820-430. In deciding if the group could make that choice the group is considered to have been a company for that year with each entity being a division of that company. [Schedule 1, item 6, subsection 820-445(1)]

1.38 The choice will also have no effect where the resident TC group would be treated as an inward investing entity (ADI) as a result of the application of section 820-575, were no choice to be made under section 820-430. In this situation the inward investing entity (ADI) rules will continue to apply to the resident TC group. [Schedule 1, item 6, subsection 820-445(2)]

1.39 This exception effectively acts as a tiebreaker where there would otherwise be a conflict between the ADI election and the resident TC grouping rules as to whether the inward or outward investing entity (ADI) rules should apply.

ADI election interaction with a head company and a single resident company

1.40 Where an entity is a member of a consolidated group or MEC group, a choice made under section 820-430 by that entity to apply the ADI rules will have no effect while that entity is a subsidiary member of that group. This means that a subsidiary is covered by the choice made by the head company of the consolidated group or MEC group while it is a member of that group. [Schedule 1, item 6, subsection 820-445(3)]

1.41 A choice made by an entity to apply the ADI rules will also have no effect for a grouping period where a head company or single resident company has made a choice under section 820-597 or 820-599 to include an Australian branch of a foreign bank as part of the entity. This is because a choice made under section 820-597 or 820-599 will already result in the entity being classified as either an inward or outward investing entity (ADI) for the grouping period. [Schedule 1, item 6, subsection 820-445(4)]

1.42 As was the case for resident TC groups, negating the effect of the ADI election under section 820-430 where a choice has been made under either section 820-597 or 820-599 effectively acts as a tiebreaker in deciding which ADI rules should apply to a head company or a single resident company.

1.43 It should be noted that an inward investor (financial) which has elected to be treated as if it were an inward investing entity (ADI) will still be unable to group with a head company or single resident company for thin capitalisation purposes. This is consistent with the policy that only Australian branches of foreign banks can be treated as part of a head company or a single resident company.

Revaluing assets for thin capitalisation purposes

1.44 Under the existing thin capitalisation rules, an entity may use a value of an asset for thin capitalisation purposes other than the value reflected in its books of account. The new value for thin capitalisation purpose must be determined by an independent valuer in accordance with the relevant accounting standards. It is assumed that only entities that carry assets on their balance sheet at the lesser of cost or recoverable amount would take advantage of these provisions.

1.45 The amendments modify the existing provisions to allow:

•

a suitably qualified employee to undertake the revaluation provided that it is verified by an external independent valuer;

•

the revaluation of one or more assets in an asset class provided that no asset in the asset class has fallen in value; and

•

an entity to cease revaluing its assets where it no longer wants to make use of that revaluation for thin capitalisation purposes.

1.46 The amendments also include record keeping requirements where an entity revalues an asset for thin capitalisation purposes.

1.47 The amendments clarify that where an entity undertakes a revaluation of its assets and that revaluation is reflected in its statutory accounts, those values can be used for thin capitalisation purposes. [Schedule 1, item 14, subsection 820-680(2A)]

External validation of a revaluation made internally

1.48 The existing law only allows an independent valuer to revalue the assets in accordance with the relevant accounting standards. This must be someone who is an expert in valuation and would not have a conflict of interest in undertaking the revaluation. The amendments allow an employee (or the like) of the entity (an internal expert) to undertake the revaluation in accordance with the accounting standards provided they have no other conflict of interest. [Schedule 1, item 14, paragraphs 820-680(2B)(a) and 820-680(2B)(c)]

1.49 However, the revaluation must be verified by someone who is also an expert but is not an employee of the firm (an external expert). That is a person who does not have a conflict of interest in verifying the revaluation. The external expert must review and agree to the methodology including the validity of any assumptions, the accuracy and reliability of the data and other information used. [Schedule 1, item 14, paragraph 820-680(2B)(b)]

Revaluation of individual assets

1.50 The existing provisions rely on the accounting standards to determine how assets are to be revalued, the asset class that can be revalued and the frequency of revaluations. Generally, the accounting standards require that all assets in an asset class be revalued. The amendments provide a variation to the requirements of the accounting standards by allowing an entity to revalue one or more assets in an asset class provided that no asset in the asset class has fallen in value (including unrealised gains and losses). [Schedule 1, item 14, subsection 820-680(2C)]

Example 1.1

Assets A (carrying value $100) and B (carrying value $100) are the only assets in a class of assets. The following shows potential unrealised gains or losses on assets A and B and indicates whether asset A can be revalued for thin capitalisation purposes.

Asset A (value reflecting unrealised gains and losses)	Asset B (value reflecting unrealised gains and losses)	Value of asset class in accounts (book value)	Can asset A be revalued for thin capitalisation purposes?	Additional value of asset A that can be used in the thin capitalisation calculation
150	120	200	yes	50
150	100	200	yes	50
150	80	200	no	-
150	50	200	no	-
200	0	200	no	-

When further revaluation of assets is required

1.51 Where an entity undertakes a revaluation of assets specifically for thin capitalisation purposes it must continue to undertake the revaluation at the frequency required by the relevant accounting standard. This may require annual or less frequent revaluations. [Schedule 1, item 14, subsection 820-680(2D)]

1.52 Where an entity does not make a revaluation in accordance with the frequency requirements of the relevant accounting standard it must revert back to using the book value of the asset. This applies whether the entity is revaluing an asset class or a single asset (or more than one asset) in that class. [Schedule 1, item 14, subsection 820-680(2E)]

Records about asset revaluations

1.53 An entity must keep all records associated with a revaluation of assets under subsection 820-680(2). An exception to this obligation will be where the valuation is covered under subsection 820-680(2A). [Schedule 1, item 15, subsection 820-985(1); item 13, note in subsection 820-680(2)]

1.54 The records of a revaluation must contain details relating to:

•

the methodology used in the revaluation including any assumptions;

•

how the methodology was applied including any relevant data and other information used;

•

the name and credentials of the expert making the revaluations; and

•

the remuneration and expenses paid to the expert by the entity.

[Schedule 1, item 15, subsection 820-985(2)]

1.55 Where the revaluation is made by an independent internal expert, the entity must also keep records relating to:

•

name and credentials of the external expert;

•

the amount of remuneration the external expert received;

•

the expert's review of the methodology used to make the revaluation; and

•

the expert's agreement as to whether or not the methodology is suitable.

[Schedule 1, item 15, subsection 820-985(3)]

1.56 The records of the revaluation must be prepared before the entity lodges its income tax return for the income year to which the revaluation applies in whole or part. [Schedule 1, item 15, subsection 820-985(4)]

Arrangements for borrowing securities

1.57 The current thin capitalisation legislation includes specific rules for transactions associated with reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements. The underlying policy position is that the gross profit margin on such transactions is small and that entities should not be required to hold a high amount of capital against the assets generated from such transactions.

1.58 The amendments, some of which increase the equity requirement while others reduce it, refine the existing rules. A number of the amendments result in a greater equity requirement. Overall, the amendments should provide for more consistent thin capitalisation outcomes.

1.59 The amendments introduce the definition of borrowed securities amount. These are the liabilities of an entity incurred under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement. [Schedule 1, item 26, definition of 'borrowed securities amount' in subsection 995-1(1)]

1.60 The calculation of adjusted average debt has been amended to include the average value of the entity's borrowed securities amount. In addition, the definition of non-debt liabilities has been amended to include entity's borrowed securities amount. The effect of these amendments will increase the entity's equity requirement. However, without these amendments the existing treatment allows the sheltering of excess debt. [Schedule 1, item 18, subsection 820-85(3); item 19, subsection 820-120(2); item 20, subsection 820-185(3); item 21, subsection 820-225(2); item 27, definition of 'non-debt liabilities' in subsection 995-1(1)]

1.61 The definition of on-lent amount has been amended to include shares listed on an approved stock exchange. This will reduce the equity requirement so that it is equivalent to that required by APRA. However this treatment will only apply to genuine securities dealers and where market values can be easily verified. [Schedule 1, item 28, definition of 'on-lent amount' in subsection 995-1(1)]

1.62 The calculation of zero capital amount has been amended to only include amounts that have been received by the entity from the sale of debt interests under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement. This is similar to APRA equity requirements for such arrangements and reflects commercial practice. [Schedule 1, item 22, subsection 820-942(1)]

1.63 The calculation of zero capital amount has also been amended to include rights to the return of collateral where the entity has acquired securities under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement but where the entity has not repurchased the securities under the arrangement and the asset provided as security is not shares. Non-share assets such as cash or debt interests provided as security will be treated as zero capital amount. This new treatment will ensure that the right to the return of collateral has the same equity requirements as the collateral itself. [Schedule 1, item 23, subsection 820-942(1); item 24, subsection 820-942(1); item 25, subsection 820-942(1)]

Definition of financial entity

1.64 The thin capitalisation rules recognise that financial entities have a higher level of debt funding than non-financial entities in order to support their financial intermediation activities. A requirement for qualifying as a financial entity is to hold an Australian financial services licence within the meaning of the Corporations Act 2001 that covers dealing in securities, managed investment products and government debentures, stocks and bonds.

1.65 The definition of financial entity has been amended to include an entity whose Australian financial service licence covers dealings in derivatives. This will allow a qualifying entity that trades in derivatives to elect to be treated as an ADI for thin capitalisation purposes in Subdivision 820-EA. [Schedule 1, item 29, definition of 'financial entity' in subsection 995-1(1)]

1.66 The definition has also been amended so that an entity that is exempted from the need to hold an Australian financial service licence by paragraphs 911A(2)(h) and (l) of the Corporations Act 2001 will not be prevented from qualifying as a financial entity. These paragraphs relate to where an entity is regulated by an overseas authority or is covered by a specific ASIC exemption. This will ensure that an entity that is not required to hold an Australian financial services licence will not be prevented from qualifying as a financial entity provided that it meets the other relevant requirements. [Schedule 1, item 29, definition of 'financial entity' in subsection 995-1(1)]

Cost-free debt capital

1.67 The concept of cost-free debt capital in the thin capitalisation rules seeks to prevent the thin capitalisation calculations being manipulated by the injection of a loan that does not give rise to debt deductions (i.e. an interest-free loan) just prior to a valuation day, which is repaid shortly thereafter. Where an interest-free loan meets the definition of cost-free debt capital it is included in the entity's adjusted average debt.

1.68 An interest-free loan is cost-free debt capital where:

•

the borrower and lender are both subject to the thin capitalisation rules but have different valuation days or a different number of valuation days; or

•

only the borrower is subject to the thin capitalisation rules and the debt interest has been on issue for less than 180 days.

1.69 To ensure the genuine long term interest-free loans are not caught by the 180 day rule, the provision has been amended so that where the debt interest remains on issue for 180 days or more is not cost-free debt capital. [Schedule 1, item 31, subsection 820-946(4)]

1.70 For example, where an interest-free loan has been provided by an entity not subject to the thin capitalisation rules and is provided 60 days before the valuation day, it will currently be cost-free debt capital and added to the entity's adjusted average debt. This is irrespective of whether the loan is repaid the day after the valuation day or at some later date. Under the amended provision, if the loan is repaid up to 119 days after the valuation day it will remain cost-free debt capital. However, if the loan is repaid after 120 days or more it is not cost-free debt capital.

1.71 The definition of cost-free debt capital has been amended to exclude an entity that is not subject to the thin capitalisation rules because it is a special purpose entity and to clarify that the asset threshold test at section 820-37 only applies to outward investors. [Schedule 1, item 30, paragraphs 820-946(1)(c) and 820-946(1)(da)]

Associate entity debt

1.72 Associate entity debt seeks to ensure that there is no double counting of debt amounts that have been on-lent to an associate and the debt is tested in the associate.

