Edited version of your written advice

Authorisation Number: 1051216904592

Date of advice: 21 April 2017

Ruling

Subject: Income tax treatment of intragroup payments relating to management equity incentive plan

Question 1

Will the Intercompany Allocation payable to XCo Limited by its subsidiaries AusCo and ForCo for the issue by XCo of restricted equity interests settled solely in ordinary XCo shares to the employees of those subsidiaries pursuant to the XCo Management Equity Incentive Plan be assessable income of XCo Limited under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the Intercompany Allocation be assessable to XCo as statutory income under section 6-10 of the ITAA 1997 due to the operation of section 15-15 of that Act?

Answer

No

Question 3

Will the Intercompany Allocation be assessable to XCo as statutory income under section 6-10 of the ITAA 1997 due to the operation of section 20-20 of that Act?

Answer

No.

Question 4

Will the Intercompany Allocation be assessable to XCo as statutory income under section 6-10 of the ITAA 1997 due to the operation of section 102-5 of that Act, specifically as a result of CGT event D1 or CGT event H2 happening (pursuant respectively to sections 104-35 and 104-155 of that Act)?

Answer

No.

Question 5

Will the Intercompany Allocation be assessable to XCo as statutory income under section 6-10 of the ITAA 1997 due to the operation of Division 230 of that Act, specifically subsection 230-15(1)?

Answer

No.

Question 6

Will the Intercompany Allocation give rise to a transfer pricing benefit under section 815-120 of Subdivision 815-B of the ITAA 1997?

Answer

No.

Relevant facts and circumstances

1. XCo Limited, an Australian resident company listed on the Relevant Stock Exchange, together with its wholly-owned subsidiaries AusCo, an Australian resident company, and XYCo, a foreign resident company (the XCo Group), is in the mining business.

2. XCo Limited is the head company of a consolidated group of which AusCo is a subsidiary member.

3. XCo operates an equity employee incentive plan (the Plan) with the aim of further the XCo Group's growth and profitability through encouraging share ownership on the part of its employees and aligning employee goals with those of its shareholders. This alignment is intended to be achieved by linking Awards under the Plan directly to the achievement of corporate goals, for example total shareholder return and/or return on capital. Employees of AusCo and XYCo are eligible to participate in the Plan.

4. Under the Plan, XCo Limited may grant Awards in the form of certain types of restricted equity which convert into ordinary shares in XCo Limited tradeable on the ASX once the performance conditions under the relevant Awards have been satisfied by the relevant employees. The restricted equity is subject to non-transferability clauses which prevent participants in the Plan from selling, transferring, pledging, assigning or otherwise alienating or hypothecating it prior to the satisfaction of those conditions.

5. There is no trust over the restricted equity, which is delivered to each participant upon the grant date under the relevant Award.

6. When XCo Limited issues a restricted equity Award under the Plan, it allocates the value of the Award (plus associated costs) amongst AusCo and XYCo on a monthly basis (the Intercompany Allocation) for accounting purposes.

7. The value of the Intercompany Allocation accords with the fair value of the restricted equity awarded to the relevant subsidiary's employees under the Plan measured on the grant date, as required under the Relevant GAAP.

8. For accounting purposes, AusCo and XYCo record the Intercompany Allocation as an expense (share-based payment expense) with a corresponding intercompany payable to XCo Limited. In its accounts, XCo Limited books the corresponding intercompany receivable against equity (representing the value of the restricted equity award). It does not book an expense in respect of the Intercompany Allocation to AusCo and XYCo.