1.73 The provision has been amended to ensure that the reference to the asset threshold test in section 820-37 is consistent with the policy intention. Under the existing law the reference to the asset threshold test could possibly apply to inward investors. The amendment ensures that it only applies to outward investors. [Schedule 1, item 32, paragraph 820-910(2)(b)]

1.74 An additional provision has also been included to ensure that a loan is not treated as associate entity debt where it has been on-lent to an associate if that entity is an exempt special purpose entity by virtue of section 820-39. [Schedule 1, item 32, paragraph 820-910(2)(c)]

1.75 Under the existing law, a loan to a foreign entity only qualifies as associate entity debt to the extent that it is attributable to the Australian operations of the foreign entity. Subparagraph 820-910(2)(a)(ii) defines Australian operations as carrying on business at or through a permanent establishment. [Schedule 1, item 32, subsections 820-910(2) and (2A)]

1.76 The provision has been amended to expand the definition of Australian operations to include situations where assets are held for the purposes of producing Australian assessable income. This change makes the definition of associate entity debt consistent with definitions of controlled foreign entity debt, controlled foreign entity equity and associate entity equity. [Schedule 1, item 32, paragraph 820-910(2A)(b)]

What borrowing expenses are excluded from being a debt deduction?

1.77 The definition of a debt deduction excludes borrowing expenses, deductible under section 25-25, that were incurred prior to 1 July 2001. This is to ensure that the deductibility of borrowing expenses incurred prior to the commencement of the present thin capitalisation regime are not affected.

1.78 To ensure consistency, borrowing expenses that were deductible under section 67 of the ITAA 1936 (the predecessor to section 25-25) will also be excluded from the definition of a debt deduction [Schedule 1, item 33, paragraph 820-40(1)(c)]. In effect this will only apply in relation to expenses incurred in the 1996-1997 income year as the 5 year period in which the deduction can be claimed expires in the 2001-2002 income year.

1.79 This amendment has effect for income years commencing on or after 1 July 2001.

What is a foreign controlled Australian partnership?

1.80 When determining what is a foreign controlled Australian partnership for partnerships that are not corporate limited partnerships, paragraph 820-795(2)(a) refers to a definition of Australian partnership. Australian partnership is not however defined for the purposes of the ITAA 1997. As a result paragraph 820-795(2)(a) is amended so that it takes its meaning from section 337 of Part X of the ITAA 1936. [Schedule 1, item 34, paragraph 820-795(2)(a)]

What is the basis underlying the arm's length debt amount

1.81 The arm's length debt amount seeks to determine an amount of debt that an independent lender would provide to the Australian operations of an entity. References in paragraphs 820-105(1)(b) and 820-215(1)(b) of the arm's length debt amount do not specifically mention Australian operations.

1.82 The policy intention is to compare the arm's length debt amount of the Australian operation with the actual level of Australian debt. To ensure this objective is achieved the factual assumptions that are to be used when calculating the arm's length debt amount have been amended so as to focus on only the Australian operations of the entity. [Schedule 1, item 36, paragraphs 820-105(2)(f) and 820-105(2)(g); item 38, paragraphs 820-215(2)(f) and 820-215(2)(g)]

1.83 This amendment has effect for income years commencing on or after 1 July 2001.

Maximum allowable debt

1.84 Because of the way in which worldwide equity is defined, it is possible for an Australian entity and its controlled foreign entities to have negative worldwide equity. The amendment will prevent an entity in this situation from using the worldwide gearing debt amount to determine its maximum allowable debt because otherwise the entity would be allowed more debt than assets for thin capitalisation purposes. This is an inappropriate outcome and the amendment is necessary to protect the revenue.

Non-debt liabilities

1.85 The amendment will ensure that all entities subject to the thin capitalisation rules use the same definition of non-debt liabilities. The current definition of non-debt liabilities only recognises a provision for a distribution of profit made by a corporate tax entity. The amendment allows all entities subject to thin capitalisation rules to exclude provisions for distributions of profit in their calculation of non-debt liabilities. This ensures, for example, that a company and a trust (in the same financial position) will have the same value for non-debt liabilities.

Records about Australian permanent establishments

1.86 Subdivision 820-L requires that an inward investor carrying on business in Australia at or through a permanent establishment will:

•

need to prepare separate financial statements for their permanent establishments;

•

need to prepare those statements in accordance with the Australian accounting standards; and

•

be liable for a penalty if they fail to comply with these requirements.

1.87 The law provides the Commissioner with a discretion to waive all or part of an accounting standard if the Commissioner decides that it is unreasonable for the entity to comply with that standard.

1.88 The provisions have been amended to exclude from the record keeping requirement entities with a permanent establishment in Australia:

•

where total revenue attributable to the Australian permanent establishment is less than $2 million [Schedule 2, item 2, subsection 820-960(1)] ; or

•

where the carrying on of its business in Australia does not meet the definition of permanent establishment within the meaning of the relevant double tax agreement [Schedule 2, item 2, subsection 820-960(6)].

1.89 The provisions have been amended to allow an entity to satisfy the record keeping requirements by preparing financial statements for its Australian permanent establishment using the Australian accounting standards or the accounting standards of Germany, Japan, France, USA, UK, Canada, New Zealand or the international accounting standards. [Schedule 2, item 2, subsections 820-960(1A), (1B), (1C), (1D) and (2)]

1.90 The provisions extend the Commissioner's discretion to minimise the record keeping requirements to classes of entities. In addition, the Commissioner is required to publish details of the exercise of the discretion with respect to record keeping requirements in the Commonwealth Government Gazette. [Schedule 2, item 2, subsections 820-960(4) and (5)]

1.91 These amendments seek to reduce compliance costs for taxpayers and minimise ATO administrative arrangements in relation to the record keeping requirements.

Excluded equity interests

1.92 Previously, it was considered that the risk of manipulating the thin capitalisation rules by raising equity would be minimal as issuing shares is a protracted and costly exercise. However, the effect of the debt/equity rules is that some financial instruments commonly regarded as debt are now classified as equity although they do not necessarily have the features of a traditional equity instrument.

1.93 This has implications for the thin capitalisation regime as these types of equity interests can be readily moved in and out of entities at around the time that assets and debts are measured for thin capitalisation purposes (the valuation days). The effect of the transaction is that the assets of the borrowing entity are increased thereby increasing the maximum allowable debt of that entity. Where both the issuer and holder are subject to the thin capitalisation rules and have the same measurement days there is a no mischief, as an equity injection is deducted from the assets of the holder thereby reducing its maximum allowable debt. However, where this is not the case, the thin capitalisation outcome can be manipulated by such transactions.

1.94 The amendments introduce a new term excluded equity interest. An equity interest is an excluded equity interest where both the issuer and holder are associates and the equity interest is on issue for less than 180 days. An equity interest that meets this definition is not an excluded equity interest where both the issuer and the holder are subject to the thin capitalisation rules and have the same valuation days and number of valuation days. [Schedule 2, item 33, definition of 'excluded equity interest' in subsection 995-1(1)]

1.95 Excluded equity interests are deducted from assets in the method statements for determining the safeharbour debt amount of the issuer. An excluded equity interest will reduce the maximum allowable debt of that entity. This is an integrity measure to ensure that the issuer does not get an advantage where equity interests are issued prior to a valuation day and cancelled shortly thereafter. [Schedule 2, item 5, section 820-95; item 7, subsection 820-100(2); item 9, subsection 100(3); item 11, section 820-195; item 13, subsection 820-200(2); item 15, subsection 820-200(3); item 17, section 205; item 19, subsection 210(2); item 21, subsection 820-210(3)]

1.96 To ensure that genuine long term equity interests are not caught by the 180 day rule, equity interests that remain on issue for 180 days or more are not excluded equity interests. [Schedule 1, item 31, subsection 820-946(4)]

1.97 The concept of 'on issue' for an excluded equity interest has also been introduced. This concept is only relevant to an excluded equity interest and does not apply more broadly. It is designed to ensure that the provisions cannot be circumvented by extinguishing the value of the equity interest while it remains in existence. [Schedule 2, item 34, definition of 'on issue' in subsection 995-1(1)]

Excluding disallowed deductions from the CGT cost base

1.98 The CGT rules allow non-capital costs of ownership of a CGT asset acquired after 20 August 1991 to be included in the cost base of the asset to the extent that they are not deductible for income tax purposes.

1.99 However, it was not the intent of the thin capitalisation regime that inclusion in the cost base of the CGT asset be permitted where debt deductions were disallowed because an entity exceeded prescribed gearing levels. Such an outcome would undermine the policy intent of the thin capitalisation rules of preventing multinational entities allocating an excessive amount of debt to their Australian operations.

1.100 Accordingly, this bill introduces provisions that will exclude debt deductions disallowed as a result of the thin capitalisation rules from being included as part of the CGT cost base. [Schedule 2, item 41, section 110-54]

1.101 Notes signposting the CGT treatment have also been added to provisions which determine the amount of the debt deduction to be disallowed. The notes highlight that any debt deduction disallowed is not to be included as part of the cost base of a CGT asset. For debt deductions disallowed to entities that are members of a resident TC group or where a permanent establishment has joined a head company or a single company, a similar note has also been added. The sections that now include this note are sections 820-115, 820-220, 820-325, 820-415, 820-465 and 820-605. [Schedule 2, items 42 to 48]

1.102 These amendments apply to a capital gain made from a CGT event happening on or after 1 July 2002. [Schedule 2, item 49]

Premium excess amount

1.103 The premium excess amount in section 820-920(3) ensures that entities are not unfairly penalised under the thin capitalisation rules where the holding value of an investment in an associate is greater than the book value of the associate entity (i.e. where the investor has paid a premium). Currently, steps 1 and 2 of the premium excess amount use slightly different definitions to identify the investment. Step 2 in the method statement has been amended to ensure that the definitions are aligned. [Schedule 2, item 52, subsection 820-920(3)]

Attributable safeharbour excess amount

1.104 The attributable safeharbour excess amount determines the amount of excess debt capacity that an entity can carry back from its associate. Inward investors (financial) have been included in step 1 for completeness. [Schedule 2, item 53, subsection 820-920(4)]

Adjusted average equity capital for consolidated entities or groups

1.105 Subsection 820-589(3) provides the methodology for determining adjusted average equity capital for the head company of a consolidated group or MEC group that is required to use the outward investing entity (ADI) rules. Subsection 820-613(3) applies similarly when a head company or single resident company includes an Australian bank branch of a foreign bank as part of itself for thin capitalisation purposes.

1.106 Presently, these calculations are based on the entire operations of the relevant head company or single resident company. That is, it covers both their Australian and foreign based operations. This is inconsistent with both the policy underlying the thin capitalisation regime (that concentrates on only the Australian operations of an entity) and the definition of adjusted average equity capital for outward investing entities (ADI) contained in Subdivision 820-D.

1.107 In Subdivision 820-D adjusted average equity capital is determined by calculating the average value of the equity capital of the entity (net of any equity attributable to an overseas permanent establishment) less the average value of CFE equity (net of CFE equity attributable to the overseas permanent establishment).

Amendments necessary given the present definition of 'equity capital'

1.108 Subsection 820-589(3) is amended by this bill to align the calculation of adjusted average equity capital for a head company of a consolidated group or MEC group with methodology set out in Subdivision 820-D. This is achieved by excluding both the equity capital attributable to an overseas permanent establishment and CFE equity (net of CFE equity attributable to the overseas permanent establishment) from the head company's calculation. [Schedule 2, items 36 and 37, subsection 820-589(3)].

1.109 A similar amendment has also been made where an Australian bank branch of a foreign bank is included as part of the head company or single company. [Schedule 2, item 40, paragraphs 820-613(3)(a) and 820-613(3)(b)]

1.110 The information to be used by each entity that is a member of the group in the determination of the value of adjusted average equity capital is that which would be contained in a set of consolidated accounts prepared in accordance with accounting standards at the measurement time. [Schedule 2, item 39, subsection 820-589(4)]

1.111 The interim grouping provisions contained in Subdivision 820-F for entities that are members of a resident TC group are also to be amended to exclude both the equity capital attributable to an overseas permanent establishment and CFE equity (net of CFE equity attributable to the overseas permanent establishment) from the calculation of adjusted average equity capital. [Schedule 2, item 35, subsection 820-562(3)]

1.112 The amendments to align the definition of adjusted average equity capital apply for income years commencing on or after 1 July 2002.

Amendments following the change to 'equity capital' definition as from 1 July 2003

1.113 Provisions dealing with the determination of adjusted average equity capital and average equity capital for the head company of a consolidated group or MEC group and a single resident company are also to be amended. This is a result of the change to the definition of equity capital effective for income years commencing on or after 1 July 2003 (see paragraphs 1.1202 to 1.1268)

How does Subdivision 820-D apply to the head company of a MEC group?

1.114 The new definition of equity capital means that the head company of a consolidated group that is classified as an outward investing entity (ADI) would apply Subdivision 820-D as if it were a single entity when calculating adjusted average equity capital because the relevant value will now be reflected in the head company.

1.115 Additional rules to apply Subdivision 820-D are now only required in relation to the head company of a MEC group to ensure that equity capital not directly reflected in the head company of the MEC group is taken in account. This is necessary because the head company of the MEC group does not own the other tier-1 companies within the MEC group. Rather their common parent is an offshore entity.

1.116 The new provision in calculating adjusted average equity capital ensures the ADI equity capital of the head company of a MEC group takes into account any equity interest or debt interest in the head company that are held at the measurement time by entities that are not members of the group. It similarly assumes that equity interests and debt interest in other eligible tier-1 companies are treated as if they were an equity interest or debt interest of the head company, but again only if held at the measurement time by entities that are not members of the group. [Schedule 3, item 6, subsection 820-589]

1.117 Reflecting this, section 820-589 as amended (see paragraphs 1.108 and 1.110) is to be replaced for income years commencing on or after 1 July 2003.

How does Subdivision 820-D apply if the head company or single resident company includes an Australian bank branch?

1.118 The calculation of adjusted average equity capital has also been amended where the outward investing entity (ADI) rules in Subdivision 820-D are to be applied to a head company or single resident company that has included an Australia bank branch of a foreign bank in its group for thin capitalisation purposes.

1.119 In this situation the adjusted average equity capital of the head company or single resident company is adjusted and increased to include:

•

the ADI equity capital of the foreign bank attributable to each of its Australian branches (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

[Schedule 3, item 8, subsections 820-613(2) and (3)]

1.120 This amendment to subsections 820-613(2) and (3) applies for income years commencing on or after 1 July 2003.

How does Subdivision 820-D apply to a resident TC group?

1.121 The new definition of equity capital has no application to resident TC groups as entities are unable to form a resident TC group for income years that commence on or after 1 July 2003.

Definition of equity capital

1.122 In the existing law, the meaning of equity capital varies depending on the classification of an entity. There are 3 different definitions depending on whether the entity is an outward investing ADI, a trust or partnership, or any other type of entity.

1.123 The amendments provide a new definition of equity capital that applies to all entities. The definition incorporates the concept of an 'equity interest' as defined in Subdivision 974-C and in section 820-930 for trusts and partnerships. An equity interest is valued at its issue price less any unpaid amount. [Schedule 3, items 11 and 12, definitions of 'equity capital' and 'equity interest in an entity' in subsection 995-1(1)]

1.124 Equity capital also includes:

•

general reserves and asset revaluation reserves;

•

opening retained earnings (less any distributions declared but not paid that are not attributable to the entity's earnings for the current year) or accumulated losses (i.e. negative retained earnings);

•

current year earnings (net of expected tax and distributions) or losses; and

•

provisions for distributions.

1.125 These amendments clarify the initial policy intention by clearly stating that current year profits (or losses) and provisions for distributions are included in the definition of equity capital. It also clarifies that accumulated losses (or negative retained earnings) are a deduction against equity capital.

1.126 The change in the definition of equity capital gives rise to a number of consequential amendments. The definition of worldwide equity also has to be amended. [Schedule 3, item 14, definition of 'worldwide equity' in subsection 995-1(1)]

1.127 The amendments include a new definition - that of ADI equity capital. This allows an ADI (or an entity applying the ADI rules) to include cost-free loans in its adjusted average equity capital or average equity capital for thin capitalisation purposes [Schedule 3, items 8 and 9, subsections 820-613(2) and (3) and 820-615(2)]. This provides similar treatment of cost-free loans to that available to non-ADIs. To be included in ADI equity capital a debt interest must be on issue for 90 days or more and not give rise to any costs for the issuer [Schedule 3, item 10, definition of 'ADI equity capital' in subsection 995-1(1)].

1.128 These amendments take effect from income years commencing on or after 1 July 2003.

Average equity capital

1.129 In situations where a head company or single resident company is treated as an inward investing entity (ADI), that head company or single resident company is required to apply the rules in Subdivision 820-E.

1.130 Resulting from the change to the equity capital definition that is applicable for income years commencing on or after 1 July 2003, the definition of average equity capital is also to be amended.

1.131 For income years commencing on or after 1 July 2003 the average equity capital of a head company or single resident company for the period will be the sum of:

•

ADI equity capital of the company for the test period; plus

•

the ADI equity capital of the foreign bank attributable to each of its Australian branches (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

[Schedule 3, item 9, subsection 820-615(2)]

Assets and liabilities

1.132 The thin capitalisation rules require an entity to comply with the accounting standards when determining the value of its assets, liabilities and equity. The terms 'assets' and 'liabilities' are not defined for the purposes of Division 820. Consequently, they have their normal legal meaning. This can lead to some assets or liabilities not being able to be valued using the accounting standards. Alternatively, some balance sheet items might not meet the normal legal meaning of asset or liability.

1.133 To overcome these anomalies the accounting standards are to be used to determine the definition of an asset and liability. [Schedule 3, item 16, subsection 820-680(1)]

1.134 An additional provision has also been inserted to remove any doubt that the requirements of subsection 820-680(1) to value assets and liabilities in accordance with accounting standards only covers those assets or liabilities that, according to the accounting standards, can or must be recognised at the relevant measurement time. [Schedule 3, item 17, subsection 820-680(1A)]

Foreign dividend account

1.135 The FDA operates so that an unfranked foreign sourced dividend paid to non-resident investors by a resident company is exempt from dividend withholding tax. Debiting the FDA account for non-deductible expenses incurred in relation to section 23AJ income is designed to ensure the FDA surplus correctly reflects the amount the company is able to pay its shareholders without there being any dividend withholding tax liability.

1.136 However, the interaction of section 25-90 with the FDA provisions has resulted in interest expenses that would otherwise give rise to an FDA debit now failing to satisfy the conditions for an FDA debit. This results in the FDA being overstated.

1.137 This amendment reinstates as an FDA debit, expenditure deductible due to the operation of section 25-90 that is incurred in respect to dividends exempt under section 23AJ. [Schedule 4, item 1, paragraph 128TB(1)(b)]

Application and transitional provisions

1.138 Amendments to Schedule 1 apply to income years that commence on or after 1 July 2001. [Schedule 1, item 1]

1.139 Amendments to Schedule 2 (except Part 5) and Schedule 4 apply to income years that commence on or after 1 July 2002. [Schedule 2, item 1; Schedule 4, item 2]

1.140 Amendments made by Schedule 2, Part 5 (except items 50 and 51) do not apply for the purposes of working out a capital gain made from a CGT event happening before 1 July 2002 [Schedule 2, item 49]. The amendment made by item 50 is to be taken always to have had effect [Schedule 2, item 51].

1.141 Amendments to Schedule 3, Parts 1 and 2 apply to income years that commence on or after 1 July 2003 [Schedule 3, items 15 and 18]. However, the application of Part 2 does not affect the interpretation of subsection 820-680(1) as it applies to income years that commence before that date.

Consequential amendments

1.142 The existing paragraphs 820-589(3)(a) and 820-589(3)(b) and the note to subsection 820-589(3) have been replaced by subsection 820-589(4) as a consequence of the amendments to subsection 820-589 (see paragraph 1.108). [Schedule 2, items 37 and 38]

1.143 Amendments to paragraphs 820-105(2)(d) and 820-215(2)(d) that change the reference from 'paragraph (e)' to 'paragraphs (e), (f) and (g)' results in the inclusion of additional factual assumptions when determining the arm's length debt amount. [Schedule 1, item 35, paragraph 820-105(2)(d); item 37, paragraph 820-215(2)(d)]

1.144 Amendments to subsections 262A(2AA), 262A(3) and paragraph 262A(3)(c) of the ITAA 1936 update references as a result of amendments to provisions covering both revaluation of assets and record keeping requirements for permanent establishments. [Schedule 1, items 16 and 17; Schedule 2, item 3]

1.145 Technical amendments to the calculation of safeharbour debt amount, cost-free debt capital are the result of the inclusion of the term excluded equity interest. [Schedule 2, items 4, 6, 7, 8, 10, 12, 14, 16, 18, 20 and 22 to 29]

1.146 A technical amendment to item 31 of Schedule 4 to the Taxation Laws Amendment Act (No. 7) 2000 ensures that section 110-37 is correctly located within the ITAA 1997 under the group heading 'What does not form part of the cost base'. At present, section 110-37 is inappropriately located above this heading. [Schedule 2, item 50]

1.147 Amendments to subsections 820-300(3), 820-330(3), 820-611(2) and paragraph 820-395(3)(a) result from the change in the definition of equity capital together with the inclusion of the term ADI equity capital. [Schedule 3, items 1 to 5 and 7]

1.148 The repeal of the definition of 'equity interest in a company' results from the change in the definition of an 'equity interest in an entity'. [Schedule 3, item 13]

Chapter 2 - Fringe benefits tax - certain exemptions for public hospitals

Outline of chapter

2.1 Schedule 5 to this bill amends subsection 5B(1E) and section 57A of the FBTAA 1986 to ensure that fringe benefits provided to employees whose duties are performed in, or in connection with, a public hospital will continue to be subject to the $17,000 capped FBT exemption, whether or not the hospital is a PBI.

2.2 This Schedule also amends section 140 of the FBTAA 1986 so that for the purposes of the remote area housing FBT exemption, a remote area for a public hospital will be one that is at least 100 kilometres from a population centre of 130,000 or more, whether or not the hospital is a PBI.

Context of amendments

2.3 Certain public hospitals are currently provided with an FBT exemption of up to $17,000 of grossed-up taxable value per employee. As part of the Government's response to the Report of the Inquiry into the Definition of Charities and Related Organisations, the FBTAA 1986 will be amended so that fringe benefits provided to employees whose duties are performed in, or in connection with, a public hospital will continue to be subject to the $17,000 capped FBT exemption, whether or not the hospital is a PBI.

2.4 Currently, public hospitals of the Commonwealth, a State or a Territory must be a PBI in order for the exemption to apply. This amendment will ensure that a change in the structure of these hospitals that results in their no longer meeting the PBI requirements does not cause them to lose access to the $17,000 capped FBT exemption.

2.5 Housing fringe benefits are FBT exempt where they are provided in a remote area. For public hospitals, a remote area is one that is at least 100 kilometres from a population centre of 130,000 or more. However, public hospitals of the Commonwealth, a State or a Territory must be a PBI for this treatment to be available to them.

2.6 The proposed amendment will ensure that for public hospitals, a remote area will continue to be one that is at least 100 kilometres from a population centre of 130,000 or more, whether or not the hospital is a PBI.

2.7 As these amendments are designed to ensure that public hospitals continue to be entitled to these concessions, they will not alter the current taxation treatment of public hospitals.