9. The accounting treatment is summarised in the table below, and follows the Relevant GAAP approach which XCo Limited is required to use for their relevant reporting purposes.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 15-15

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 20-15

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 102-25

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-15

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 104-30

Income Tax Assessment Act 1997 section 104-35

Income Tax Assessment Act 1997 section 104-40

Income Tax Assessment Act 1997 section 104-45

Income Tax Assessment Act 1997 section 104-47

Income Tax Assessment Act 1997 Subdivision 104-E

Income Tax Assessment Act 1997 Subdivision 104-F

Income Tax Assessment Act 1997 section 104-135

Income Tax Assessment Act 1997 section 104-145

Income Tax Assessment Act 1997 section 104-150

Income Tax Assessment Act 1997 section 104-155

Income Tax Assessment Act 1997 Subdivision 104-I

Income Tax Assessment Act 1997 Subdivision 104-J

Income Tax Assessment Act 1997 Subdivision 104-K

Income Tax Assessment Act 1997 Subdivision 104-L

Income Tax Assessment Act 1997 subsection 230-15(1)

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 section 230-50

Income Tax Assessment Act 1997 Subdivision 230-G

Income Tax Assessment Act 1997 section 230-440

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 Subdivision 815-B

Income Tax Assessment Act 1997 section 815-120

Income Tax Assessment Act 1997 Subdivision 974-B

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 Subdivision 974-C

Income Tax Assessment Act 1997 section 974-70

Income Tax Assessment Act 1997 section 974-75

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 subsection 995-1(1)

Income Tax Assessment Act 1936 section 25A

Income Tax Assessment Act 1936 former paragraph 26(a)

Reasons for decision

All legislative references below are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.

Questions 1 - 6: Exception where Intercompany Allocation is from subsidiary that is a subsidiary member of a consolidated group

Summary

Where an Intercompany Allocation derived by XCo Limited is from AusCo, a subsidiary member of the XCo Limited consolidated group, the Intercompany Allocation is ignored under the single entity rule. The answer to all of questions 1 - 6 in this situation is 'no'.

Detailed reasoning

Subsection 701-1(1) (the 'single entity rule' or SER) states:

If an entity is a *subsidiary member of a *consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the *head company of the group, rather than separate entities, during that period.

Subsection 701-1(2) sets out the 'head company core purposes' as follows:

(a) working out the amount of the *head company's loss (if any) for income tax calculated by reference to any income year in which any of the period occurs or any later income year; and

(b) working out the amount of the head company's loss (if any) of a particular *sort for any such income year.

Subsection 701-1(3) sets out the 'entity core purposes' which are the same as the head company core purposes (with 'entity' substituted for 'head company').

Some subsidiaries of XCo Limited that had employees who participated in the Plan (Subsidiaries) were Australian resident entities which, for all or part of the XCo Limited consolidated group's period of existence, were subsidiary members of that group. Any Intercompany Allocations derived by XCo Limited from any Subsidiary while it was a subsidiary member of the consolidated group would be ignored for the head company core purposes and entity core purposes under the SER.

See also Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 at paragraph 8, which states:

… the SER has the effect that:

(a) the actions and transactions of a subsidiary member are treated as having been undertaken by the head company;

(b) the assets a subsidiary member of a the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group;

(c) assets where the rights and obligations are between members of a consolidated group (intra group assets) are not recognised for income tax purposes during the period they are held within the group whether or not the asset, as a matter of law, was created before or during the period of consolidation … ; and

(d) dealings that are solely between members of the same consolidated group (intra-group dealings) will not result in ordinary or statutory income or a deduction to the group's head company.

Therefore, in relation to these Intercompany Allocations, the answer to all of questions 1 - 6 is 'no' (regardless of what the answer might have been had the SER not applied).

For the Intercompany Allocations between XYCo and XCo Limited, the reasons for decision for each question are set out separately for each question below.

Question 1

Summary

The Intercompany Allocation payable to XCo Limited by XYCo is consideration for restricted equity to be awarded to employees of XYCo. The consideration covers the fair value of the restricted equity measured at the grant date (plus associated costs).

The character of an Intercompany Allocation from the perspective of XYCo does not determine its character in XCo Limited's hands. The accounting treatment of the Intercompany Allocations adopted by XCo Limited and XYCo is suggestive of them being receipts of capital, but is not in itself determinative.

The receipt of Intercompany Allocations is not an ordinary incident of XCo Limited conducting its business of mining, production and marketing of inorganic minerals and chemicals. Moreover, there is no evidence of an intention on the part of XCo Limited to make a profit or gain from such transactions. What is given in return for the Intercompany Allocations is equity, which is of a capital nature. This colours the receipts accordingly.