2.8 This measure will not affect the entitlement to these concessions of any other taxpayers.

Summary of new law

2.9 The amendments in this Schedule ensure that, whether or not a public hospital is a PBI:

•

public hospitals of the Commonwealth, a State or Territory will continue to have access to the $17,000 capped FBT exemption; and

•

for the purposes of the remote area housing FBT exemption, a remote area for a public hospital will be one that is at least 100 kilometres from a population centre of 130,000 or more.

2.10 As these amendments will allow all public hospitals to access these concessions, the provisions that specifically allow public hospitals that are not hospitals of the Commonwealth, a State or a Territory to receive these concessions are no longer required.

Detailed explanation of new law

$17,000 capped FBT exemption

2.11 Currently, public hospitals that are PBIs and public hospitals that are not a hospital of the Commonwealth, a State or a Territory receive an FBT exemption of up to $17,000 of grossed-up taxable value per employee. This means that public hospitals of the Commonwealth, a State or a Territory must qualify as a PBI in order for the capped FBT exemption to apply.

2.12 The amendments will provide an FBT exemption of up to $17,000 of grossed-up taxable value per employee where the employee works in a public hospital, and is employed by:

•

the public hospital; or

•

a government body.

[Schedule 5, items 1, 2, 4 and 5]

2.13 The amendments remove the requirement that public hospitals of the Commonwealth, a State or a Territory must also be a PBI in order to qualify for the exemption. [Schedule 5, items 1, 2, 4 and 5]

2.14 As this measure will allow all public hospitals to access this concession, the provision that specifically allows public hospitals that are not hospitals of the Commonwealth, a State or a Territory to receive this concession is no longer required. [Schedule 5, items 2, 4 and 5]

Exemption for remote area housing fringe benefits

2.15 Housing fringe benefits are FBT exempt where provided in a remote area. In relation to public hospitals, a remote area is one that is at least 100 kilometres from a population centre of 130,000 or more. However, public hospitals of the Commonwealth, a State or a Territory must be a PBI for this treatment to apply. Other employers receive an exemption where the fringe benefit is provided at least 40 kilometres from a population centre of 14,000 or more and at least 100 kilometres from a centre of 130,000 or more.

2.16 The amendments provide that in relation to public hospitals, a remote area will be one that is at least 100 kilometres from a population centre of 130,000 or more, where the employee works in a public hospital, and is employed by:

•

the public hospital; or

•

a government body.

[Schedule 5, items 6 and 7]

2.17 The amendments remove the requirement that public hospitals of the Commonwealth, a State or a Territory must also be a PBI in order for this treatment to be available. [Schedule 5, items 6 and 7]

2.18 As this measure will allow all public hospitals to receive this treatment, the provision that specifically allows public hospitals that are not hospitals of the Commonwealth, a State or a Territory to receive this treatment is no longer required. [Schedule 5, items 6 and 7]

Application provisions

2.19 These amendments apply in relation to benefits provided on or after 1 April 2003. [Schedule 5, item 8]

2.20 These amendments are designed to preserve the current treatment for public hospitals under these exemption provisions. As such, there will be no disadvantage to taxpayers by applying these amendments retrospectively.

Chapter 3 - Reducing tax on excessive component of ETPs

Outline of chapter

3.1 Schedule 6 to this bill will amend the Income Tax Rates Act 1986, the Superannuation Contributions Tax (Assessment and Collection) Act 1997 and the Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997 to reduce tax on the excessive component of an ETP. The amendments will:

•

impose a tax rate of 38% plus the Medicare levy on that portion of the excessive component of an ETP that reflects the taxed element of the retained amount of the post-June 1983 component of the ETP (called the post-June 1983 taxed element here). The remainder of the excessive component will continue to be taxed at 47% plus the Medicare levy; and

•

reduce the amount of the surchargeable contributions reported by a superannuation fund for a year in which it paid an ETP with an excessive component.

Context of amendments

Background

3.2 The excessive component of an ETP is the portion of the payment that exceeds the taxpayer's RBL. For the 2002-2003 income year the lump sum RBL is $562,195. If the ETP is a death benefit then the relevant RBL is the pension RBL of the deceased, which is $1,124,384 in 2002-2003. The RBL is designed to limit the maximum amount of concessionally taxed superannuation benefits that a person may receive in their life time. The excessive component of an ETP is currently subject to a tax rate of 47% plus the Medicare levy.

3.3 Under current taxation arrangements for ETPs paid from a superannuation fund which has been taxed on contributions, there is the potential for the excessive component of an ETP to be subjected to an effective rate of tax greater than 47% plus the Medicare levy.

3.4 Also, in the year the excessive ETP is paid, it is possible that superannuation surcharge may be payable on the surchargeable contributions made during the year. When combined with the tax payable on the excessive component of the ETP, the surcharge liability could also increase the taxpayer's effective tax rate above 47% plus the Medicare levy in that year.

3.5 In the 2002-2003 Federal Budget the Government confirmed it would reduce the effective rate of tax on the excessive component portion of an ETP.

3.6 The requirement that superannuation funds withhold tax at 48.5% where a member does not quote their TFN to the fund will not change. Also those who do not quote their TFN and have a surcharge liability will not qualify for the surcharge reduction.

Summary of new law

3.7 There are a number of components to an ETP. However only some of them count toward the RBL and therefore potentially contribute to an excessive superannuation benefit. In the case of an ETP paid by a superannuation fund, these are the:

•

retained amount of the CGT exempt component;

•

retained amount of the pre-July 1983 component;

•

85% of the untaxed element of the retained amount of the post-June 1983 component; and

•

taxed element of the retained amount of the post-June 1983 component.

3.8 The proposed amendments tax the post-June 1983 taxed element of an excessive component of an ETP (this element has been already subject to contributions tax) at 38% plus the Medicare levy rather than at 47% plus the Medicare levy as at present. The remainder of the excessive component of the ETP would continue to be taxed at 47% plus the Medicare levy.

3.9 If an ETP from a superannuation fund has an excessive component, any surchargeable contributions reported by the fund for that year, in respect of the relevant member, will be reduced. The surchargeable contributions will be reduced by the lesser of the amount of the grossed up excessive component or the surchargeable contributions; where

•

the grossed up excessive component is equal to the excessive component, grossed up for any post-June 1983 taxed element of the excessive component. Grossing up is achieved by dividing the post-June 1983 taxed element of the excessive component by 0.85%.

Detailed explanation of new law

Definitions

3.10 This bill will insert the definition of an ETP, post-June 1983 component, retained amount and taxed element into the Income Tax Rates Act 1986. [Schedule 6, items 1 to 4]

How are the rates of tax applied?

3.11 The amendment introduces a new tax rate of 38% into Schedule 7 (General rates of tax) and Schedule 9 (Rates of tax by reference to notional income) of the Income Tax Rates Act 1986, for resident and non-resident taxpayers. [Schedule 6, items 5 to 8]

3.12 The Schedules apply the new tax rate to the excessive component part of the taxable income that represents the taxed element of the post-June 1983 component. The remainder (if any) of the excessive component part of the taxable income is taxed at the rate of 47% (plus the Medicare levy). [Schedule 6, items 5 to 8]

3.13 This treatment is achieved by calculating what the taxed element of the retained amount of the post-June 1983 component of the ETP would have been if the excessive component had been zero. The amount of the excessive component part of the taxable income that equals the difference between this amount and the actual taxed element of the retained amount of the post-June 1983 component of the ETP is subject to the 38% tax rate plus the Medicare levy. If the ETP is a death benefit paid to a dependant then section 27AAA of the ITAA 1936 is disregarded in determining the amount to which the lower tax rate applies. The remainder (if any) of the excessive component part of the taxable income is taxed at a rate of 47% plus the Medicare levy. [Schedule 6, items 5 to 8]

Example 3.1

Nick receives an ETP from a superannuation fund of $50,000. All of the ETP is post-June 1983 component (the whole of which is a taxed element).

Due to Nick's previous superannuation benefits, the Commissioner determines that the entire ETP is excessive. The Commissioner recalculates the components of the ETP, and finds that all of the components are nil except for the excessive component of $50,000.

If the excessive component had been nil, the taxed element of the retained amount of the post-June 1983 component of the ETP would have been $50,000. Due to the determination that the benefit is excessive, the Commissioner has reduced this amount to nil. The difference between these amounts, that is $50,000, is taxed at 38% (plus the Medicare levy).

In this example there is no remaining part of the excessive component to tax at the 47% rate.

Example 3.2

Harry receives an ETP from his superannuation fund of $700,000, which consists of a post-June 1983 component of $450,000, (comprising a taxed element of $300,000 and an untaxed element of $150,000), and a pre-July 1983 component of $250,000.

The Commissioner makes an RBL determination taking into account Harry's previous superannuation benefits, and finds that $350,000 of the ETP is excessive.

The Commissioner recalculates the components of the ETP. The new taxed element of the post-June 1983 component is $150,000, the new untaxed element of the post-June 1983 component is $75,000, and the new pre-July 1983 component is $125,000.

The difference between $300,000 (the taxed element of the post-June 1983 component of the original ETP) and $150,000 (the taxed element of the post-June 1983 component of the ETP recalculated by the Commissioner after the determination of the excessive component), is $150,000. This amount represents the post-June 1983 taxed element of the excessive component and is taxed at 38% plus the Medicare levy.

The remainder of the excessive component (i.e. $200,000) is subject to a tax rate of 47% plus the Medicare levy.

Example 3.3

Susan receives an ETP from the superannuation fund of her deceased husband, Tom. The amount of the ETP is $50,000 and it is entirely a post-June 1983 component (the whole of which is a taxed element).

Due to Tom's previous superannuation benefits, the Commissioner determines that $20,000 of the ETP is excessive. Therefore the taxed element of the post-June 1983 component is reduced to $30,000. Under section 27AAA of the ITAA 1936 the Commissioner further reduces the taxed element of the post-June 1983 component to nil.

If the excessive component had been nil and section 27AAA of the ITAA 1936 is disregarded, then the taxed element of the post-June 1983 component would have been $50,000. The difference between this amount and the taxed element of the post-June 1983 component of the ETP of $30,000 (after the Commissioner determined an excessive component, but still disregarding section 27AAA) is $20,000. This amount represents the post-June 1983 taxed element of the excessive component for the purposes of the measure and is taxed at 38%.

Note: If section 27AAA is not ignored then the section would automatically reduce the $50,000 and $30,000 amounts in the previous paragraph of the example to nil. The difference between the two would be nil and consequently the entire excessive component would be taxed at 47%.

How are the surchargeable contributions reduced?

3.14 The amendments to section 8 of the Superannuation Contributions Tax (Assessment and Collection) Act 1997 and to section 9 of the Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997 insert a method for calculating the reduced surchargeable contributions where an ETP with an excessive component has been paid.

3.15 The reduction in surchargeable contributions is only in respect of the fund (if any) that has paid the member an ETP with an excessive component and only in respect of the financial year in which the ETP is paid.

3.16 The amount of surchargeable contributions of a member for a financial year is the amount worked out under subsection 8(2) or (3) of the Superannuation Contributions Tax (Assessment and Collection) Act 1997, reduced by the amount worked out under subsection 8(9), if:

•

a superannuation fund, approved deposit fund or retirement savings account pays an ETP to the member in the financial year; and

•

the ETP has an excessive component.

3.17 New subsection 8(9) sets out the steps for calculating the amount of the reduction. The members surchargeable contributions can not be reduced to less than zero, so the reduction is the lesser of the member's original surchargeable contributions reported by the payer of the ETP and a grossed up form of the excessive component (steps 7 and 8).

3.18 The grossed up excessive component takes into account the fact that contributions tax may have reduced the size of the excessive component.

3.19 The taxed element of the retained amount of the post-June 1983 component of the ETP is subtracted from the amount that would have been the taxed element of the retained amount of the post-June 1983 component of the ETP if the excessive component of the ETP had been nil (steps 1 to 3). This amount represents the part of the excessive component that has been subject to contributions tax.

3.20 Dividing this amount by 0.85 increases it to an amount that represents the level of taxed contributions involved in generating the excessive component (step 4).

3.21 The size of this increase is found by subtracting the amount that represented the part of the excessive component that has been subject to contributions tax (step 5).

3.22 The size of the increase is added to the excessive component to get the grossed up form of the excessive component (step 6).

3.23 As noted above, the member's surchargeable contributions are reduced by the lesser of the grossed up form of the excessive component and the member's original surchargeable contributions to the payer of the ETP (steps 7 and 8).

3.24 The reduction in surchargeable contributions effectively prevents the surcharge from applying in addition to the tax on the excessive component of an ETP for the year in which the ETP is paid.

3.25 Similarly subsections 9(2) and (4), and new subsections 9(9) and (10) of the Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997 apply in the same way as the above to reduce the surchargeable contributions for members of these funds. [Schedule 6, items 11 and 16]

3.26 This bill also amends the adjusted taxable income provisions in the Superannuation Contributions Tax (Assessment and Collection) Act 1997 to ensure that the calculation of the adjusted taxable income is not affected by the changes in this bill. The adjusted taxable income of members of constitutionally protected superannuation funds is also unaffected by these changes. [Schedule 6, items 9 and 10]

Example 3.4

Maria receives an ETP from her superannuation fund of $602,000, which consists of a post-June 1983 component of $541,800 (the whole of which is a taxed element) and a pre-July 1983 component of $60,200.

The Commissioner makes an RBL determination and finds that in this example $17,000 of the ETP is excessive. The Commissioner recalculates the components of the ETP. The new taxed element of the post-June 1983 component is $526,500, the new pre-July 1983 component is $58,500, the remaining $17,000 of the ETP is an excessive component.

Maria's superannuation fund reports to the Commissioner $30,000 of surchargeable contributions in respect of Maria for the financial year in which she receives her ETP.

The Commissioner reduces Maria's surchargeable contributions by an amount determined by following the steps in new subsection 8(9):

•

the amount that would have been the taxed element of the retained amount of the post-June 1983 component of the ETP if the excessive component had been nil is $541,800 (step 1);

•

the taxed element of the retained amount of the post-June 1983 component of the ETP is $526,500 (step 2);

•

the difference between these amounts is $15,300 (step 3);

•

$15,300 divided by 0.85 is $18,000 (step 4);

•

the increase over $15,300 is $2,700 (step 5);

•

adding this amount to the excessive component gives $19,700 (step 6);

•

the surchargeable contributions reported by the fund that paid Maria her ETP for the relevant year are $30,000 (step 7); and

•

the lesser of $19,700 and $30,000 is $19,700 (step 8).

Maria's surchargeable contributions are reduced by $19,700. If Maria has no other surchargeable contributions (to other funds for example) her new surchargeable contributions would be $10,300.

Definitions

3.27 This bill will insert the definition of excessive component, post-June 1983 component, retained amount and taxed element into the Superannuation Contributions Tax (Assessment and Collection) Act 1997. [Schedule 6, items 12 to 15]

3.28 This bill will insert the definition of excessive component, post-June 1983 component, retained amount and taxed element into the Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997. [Schedule 6, items 17 to 20]

Technical correction

3.29 This bill will amend the definition of excessive component part of the taxable income in the Income Tax Rates Act 1986 to include a reference to the Income Tax Assessment Act 1936. This is a technical correction of a drafting error. [Schedule 6, item 22]

Application

3.30 The amendments described in paragraphs 3.1 to 3.27 will apply to ETPs made on or after 1 July 2002. [Schedule 6, item 21]

3.31 The amendment described in paragraph 3.28 applies to assessments for the 1994-1995 year and later years of income. [Schedule 6, item 23]

Regulation impact statement - Policy objective

3.32 The policy objective of this measure is to reduce the effective rate of tax on the excessive component of an ETP paid by a superannuation fund.

3.33 The excessive component of an ETP is the amount that exceeds the member's RBL. The lump sum RBL for the 2002-2003 income year is $562,195. (It is indexed annually.) Currently, the excessive component of an ETP from a superannuation fund is subject to tax at 47%, plus the Medicare levy of 1.5%.

3.34 Some of the excessive component may have been subject to contributions tax when it was contributed to the superannuation fund, as well as being subject to tax at 48.5% when withdrawn from the super fund. Depending on a taxpayer's individual circumstances, superannuation surcharge may also have been payable. As such, the effective rate of tax on some of the excessive component may exceed 48.5%.

Implementation options

3.35 This bill reduces the tax rate payable on that portion of the excessive component of an ETP that reflects the taxed element of the retained amount of the post-June 1983 component of the ETP to 38% plus the Medicare levy. The remainder of the excessive component will continue to be taxed at the rate of 47% plus the Medicare levy.

3.36 Currently the whole amount of the excessive component of an ETP is taxed at the rate of 47% plus the Medicare levy.

3.37 The implementation of this measure could extend to reducing the tax rate on the whole amount of the excessive component of an ETP. However, this would be inconsistent with the policy objective of the measure.

3.38 With regard to superannuation surcharge, any surchargeable contributions reported by the fund in respect of the member for the year in which the excessive ETP is paid, will be reduced. The surchargeable contributions will be reduced by the lesser of the amount of the grossed up excessive component or the surchargeable contributions. The grossed up excessive component is equal to the excessive component, grossed up for any post-June 1983 taxed element. (The grossing up ensures that taxpayers are not disadvantaged because contributions tax has been paid.)

Assessment of impacts

3.39 This measure will impact on those taxpayers who receive an excessive ETP. Such taxpayers will benefit from the tax rate and superannuation surcharge reduction for ETPs made on or after 1 July 2002.

3.40 Superannuation funds currently provide information to the ATO regarding the components of an ETP when one is paid to a member. As such, it is expected that superannuation funds will incur minimal additional compliance costs because of the reduction in the tax rate applying to the post-June 1983 taxed component.

3.41 Superannuation funds currently report surchargeable contributions for each member to the ATO each year. This information, together with information on the amount of the excessive ETP will be used to ascertain by how much the surchargeable contributions should be reduced. As such, it is expected that superannuation funds will incur minimal additional compliance costs for this aspect of the measure.

Government revenue

3.42 The revenue cost of this measure is expected to be $5 million in each of 2003-2004, 2004-2005 and 2005-2006.

Administration costs

3.43 The ATO uses the information provided by funds to ascertain (and then advise) taxpayers if they have an excessive ETP and of the amount of the excessive component. Taxpayers then use this information in completing their taxation return.

3.44 In administering this measure, the ATO will need to undertake further calculations in determining the tax rate payable on an excessive ETP since the various components will need to be calculated and the appropriate rate of tax applied before a tax assessment can be generated.

3.45 The ATO will also need to carry out additional calculations to determine by how much the surchargeable contributions made to the fund which paid the excessive ETP should be reduced.

3.46 This will impose additional compliance costs on the ATO, however the number of taxpayers who receive an excessive ETP each year is not large.

Chapter 4 - Application of same business test

Outline of chapter

4.1 Schedule 7 to this bill amends Division 165 of the ITAA 1997 to remove an anomaly that prevents a company from accessing the SBT to determine its eligibility to deduct a tax loss incurred in a previous year, or write off a bad debt, in circumstances where the company has failed the COT but is unable to identify the precise date on which that failure occurred.

Context of amendments

4.2 Under the income tax law taxpayers are entitled to deduct in an income year losses incurred in a previous income year. Special rules apply to companies.

4.3 Companies are allowed to deduct a prior year loss if they pass the COT. Broadly, more than 50% ownership of the company must be maintained from the beginning of the year of the loss until the end of the year in which the deduction is claimed. If the company does not pass this test, it can still claim a deduction if it passes the SBT. Broadly, a company must carry on the same business both immediately before the disqualifying change of ownership and during the year it claims the deduction for the loss.

4.4 Similarly, a company cannot deduct a debt that it writes off as bad in the current year unless it satisfies either the COT or the SBT.

4.5 Problems inherent in the current law have become apparent in circumstances where a company is unable to positively satisfy the COT, but is also unable to demonstrate a specific date on which it failed the COT. That is, the company is unable to establish a test time for which the SBT can be applied.

4.6 The amendments in Schedule 7 to this bill provide for a default test time at which the SBT can be applied if the company is unable to determine precisely when it has failed the COT.

Summary of new law

4.7 The new law widens the circumstances in which the SBT will be available to companies that have failed the COT. This is achieved by providing a default test time at which the SBT can be applied if the company is unable to determine precisely when it has failed the COT.

4.8 In the case of tax losses, the test time for application of the SBT is the latest time that the company can show that it has satisfied the COT.

4.9 However, if it is not practicable for the company to show that it has maintained the same owners for any period since the incurring of the loss, the default test time for application of the SBT is the start of the loss year or, if the company came into being during the loss year, the end of the loss year.

4.10 In the case of bad debts, the test time for application of the SBT is the latest time that the company can show that it has satisfied the COT.

4.11 However, if it is not practicable for the company to show that it has maintained the same owners for any period since the incurring of the bad debt, the default test time for application of the SBT will apply.

4.12 If the debt was incurred in the current year and the company was in being throughout the current year, the default test time is the start of the current year.

4.13 If the debt was incurred before the current year, or the company came into being during the current year, the default test time is the end of the day on which the debt was incurred.

4.14 The amendments proposed by this bill do not affect the rules required for satisfaction of the SBT contained in section 165-210. The amendments merely provide for a default test time in circumstances where the SBT would not otherwise be available to the company.

Detailed explanation of new law

The general rule

Restatement of current law

4.15 As part of providing a default test time for applying the SBT, the test time in the existing provisions is being restated. That is, for most companies the identifiable failure of the COT will continue to be the test time.

Extension of availability of the SBT

4.16 The new law also widens the circumstances in which the SBT can be applied, by providing a default test time at which the SBT can be applied if it is not practicable for the company to show precisely when it has failed the COT.

When is it not practicable for a company to show that it fails the COT?

4.17 Impracticability may arise where the necessary information on the beneficial ownership of shares does not exist or where the information cannot reasonably be obtained.

4.18 Also, a company may be able to identify the beneficial owners of its shares such that it may know that it has not satisfied the COT as between, say, the beginning of the loss year and the end of the income year. However, it may be impracticable to point to the time it actually failed the test.

Example 4.1

A majority shareholder in Company X is Company A, which is registered in a foreign country. Under the corporations registration laws in that country, Company A may voluntarily release the names of its shareholders or details of any change of ownership, but is not legally obliged to do so.

Company X seeks the information but Company A does not release it. Company X is not able to satisfy the COT for any period of time, as the inability of Company X to obtain details of any change of ownership of Company A means that it is not practicable for Company X to show that it has maintained the same owners.

Example 4.2

Company X is wholly-owned by a non-resident, Company A. More than 50% of the shares in Company A are bearer shares. While the information is sought Company X is unable to identify the beneficial owners.

Company X is not able to satisfy the COT for any period of time, as the inability to identify the beneficial owners of the bearer shares means that it is not practicable for Company X to show that it has maintained the same owners.

Default test time for the use of the SBT for deduction of tax losses

Current rules for applying the COT when seeking to deduct tax losses

4.19 Under the current law, the COT is satisfied if the company has maintained the same owners at all times during the period from the start of the loss year to the end of the income year. This is known as the ownership test period.

4.20 This bill does not amend the current rules for applying the COT when seeking to deduct tax losses.

Practicable to show that the company can satisfy the COT for some period

4.21 Where it is practicable for the company to show that it can satisfy the COT for some period of time, but not for the entire ownership test period, the test time for application of the SBT is the latest time that the company can demonstrate that it has satisfied the COT. [Schedule 7, item 1, subsection 165-13(2), item 1 in the table]

4.22 For a company that is able to point to the actual time of failure of the COT as required under the current provisions, the time of failure will equate to the latest time it is practicable to show that the company has satisfied the COT. There is no change in the test in this case. Companies that can demonstrate failure of the COT, or indeed satisfaction of it, will continue to be required to do so.