As such, the Intercompany Allocation is not ordinary income of XCo Limited and so is not included in its assessable income under section 6-5.

Detailed reasoning

Subsection 6-5(1) states:

Your assessable income includes income according to ordinary concepts, which is called ordinary income.

Subsection 6-5(2) states:

If you are an Australian resident, your assessable income includes the *ordinary income you *derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

There is no statutory definition of 'income according to ordinary concepts', so guidance must be sought in the common law. Reference to that term can be traced to the judgment of Jordan J of the NSW Supreme Court in Scott v Commissioner of Taxation (NSW) (1935) 3 ATD 142 (which concerned the Income Tax (Management) Act 1928 (NSW)). He stated (at pp. 144-145):

The word 'income' is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of receipts.

The 'ordinary concepts' test has been applied many times by various courts since in determining whether or not a particular receipt is income. There is no complete set of rules for determining the question of whether an amount is ordinary income. The courts have laid down certain indicia which are frequently of assistance. These include:

● whether the amount has the characteristics of periodicity, regularity or recurrence

● whether it is convertible into money or money's worth (see Federal Commissioner of Taxation v. Cooke and Sherden 80 ATC 4140 at 4147-4148.)

● the character of a right or thing disposed of in exchange for the receipt

● whether it is associated with business activities or services rendered, as distinct from the mere sale of property, and

● whether it is solicited, as distinct from a windfall.

However, these indicia are neither complete nor conclusive in all cases. For example, although the High Court in Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693 remarked that the first point above had been considered to be a hallmark of receipts in the nature of income in accordance with the ordinary concepts and usages of mankind, it nevertheless found that in the circumstances of that case, a profit on an isolated transaction was of that very nature. In their joint judgment, Mason ACJ, Wilson, Brennan, Deane and Dawson JJ said (at CLR 209-210; ATC 4366-4367):

But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business.

As Kitto J said In The Squatting Investment Co Ltd v. Federal Commissioner of Taxation (1952-1953) 86 CLR 570 at 627; (1953) 10 ATD 126 at 146:

The question whether a receipt comes in as income must always depend for its answer upon a consideration of the whole of the circumstances.

It is well established that the character of a receipt is to be determined from the point of view of the recipient, not the payer or someone else. In McLaurin v. Federal Commissioner of Taxation (1961) 104 CLR 381, Dixon CJ, Fullagar and Kitto JJ stated in their joint judgment in the High Court (at 391):

… in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of the recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it.

See similarly in this respect the judgments of Windeyer J in Scott v. Federal Commissioner of Taxation (1966) 117 CLR 514 at 526; (1966) 14 ATD 286 at 293 and of Bowen CJ in The Federal Coke Company Pty Ltd v. Federal Commissioner of Taxation 77 ATC 4255 at 4264. See also GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1989-1990) 170 CLR 124 at 136-137; 90 ATC 4413 at 4419.

In Federal Commissioner of Taxation v. Montgomery (1999) 198 CLR 639; [1999] HCA 34; 99 ATC 4749 Gaudron, Gummow, Kirby and Hayne JJ stated in their majority judgment:

It is … wrong to assume exact congruence between the capital or revenue character of a sum as a receipt and its character as expenditure; it is also wrong to assume exact congruence between the character of a sum when received or paid by one taxpayer and its character when received or paid by another. The assertion of some such congruence or symmetry diverts attention from the fundamental inquiry in a case like the present: is the receipt income according to ordinary concepts?

In Federal Coke, Brennan J stated (77 ATC 4255 at 4273):

When a recipient of moneys provides consideration for the payment, the consideration will ordinarily supply the touchstone for ascertaining whether the receipt is on revenue account or not. The character of an asset which is sold for a price, or the character of a cause of action discharged by a payment will ordinarily determine, unless it be a sham transaction, the character of the receipt of the price or payment. The consideration establishes the matter in respect of which the moneys are received. The character of the receipt may then be determined by the character, in the recipient's hands, of the matter in respect of which the moneys are received.