4.23 For a company that is able to demonstrate some period where it satisfies the COT but is unable to point to the actual time it failed the test, then the test time for application of the SBT is the latest point at which the company can show it satisfied the COT.

Impracticable to show failure of the COT

4.24 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the loss year, the default test time for application of the SBT is the start of the loss year. [Schedule 7, item 1, subsection 165-13(2), item 2 in the table]

Example 4.3

Company X, which came into being in 1997, incurs a tax loss during the 1999-2000 year and wishes to deduct this tax loss against income earned in the 2001-2002 year.

At all times Company X was wholly-owned by a non-resident, Company A and 75% of the shares in Company A are bearer shares. Company X is at no time able to determine the beneficial owner of these bearer shares.

As Company X is unable to determine the owner of the bearer shares, it is not practicable for Company X to demonstrate that there is a period for which it has maintained the same owners. Company X therefore has access to the SBT under subsection 165-13(2), item 2 in the table.

In order to deduct the loss, Company X must satisfy the SBT for the 2001-2002 income year by reference to the business Company X carried on immediately before the start of the loss year (i.e. 1 July 1999).

Impracticable to demonstrate failure of the COT and the company came into being during the loss year

4.25 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the loss year, and the company came into being during the loss year, the default test time for application of the SBT is the end of the loss year. [Schedule 7, item 1, subsection 165-13(2), item 3 in the table]

Example 4.4

Company X, which came into being on 1 September 1999, incurs a tax loss during the 1999-2000 year and wishes to deduct this tax loss against income earned in the 2001-2002 year.

At all times Company X was wholly-owned by a non-resident, Company A and 75% of the shares in Company A are bearer shares. Company X is at no time able to determine the beneficial owner of these bearer shares.

As Company X is unable to determine the owner of the bearer shares, it is not practicable for Company X to demonstrate that there is a period for which it has maintained the same owners. Company X therefore has access to the SBT under subsection 165-13(2), item 3 in the table.

In order to deduct the loss, Company X must satisfy the SBT for the 2001-2002 income year by reference to the business Company X carried on immediately before the end of the loss year (i.e 30 June 2000).

Default test time for the use of the SBT for deduction of bad debts

Current rules for applying the COT when seeking to deduct bad debts

4.26 The current law provides for a 'first continuity period' and a 'second continuity period'.

•

If the debt was incurred prior to the current year, the first continuity period is the period from the day the debt was incurred to the end of that income year, and the second continuity period is the current year.

•

If the debt was incurred in the current year, the first continuity period is the period from the start of the current year to the day the debt was incurred, and the second continuity period is the period from the day after the debt was incurred to the end of the current year.

4.27 Under the current law, the COT will be satisfied if the company can demonstrate that it has maintained the same owners at all times from the start of the first continuity period to the end of the second continuity period.

Practicable to show that the company can satisfy the COT for some period

4.28 Where it is practicable for the company to show that it can satisfy the COT for some period of time from the start of the first continuity period but not for the entire period through to the end of the second continuity period, the test time for application of the SBT is the latest time that the company can demonstrate that it has satisfied the COT. [Schedule 7, item 16, subsection 165-126(2), item 1 in the table]

4.29 For a company that is able to point to the actual time of failure of the COT as required under the current provisions, the time of failure will equate to the latest time it is practicable to show that the company has satisfied the COT. There is no change in the test in this case. Companies that can demonstrate failure of the COT, or indeed satisfaction of it, will continue to be required to do so.

4.30 For a company that is able to demonstrate some period where it satisfies the COT but is unable to point to the actual time it failed the test, then the test time for application of the SBT is the latest point at which the company can show it satisfied the COT.

Debt incurred before the current year

4.31 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the debt was incurred before the current year, the default test time for the application of the SBT is the end of the day on which the debt was incurred. [Schedule 7, item 16, subsection 165-126(2), subitem 2(a) in the table]

Example 4.5

Company X incurs a debt on 14 September 1999 and writes off the debt as bad during the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the bad debt, Company X must demonstrate that it satisfies the SBT for the current year (i.e. 2001-2002) by reference to the business the company carried on immediately before the end of the day on which the debt was incurred (i.e. 14 September 1999).

The company came into being during the current year

4.32 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the company came into being during the current year, the default test time for the application of the SBT is the end of the day on which the debt was incurred. [Schedule 7, item 16, subsection 165-126(2), subitem 2(b) in the table]

Example 4.6

Company X comes into being on 2 August 2001. Company X incurs a debt on 28 October 2001 and writes off the debt as bad during the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the debt, Company X must demonstrate that it satisfies the SBT for the period from 29 October 2001 to the end of the 2001-2002 year by reference to the business the company carried on immediately before the end of the day on which the debt was incurred (i.e. 28 October 2001).

Debt incurred in the current year and the company in being through the current year

4.33 If it is not practicable for the company to show that it has maintained the same owners for any period since the start of the first continuity period, and the debt was incurred in the current year, and the company was in being throughout the current year, the default test time for the application of the SBT is the start of the current year. [Schedule 7, item 16, subsection 165-126(2), item 3 in the table]

Example 4.7

Company X incurs a debt on 15 December 2001 and writes off the debt as bad during the 2001-2002 income year. Company X is in being throughout the 2001-2002 income year.

Company X has determined that it is not practicable for it to show that there is any period for which it satisfies the COT.

In order to deduct the debt, Company X must demonstrate that it satisfies the SBT for the period from the day after the debt was incurred (i.e. 16 December 2001) to the end of the 2001-2002 year by reference to the business the company carried on immediately before the start of the current year (i.e. 1 July 2001).

Effect of amendments on listed public companies

4.34 The amendments in this bill do not affect the operation of Division 166, which deals with the income tax consequences of changing ownership or control of a listed public company.

4.35 Subsection 166-5(3) provides that a listed public company is taken to have failed to meet the conditions in section 165-12 if there has been no substantial continuity of ownership of the company between the start of the loss year and the end of any income year, or any time of abnormal trading, that occurs during the ownership test period. As the subsection provides a specific deemed failure of the COT, listed public companies in this situation have automatic access to the SBT by virtue of the test time specified in subsection 166-5(5).

4.36 A company's ability to choose under section 166-15 that Subdivisions 165-A is to apply to it without the modifications made by Subdivision 166-B is not affected in any way by the amendments to Division 165 made by this bill. Consequently, listed public companies can access the default times in section 165-13 by making the choice under section 166-15.

4.37 A company's ability to choose under section 166-50 that Subdivision 165-C is to apply to it without the modifications made by Subdivision 166-C is not affected in any way by the amendments to Division 165 made by this bill. Consequently, listed public companies can access the default times in section 165-126 by making the choice under section 166-50.

Effect of amendments on existing Subdivision 165-F

4.38 Subdivision 165-F contains special provisions applying an alternative COT to companies owned by non-fixed trusts. These special provisions provide that if a company does not meet the conditions in section 165-12 for satisfaction of the COT, the company is nevertheless taken to meet those conditions if it satisfies the conditions under section 165-210 in Subdivision 165-F.

4.39 Subdivision 165-F applies both for the purposes of sections 165-12 and 165-123 in their own right and for the purposes of the notional application of those sections by sections 165-13 and 165-126 respectively.

4.40 The amendments to sections 165-13 and 165-126 apply in any circumstance where there is a failure, or deemed failure, of the COT under the ITAA 1997.

4.41 A company that is substantially owned by non-fixed trusts may be able to satisfy the requirements of Subdivision 165-F for some period after the commencement of the loss year but not for the whole of the ownership test period. In that case that company will be able to access the SBT by reference to the business carried on by the company immediately before the last time, during the ownership test period, it was practicable to show the requirements of Subdivision 165-F were satisfied.

Application and transitional provisions

4.42 The amendments relating to the use of the SBT to deduct prior year losses applies for the 1997-1998 income year and all later income years, however an amendment affecting a provision does not apply to anything to which the provision did not apply before the amendment.

4.43 The amendments relating to the use of the SBT to deduct bad debts written off applies for the 1998-1999 income year and all later income years.

4.44 Note that section 4 of this bill ensures that section 170 does not prevent amended assessments that may be required to give effect to these measures.

Consequential amendments

4.45 A technical correction is necessary to amend subsection 166-40(5) to remove an incorrect reference to paragraphs 2(a) and (b) and replace with a reference to the correct paragraphs 2(c) and (d). However, this technical correction does not affect the substance of the amendments proposed by this bill.

4.46 As a result of the reformatting of the SBT test time in table format, consequential amendments are necessary so as to make reference to the single 'condition' in each of sections 165-13 and 165-126. [Schedule 7, item 2, paragraph 165-10(b); item 4, subsection 165-115B(4); item 5, subsection 165-115BA(4) and (5); item 7, paragraph 707-125(1)(b); item 8, subsection 707-125(2); item 12, note to subsection 719-260(2); item 17, paragraph 165-120(1)(c)]

4.47 As a result of the change in terminology from 'continuity period' to 'test time', consequential amendments are necessary so as to make reference to the test time established by sections 165-13 and 165-126 and to amend the definitions. [Schedule 7, item 3, subsection 165-115B(3); item 6, paragraph 165-115BA(5)(c); item 9, subparagraph 707-125(2)(a)(ii); item 10, note to subsection 707-125(2); item 11, subsection 715-90(2); items 13, 14 and 21, definition of 'test time' in subsection 995-1(1); items 18 and 19, section 165-132; item 20, definition of 'minimum continuity period' in subsection 995-1(1)]

Chapter 5 - Tax losses

Outline of chapter

5.1 The amendments contained in Schedule 8 will ensure that corporate tax entities are no longer required to use up ('waste') losses that could be deductible in a later year of income against franked dividend (effectively tax-free) income.

5.2 Firstly, corporate tax entities will be able to choose the amount of prior year losses they wish to deduct in a later year of income. Providing choice also means that corporate tax entities could choose not to deduct prior year losses in order to pay sufficient tax to be able to frank their distributions.

5.3 Secondly, corporate tax entities will be able to treat a current year loss that would otherwise be used up against franked dividend income as a tax loss for that income year and be able to carry forward the tax loss for consideration as a deduction in a later year of income. The relevant current year loss will be identified by reference to the amount of any unused franking tax offset for the income year.

Context of amendments

Choosing to deduct a prior year loss

5.4 The Review of Business Taxation gave consideration to the operation of the income tax law whereby a corporate tax entity cannot choose the amount of prior year tax loss it wishes to deduct and specifically the impact of the new consolidation regime. Broadly, where a taxpayer has a prior year tax loss then to the extent the taxpayer has an excess of assessable income over allowable deductions in a later year of income the prior year tax loss must be deducted.

5.5 Corporate groups would usually structure to ensure that distributions from outside the group are paid to the holding company with any losses held by subsidiaries. Under the previous loss transfer provisions, the holding company and subsidiary could agree on the amount of loss to be transferred. This allows the holding company the option of not absorbing group losses against distributions received by the holding company from outside the group. The requirement to pool group losses under consolidation removes this option.

5.6 Recommendation 11.5 of A Tax System Redesigned recommended that corporate entities be able to choose the proportion of their prior year losses to be deducted in an income year.

5.7 The Review of Business Taxation also concluded that providing choice enables corporate tax entities to fully frank distributions even when they have large prior year losses. By not fully claiming the losses, a corporate tax entity could pay sufficient tax to frank the distributions.

Current year losses

What is a 'current year' loss?

5.8 In the context of this measure a current year loss is a tax loss (the excess of allowable deductions over assessable and exempt income) that a company would have otherwise incurred for an income year but for deriving franked dividend income in that year. For example, a company may have a trading loss of $100 but also received a fully franked dividend of $70. In calculating its taxable income the company is required to gross up the franked dividend by including the $30 imputation credit. The $100 trading loss is required to be deducted against the $100 grossed up amount with a resulting taxable income figure of $0. There is a notional entitlement to a franking tax offset of $30 but it is not used.

How are current year losses 'wasted'?

5.9 In the example in the previous paragraph, if the company was able to quarantine the trading loss from its taxable income calculation then its taxable income would be the grossed up franked dividend amount of $100. However, applying the franking rebate reduces the tax on the taxable income to nil. The loss can be said to be wasted because the company can achieve a nil tax outcome without using the loss.

Summary of new law

5.10 The general rule applying to all taxpayers on how to deduct prior year losses will be complemented by a specific rule that will apply to corporate tax entities. The new rule will operate in a similar manner to the general rule, by offsetting the prior year tax loss first against net exempt income. However, beyond that, corporate tax entities will be able to choose the amount of the tax loss they want to deduct. In certain circumstances that choice will be able to be changed.

5.11 For current year losses, unused franking tax offsets (the excess franking offsets) will be identified as part of the income tax calculation. The amount of excess franking offsets will be converted to an equivalent amount of a tax loss and aggregated with any other tax loss for the income year.

Detailed explanation of new law

Confining the application of the general rule on how to deduct tax losses

5.12 Section 36-15 of the ITAA 1997 is the general rule for all taxpayers on how to deduct tax losses. Because a special rule is to be inserted for corporate tax entities, section 36-15 needs to be amended to indicate its more narrow application to entities other than corporate tax entities. [Schedule 8, items 7 and 8, section 36-15 (heading), subsection 36-15(1) of the ITAA 1997]

How corporate tax entities will deduct tax losses

Corporate tax entities

5.13 The new rule will apply to corporate tax entities. Section 960-115 of the ITAA 1997 defines corporate tax entities as companies, corporate limited partnerships, corporate unit trusts and public trading trusts.

5.14 The distinguishing feature of these entities is that they are generally not entitled to a refund of excess franking offsets. Those who are entitled to such refunds (individuals, complying superannuation funds and certain other entities) are not affected by the absorption of prior year losses by franked dividend income. Refundable excess franking tax offsets effectively give these taxpayers the full benefit of the losses immediately.

Tax loss is to be absorbed first by the net exempt income

5.15 As with the general rule a corporate tax entity will be required to first deduct a prior year tax loss from any net exempt income in the later income year.

5.16 If there is no exempt income an entity can deduct so much of the tax loss as it chooses subject to the limitation set out below. [Schedule 8, item 9, subsection 36-17(2) of the ITAA 1997]

5.17 If the entity has:

•

net exempt income; and

•

assessable income exceeds allowable deductions (other than the tax loss),

the tax loss has to be first applied against net exempt income and then the entity can deduct the amount of the tax loss (if any remains) that it chooses subject to the limitation set out below. [Schedule 8, item 9, subsection 36-17(3)]

5.18 Conversely, if the entity has:

•

net exempt income; and

•

allowable deductions (other than the tax loss) exceed assessable income,

that excess must be applied against net exempt income and then the tax loss must be applied against any net exempt income that remains. There is no choice in this situation. [Schedule 8, item 9, subsection 36-17(4)]

5.19 In those circumstances where the entity has a choice it can choose a nil amount.

5.20 An entity's choice must be made in the income tax return for the relevant income year [Schedule 8, item 9, subsection 36-17(6)]. However, see below for an explanation of the circumstances when an entity can change its choice and how it does so.

A limit where an entity already has or can generate excess franking offsets for the income year

5.21 As part of this measure amendments are being made to ensure a corporate tax entity does not waste current year losses against franked dividend income. The current year loss is identified by reference to any franking tax offset that is unused (excess franking offsets) by the entity.

5.22 If an entity has excess franking offsets without deducting any amount of a tax loss then it must choose to deduct no amount of the tax loss. [Schedule 8, item 9, paragraph 36-17(5)(a)]

5.23 Similarly an entity cannot choose an amount of tax loss that would give rise to an excess franking offset [Schedule 8, item 9, paragraph 36-17(5)(b)]. Subsection 36-17(5) includes a detailed example.

5.24 If corporate tax entities were allowed to generate an excess franking offset which is then converted into a tax loss for the income year the tax loss would be 'refreshed'. That is, the prior year tax loss would become a tax loss of a later year of income. This impacts on the application of the tests for deductibility of prior year losses, specifically the continuity of ownership test in Subdivision 165-A of the ITAA 1997. Broadly, the time for testing for continuity of ownership would move to the start of the later income year in which the tax loss had been refreshed.

Changing the amount of tax loss originally chosen for deduction

5.25 When an entity chooses to deduct an amount of a tax loss it must do so in its income tax return for the relevant year of income. After an entity has lodged its tax return for the income year, in certain circumstances it will be able to either:

•

make an initial choice where it was not previously allowed to make a choice [Schedule 8, item 9, subsection 36-17(11)] ; or

•

choose another amount of tax loss over an amount previously chosen [Schedule 8, item 9, subsection 36-17(12)].

5.26 Where an entity makes an initial choice or a revised choice after lodging its income tax return it will need to notify the Commissioner in writing.

5.27 There are 3 situations when an entity can make a later initial choice or change its choice. These involve the recalculation of amounts that are generally relevant to the consideration of the amount of tax loss originally chosen.

5.28 The first situation is where the amount of tax loss an entity can deduct is recalculated. For example, as the result of a review an entity ascertains that its tax loss of an earlier income year is greater than previously calculated. Provided there is sufficient net assessable income in the later income year the entity can change its choice and deduct the increased tax loss. [Schedule 8, item 9, paragraph 36-17(10)(a)]

5.29 The second situation is where, in relation to the income year in which the tax loss is deductible, the amount of difference between assessable income and allowable deductions is recalculated.

Example 5.1

Assuming no net exempt income, Company A originally had an excess of assessable income over allowable deductions of $100. It has sufficient prior tax losses to reduce that excess to nil and chooses in its tax return to deduct a tax loss of $100.

Subsequent to lodging its income tax return, Company A reviews its tax affairs and ascertains it has an excess of $200. Because it has sufficient losses available it changes its choice and deducts a tax loss of $200.

[Schedule 8, item 9, paragraph 36-17(10)(b)]

5.30 The third situation is where, in relation to the income year in which the tax loss is deductible, the amount of net exempt income is recalculated. [Schedule 8, item 9, paragraph 36-17(10)(c)]

5.31 The ability to make initial choices or change choices after lodging the tax return for the income year in these circumstances ensures that the operation of section 36-17 closely mirrors section 36-15, the general rule for deducting tax losses. In the circumstances set out in subsection 36-17(12), section 36-15 would have operated such that the tax loss amounts deducted would be adjusted automatically.

General rules

5.32 There are some general rules that apply to the deduction of tax losses under section 36-15 that will apply in the same way to tax loss deductions under section 36-17:

•

tax losses must be deducted in the order in which they are incurred [Schedule 8, item 9, subsection 36-17(7)] ;

•

once deducted a tax loss cannot give rise to another deduction [Schedule 8, item 9, subsection 36-17(8)] ; and

•

if a tax loss (or part of a tax loss) cannot be deducted it can be considered for deduction in the next income year [Schedule 8, item 9, subsection 36-17(9)].

Group loss transfer rules

5.33 Under the group loss transfer rules there is a limit to the amount of tax loss that one member of the group (the loss company) can transfer to another member of the group. Broadly, one of the rules is that the loss company can only transfer an amount of loss that the loss company itself cannot use.

5.34 Under the current rules this equates to the tax loss which the loss company carries forward. However, by providing choice the amount of tax loss carry forward may not represent the amount of tax loss the company could not use.

5.35 To ensure the rule is maintained the amount of loss that can be transferred is the amount that would have been the carry forward tax loss if the loss company had chosen to deduct the maximum amount of tax loss that it could deduct under section 36-17. This has the effect that if the loss company chooses to deduct a lesser amount of tax loss the amount of tax loss that can be transferred is similarly reduced. [Schedule 8, item 15, subsection 170-45(1) of the ITAA 1997]

Example 5.2

A loss company in a group has a prior year tax loss of $500. In a later year of income its total assessable income exceeds its allowable deductions by $200 (and there is no net exempt income). The loss company chooses a nil amount under subsection 36-17(2). The tax loss it would carry forward if it had deducted the maximum amount would have been $300 ($500 - $200). The amount that the loss company can transfer under the group loss provisions cannot exceed $300.

5.36 With the introduction of the consolidation regime the group loss transfer rules have limited ongoing application.

Current year losses

5.37 Broadly where an entity has excess franking tax offsets because it has insufficient tax payable on taxable income the amount of that excess is converted into an equivalent amount of tax loss. This tax loss is then aggregated with any other tax loss for the year and the aggregated amount becomes the tax loss for the income year.

Calculating excess franking offsets

5.38 Firstly, calculate the amount of franking tax offsets to which the entity is entitled. Franking tax offsets are available under Division 207 as a result of receiving a franked distribution and Subdivision 210-H as a result of receiving a distribution franked with a venture capital credit.

5.39 Excluded from this amount are any franking tax offsets that are refundable offsets. Generally corporate tax entities are not entitled to a refund of excess franking tax offsets and so this would normally be a nil amount. However, there is an exception for life insurance companies who may be entitled to refundable franking tax offsets. [Schedule 8, item 11, paragraph 36-55(1)(a) of the ITAA 1997]

5.40 Secondly, calculate the amount of income tax payable. In this calculation:

•

ignore the amount of offsets calculated in the first step as well as tax offsets subject to the refundable tax offset rules or the carry forward tax offset rules. (This enables these 2 types of offsets to be maximised.); and

•

take into account all other tax offsets, if any.

[Schedule 8, item 11, paragraph 36-55(1)(b)]

5.41 If the amount from step 1 exceeds the amount from step 2, the excess is the amount of excess franking offsets. This is a defined term. [Schedule 8, item 18, definition of 'excess franking offsets' in subsection 995-1(1)]

Converting the excess franking offset into a tax loss

5.42 The amount of excess franking offset is converted into an equivalent amount of tax loss (by dividing the amount by the corporate tax rate). This tax loss needs to be added to any tax loss otherwise calculated for the income year and the aggregate amount treated as the tax loss for the income year (known as a loss year). The method statement ensures the aggregate amount of tax loss has been properly reduced by any amount of net exempt income for the income year. [Schedule 8, item 11, subsection 36-55(2)]

Example 5.3

Company B has:

•

assessable income of $200 (being a fully franked dividend of $140 and the franking credit of $60);

•

allowable deductions of $400; and

•

net exempt income of $80.

Company B calculates its section 36-10 tax loss as $120 (i.e. $400  - $200  -  $80) and its excess franking offset amount under subsection 36-55(1) as $60.

Applying the method statement:

Step 1 amount: $200 ($400 - $200)

Step 2 amount: $200 ($60 / 30%)

Step 3 amount: $400 ($200 + $200)

Step 4 amount: $320 ($400 - $80)

Company B therefore has a tax loss for the year of $320.

Application and transitional provisions

5.43 The rule about choosing to deduct a prior year loss will apply to deductions of tax losses in the income year in which 1 July 2002 falls and later income years. [Schedule 8, subitems 24(1) and (2)]

5.44 Ensuring current year losses are not wasted will apply to the income year in which 1 July 2002 falls and later income years. [Schedule 8, subitem 24(3)]

5.45 The amendments to the PAYG provisions will apply to a base year that is an income year in which 1 July 2002 falls and later income years. [Schedule 8, subitem 24(4)]

Consequential amendments

PAYG instalment provisions

5.46 Broadly, an entity's instalment rate for working out PAYG instalments is based on an entity's notional tax which is its tax for the most recent year that has been assessed (called the base year) and based on an adjusted taxable income amount.