As to the influence of accounting practices in determining the taxation of income, see the judgment of Dixon J, who wrote the majority decision in Commissioner of Taxes (South Australia) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 (Carden's case). Faced with determining the most appropriate basis, cash or accruals, on which to determine the taxable income of the deceased Dr Carden for several income years preceding his death, Dixon J entered into a discourse about how the concepts of income, profits and gains arose from principles and methods of computation developed in the business and commercial sphere. He said, at 153-154 (in part):

Income, profits and gains are conceptions of the world of affairs and particularly of business… No single formula could be devised which would effectually reduce to the just expression of a net money sum the annual result of every kind of pursuit or activity by which the members of a community seek livelihood or wealth. But in nearly every department of enterprise and employment the course of affairs and the practice of business have developed methods of estimating or computing in terms of money the result over an interval of time produced by the operations of business, by the work of the individual, or by the use of capital. The practice of these methods of computation and the general recognition of the principles upon which they proceed are responsible in a great measure for the conceptions of income, profit and gain and, therefore, may be said to enter into the determination or definition of the subject which the legislature has undertaken to tax. The courts have always regarded the ascertainment of income as governed by the principles recognized or followed in business and commerce, unless the legislature has itself made some specific provision affecting a particular matter or question. Familiar but striking examples of this necessary reliance upon commercial principles and general business understanding may be found in the case law dealing with expenditure laid out for the purpose of trade, with outgoings on account of capital, with capital profits, and with the question whether items should be taken into consideration for any given accounting period rather than for that which follows or perhaps for that which preceded.

Nevertheless, as Dixon J had allowed in the above passage, accounting practice is not determinative, being always subservient to statute and common law. This was highlighted by Mason J in Federal Commissioner of Taxation v. St Hubert's Island Pty Ltd (in liq) (1978) 138 CLR 210. He said, at 225:

Some accounting principles and practices which have been held to be appropriate in the ascertainment of a taxpayer's profit may have no application here because our statutory provisions specifically instruct us as to what constitutes assessable income and as to the items that shall be allowed as deductions from that income. The trading stock provisions contained in ss 28-36 [of the Income Tax Assessment Act 1936] are a case in point. Accounting principle and practice cannot prevail over them. [Emphasis added]

In the present case, XCo Limited, as the only listed entity within the XCo Group, seeks to reward certain employees of various subsidiaries of its global group by making equity awards in the form of restricted equity which will convert to ordinary shares in XCo Limited on the satisfaction of certain conditions. As a result of making an award to an employee of XYCo, XYCo becomes liable to pay an Intercompany Allocation to XCo Limited.

The character of the expense to XYCo (which it is not necessary to deal with here) does not determine the character of the receipt in XCo Limited's hands. Nor is the accounting treatment of the Intercompany Allocations by XCo Limited and XYCo determinative.

The question whether an Intercompany Allocation comes in as income of XCo Limited depends upon a consideration of the whole of the circumstances. XCo Limited, with its subsidiaries, is in the business of mining, and it is through that business that it ordinarily generates its income.

Its receipt of Intercompany Allocations is not an ordinary incident of conducting its business. This mitigates against it being a receipt on revenue account. However, Myer demonstrates that receipts from isolated transactions out of the ordinary course of business will generally be of an income character where the intention of entering into the transaction was to make a profit or gain. Against this, XCo Limited's purpose in making the equity awards was to reward employees of XYCo, not to make a profit or gain. The Intercompany Allocation covered the fair value of the relevant equity issues plus associated costs, nothing more.

Moreover, what was given in exchange for the Intercompany Allocation was an issue of equity, which is of a capital character. This points to the Intercompany Allocation being a receipt of a capital nature, per Brennan J in Federal Coke as quoted above.

Consideration of the overall circumstance of the case leads to the conclusion that the Intercompany Allocations are of a capital nature, and therefore not ordinary income. Accordingly, the Intercompany Allocations are not included in XCo Limited's assessable income under section 6-5.