5.47 The adjusted taxable income of an entity is generally worked out by subtracting from its assessable income for its base year:

•

any net capital gain included in assessable income;

•

all deductions other than tax losses; and

•

any tax losses carried forward to the next income year.

5.48 This general rule is modified where the amount of tax losses deducted in a year of income does not necessarily reflect the amount of tax losses that could have been deducted. In this situation, to ensure that the adjusted taxable income is correctly calculated, the calculation subtracts the lesser of any tax loss deducted in the base year and the amount of any tax loss that is carried forward to the next year.

5.49 Because a corporate tax entity will be able to choose to deduct a prior year loss it means an amount deducted in a given year may be less than the pool of carry forward losses available to them. Consequently, the modification to the general rule will need to cover corporate tax entities generally. [Schedule 8, items 22 and 23, subsections 45-330(2A) and (3) in Schedule 1 to the TAA 1953]

Consolidation interactions

5.50 Consequential amendments are needed so that the new loss rules interact appropriately with rules in section 707-310 of the ITAA 1997 that restrict the use of transferred losses by consolidated groups.

5.51 The limit on the amount of transferred losses able to be used by the head company of a consolidated group will be set on the assumption that the head company chooses to use all its available group losses [Schedule 8, item 17B, paragraph 707-310(3A)(a)]. This prevents transferred losses from being used before group losses of the same kind.

5.52 Group losses are losses incurred by the consolidated group itself. Transferred losses are losses incurred by members of the group prior to consolidating and are transferred to the head company upon entry to consolidation. The consolidation loss rules were designed so that group losses should be used before transferred losses.

5.53 Other choices made by the head company in the calculation of its actual taxable income will apply for the purposes of deriving the limit on the amount of transferred losses it can use. [Schedule 8, item 17B, paragraph 707-310(3A)(b)]

5.54 Amendments will also ensure that the amount of transferred losses able to be used by a head company is reduced to reflect the amount of available franking offsets. This ensures that subsection 36-17(5) of the ITAA 1997, which prevents an entity from deducting an amount of prior year tax loss that would give rise to an excess franking offset, does not result in transferred losses being used before group losses of the same kind. [Schedule 8, item 17A, paragraph 707-310(3)(c); item 17B, paragraph 707-310(3A)(c)]

General consequential amendments

5.55 A note to the core provision that sets out the tax payable calculation will indicate the potential for franking tax offsets to be converted into a tax loss. [Schedule 8, item 4, note 3 to subsection 4-10(3A) of the ITAA 1997]

5.56 The list of special rules about tax losses in section 36-25 of the ITAA 1997 will now include a reference to the tax loss that has been converted from excess franking offsets. [Schedule 8, item 10, section 36-25, table headed 'tax losses of corporate tax entities' of the ITAA 1997]

5.57 A number of minor consequential amendments are needed where other areas of the law refer to how a tax loss is deducted. These references will need to be either to both section 36-15 (for taxpayers generally) and section 36-17 (for corporate tax entities) or only to section 36-17. [Schedule 8, item 1, section 245-110 in Schedule 2C to the ITAA 1936; item 2, section 57-75 in Schedule 2D to the ITAA 1936; item 3, note to subsection 268-60(5) in Schedule 2F to the ITAA 1936; item 4, note 3 to subsection 4-10(3A) of the ITAA 1997; item 12, note to subsection 165-70(5) of the ITAA 1997; item 14, subsection 170-20(1) of the ITAA 1997; item 16, note to subsection 175-35(5) of the ITAA 1997]

5.58 Minor consequential amendments are also needed to modify or include notes indicating that the term tax loss and/or loss year are being modified by the inclusion of section 36-55. [Schedule 8, items 5 and 6, note to section 36-10; item 13, note to section 165-70; item 17, note to section 175-35; items 19 to 21, notes to definitions of 'loss year' and 'tax loss' in subsection 995-1(1) of the ITAA 1997]

Regulation impact statement - Background

Current year losses

5.59 The imputation system operates such that when a taxpayer is paid a franked dividend both the amount of the dividend and the attached franking credit are included in assessable income (i.e. the assessable income is 'grossed up'). A tax offset equal to the amount of the franking credit is allowed. When a corporate tax entity receives a franked dividend it is effectively freed up from further tax as a result of the franking tax offset.

5.60 A corporate entity that would otherwise have a tax loss in an income year (a 'current year loss') is essentially required to use up that loss against any franked dividend income. Because the franked dividend income is effectively tax free the loss can be said to have been wasted.

5.61 Corporate groups have in the past been able to minimise the 5wastage of losses by separating the franked dividend income and losses between different members of the group. For example, dividend income could be received by the head company of the group while various trading activities (and any losses associated with those activities) could be contained within subsidiaries.

5.62 With the advent of the consolidation regime this ability to quarantine losses from franked dividend income has been removed.

Prior year losses

5.63 The general rule is that prior year losses are automatically deductible in a later year of income. To the extent there is an excess of assessable income over allowable deductions the prior year loss becomes a deduction in that later year of income (after first being deducted against net exempt income). The amount of loss is required to be calculated and deducted in the income tax return.

5.64 The requirement to deduct a prior year loss if there is taxable income available in a later year of income results in that loss being 'wasted' to the extent the income is franked dividend income.

Policy objective

5.65 The overall objective is to ensure that corporate tax entities have the full benefit of deducting current and prior year tax losses against taxable income.

Current year losses

5.66 The objective is to ensure that corporate tax entities do not have to use up losses against franked dividend income which is effectively freed up from tax because of the availability of the franking tax offset.

5.67 In the 2002-2003 Federal Budget the Government announced that from 1 July 2002 corporate tax entities would no longer be required to waste such losses against franked dividend income. This is to apply to all corporate tax entities not only consolidated groups.

Prior year losses

5.68 The objective is to allow corporate tax entities to choose when to deduct their prior year losses to avoid wasting them.

5.69 The Review of Business Taxation concluded that companies should not be required to waste prior year losses, specifically in the context of the introduction of the consolidation regime. Recommendation 11.5 of A Tax System Redesigned recommended that corporate tax entities be able to choose the proportion of their prior year losses to be deducted in an income year.

5.70 Recommendation 11.5 is being implemented as a complementary measure to the Federal Budget announcement on the treatment of current year losses. Further, and as concluded by the Review of Business Taxation, providing this choice will enable corporate tax entities to choose not to deduct prior year losses in order to pay sufficient tax to be able to frank their distributions.

Implementation options

Current year losses

Option 1

5.71 The wasted loss can be quantified by reference to any franking tax offsets that were not able to be used by a corporate entity. Having identified the excess franking offset it would be converted back to the equivalent amount of tax loss. This amount would be aggregated with the actual tax loss for the income year, if any, and the total amount carried forward. This is able to be deducted as a prior year loss in a later year of income.

Option 2

5.72 Under this option the excess franking tax offset would be treated as a carry forward tax offset and be used to reduce income tax that would otherwise be payable in a later income year.

Prior year losses

5.73 Allowing corporate tax entities to be able to choose the amount of prior year losses that they wish to deduct is essentially a change to the mechanism for deducting losses.

5.74 For corporate entities the deduction would not be automatic but they will have to choose the amount of tax loss they wish to deduct. The amount deducted will similarly be deducted in the income tax return.

5.75 Consistent with the automatic adjustment a corporate tax entity will be allowed to change its choice of the amount of tax loss deducted in these circumstances.

5.76 Making this change to the mechanism for deducting prior year losses is the only option available.

Assessment of impacts

Impact group identification

5.77 The measure ensuring that current year losses will not be wasted against franked dividend income, potentially applies to all corporate tax entities. In practice only those entities that have the combination of franked dividend income and a current year loss (an excess of allowable deductions over other assessable income) will be impacted.

5.78 Providing choice for deducting prior year losses will apply to all corporate tax entities.

5.79 The ATO, responsible for administering the tax system, will be impacted.

5.80 Government revenue will also be impacted.

Analysis of costs / benefits

Compliance costs

Current year losses

5.81 Both option 1 and 2 for current year losses will require the identification of the excess franking tax offset amount for a year of income. However, this will be done as part of a corporate tax entity's calculation of income tax payable.

5.82 Option 1 will require the conversion of the excess franking tax offset amount into the equivalent tax loss amount and that amount aggregated with any actual tax loss for the year. As is currently the case entities will need to record this prior year loss to enable it to be carried forward for deduction in a future year of income. This effectively brings it into an existing process.

5.83 Option 2 would not require the additional step of converting the excess franking tax offset into a loss. Rather the excess amount would be treated as a carried forward tax offset. Entities would be required to separately record and track prior year losses and carry forward tax offsets. There would likely be a minor additional cost to recording and carrying forward two separate amounts and corporate tax entities will be required to become familiar with the concept of a carry forward tax offset. While the income tax law does provide a mechanism to carry forward tax offsets there are currently no tax offsets treated this way.

5.84 Compliance costs under either option will be minimal as the measure, as implemented, is essentially an adjunct either to the income tax calculation and/or the existing requirement to record and carry forward certain amounts for consideration in later years of income.

Prior year losses

5.85 Corporate tax entities will choose the amount of prior year losses they wish to deduct in their income tax return. Under the current automatic deduction of a prior year loss the amount required to be deducted is similarly included in a corporate tax entity's tax return and so the process is essentially the same.

5.86 Under the current rules where losses are required to be deducted the deduction adjusts automatically in situations where:

•

the tax loss amount is adjusted;

•

the net assessable income over allowable deductions for the income year is adjusted; or

•

net exempt income for the income year is adjusted.

5.87 For example a corporate tax entity's taxable income amount in a later year of income may be varied because of, say, an amended assessment. Therefore, in these circumstances change of choice will be allowed.

5.88 Changing choice requires an active decision by a corporate tax entity and the Commissioner will need to be notified. However, the circumstances where changing choice will be allowed generally arise because of some other process being undertaken by a corporate tax entity. For example, a corporate tax entity may be reviewing it own tax affairs and has ascertained that an adjustment is necessary or the ATO may be reviewing the affairs of the corporate tax entity. Notifying a change in choice could be part of an amendment assessment. Consequently, any additional compliance costs will be minimal.

Administration costs for the ATO

5.89 Providing corporate tax entities choice is estimated to impose a small one-off administration cost on the ATO as processing systems will have to be adjusted so as not to automatically deduct prior year losses. Providing choice will also involve some minor ongoing costs to administer changes in choice although as previously set out this will occur generally as part of some other process that would be required to be undertaken.

Government revenue

5.90 Ensuring losses are not wasted against franked dividend income is estimated to cost the revenue over the next four years:

Consultation

5.91 Consultation on implementing the proposal took place on 4 June 2002. Representatives from the Treasury, the ATO, tax practitioner and industry bodies attended. Further consultation with the same group occurred during the development of the legislation. The measure will address the concerns raised during consultation about wasting losses.

Conclusion and recommended option

5.92 Option 1 for current year losses is preferred as it means entities will not have to keep track of a separate amount of carry forward offsets but, rather, carried forward as part of a corporate tax entity's stock of prior year losses. This directly addresses the issue by restoring the 'wasted' loss. Existing rules governing the deductibility of losses (continuity of ownership and same business tests) can continue to apply to the 'restored' loss and taxpayers without wasted losses will be unaffected.

5.93 Option 2 is not preferred because it requires the use of carry forward offsets which are not currently part of the record keeping systems of corporate tax entities. Option 2 involves carrying forward 2 separate amounts, tax offsets and tax losses.

5.94 Preventing the wastage of current year losses against franked dividends will ensure that corporate groups are not disadvantaged by the impact of the consolidation regime in removing their ability to quarantine losses from franked dividends.

5.95 It is considered that providing choice in respect of deductions for prior year losses can only be implemented in accordance with the process as set out. Deductions for prior year losses can be adjusted consistent with the current rules. Allowing corporate tax entities to choose to deduct prior year losses similarly ensures that those losses are not wasted against franked dividend income.

Index