Question 2

Summary

Section 15-15 includes in a taxpayer's assessable income profit arising from the carrying on or carrying out of a profit-making undertaking or plan provided that the profit is not assessable as ordinary income under section 6-5 and does not arise in respect of the sale of property acquired on or after 20 September 1985.

In view of the answer to Question 1, neither of those provisos apply in the present case. To fall within the section, there must be a profit-making purpose in carrying on or carrying out the scheme or plan. This matter has already been considered in answering Questions 1: no such purpose is evident.

Therefore, section 15-15 does not apply to bring the Intercompany Allocations within XCo Limited's assessable income.

Detailed reasoning

Section 6-10 provides for amounts that are not ordinary income to be included in a taxpayer's assessable income by provisions about assessable income. Such amounts are called 'statutory income'.

Section 15-15 states:

(1) Your assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan.

(2) This section does not apply to a profit that:

(a) is assessable as *ordinary income under section 6-5; or

(b) arises in respect of the sale of property acquired on or after 20 September 1985.

The immediate predecessor to that provision was section 25A of the Income Tax Assessment Act 1936 (ITAA 1936), of which subsection (1) stated:

The assessable income of a taxpayer shall include profit arising from the sale by the taxpayer of any property acquired by the taxpayer for the purpose of profit-making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme.

However, with the introduction of the capital gains tax regime, section 25A of the ITAA 1936 ceased to apply in respect of the sale of property acquired on or after 20 September 1985: subsection (1A) of that section.

Section 25A of the ITAA 1936 itself replaced, effective from 24 August 1983, former paragraph 26(a) of that Act, which read:

The assessable income of a taxpayer shall include -

(a) profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit-making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme.

The second limb of this provision was examined in XCO Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 343; [1971] HCA 37; 71 ATC 4152, where Gibbs J stated (CLR at 350; HCA at [15]; ATC at 4155):

The second limb of sec. 26(a), unlike the first limb of that paragraph, does not refer in express terms to purpose but, in my opinion, a scheme is not a “profit-making scheme” simply because it yields a profit when none was intended; in the ordinary sense of the words a “profit-making scheme” is a plan devised in order to obtain a profit, and a scheme only answers that description if the taxpayer carries it out with the purpose of making a profit.

Section 1-3 states:

(1) This Act contains provisions of the Income Tax Assessment Act 1936 in a rewritten form.

(2) If:

(a) that Act expressed an idea in a particular for of words; and

(b) this Act appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style;

the ideas are not to be taken to be different just because different forms of words were used.

Subsection 15-15(1) is, in fact, written in almost the same words as the second limb of subsection 25A(1) of the ITAA 1936, which in turn copied exactly the words of former paragraph 26(a) of that Act. The notable exception is the use of the word 'plan' in place of 'scheme'. However, as the Explanatory Memorandum to the Tax Law Improvement Bill 1996 explained (at p. 21):

That part of the existing law [section 25A of the ITAA 1936] that applies to profits from carrying on any profit-making undertaking or scheme has been rewritten in section 15-15.

The rewritten section will use the word plan instead of the defined term scheme.

The existing law uses the phrase 'profit-making undertaking or scheme'.

Scheme has been defined in the pending 1996 Act. It is intended to be used in anti-avoidance contexts. As section 15-15 is not an anti-avoidance provision, plan will be used instead. There is no change from the meaning of the existing law.

There is therefore no doubt that what Gibson J had to say about the second limb of former paragraph 26(a) of the ITAA 1936 applies also to subsection 15-15(1).

In the present case, it has already been established in answering Question 1 that the Intercompany Allocation is not assessable as ordinary income under section 6-5, and paragraph 15-15(2)(b) clearly does not apply. Therefore the Intercompany Allocation falls for consideration under section 15-15.

However, it was also found, in answering Question 1, that XCo Limited had no profit-making purpose in deriving the Intercompany Allocation in the course of operating the Plan.

Therefore the Intercompany Allocation is not brought into XCo Limited's assessable income under section 15-15.

Question 3

Summary

Subdivision 20-A provides for the inclusion in a taxpayer's assessable income of an amount that as is an 'assessable recoupment', as that term is defined in sections 20-20 and 20-25. The Intercompany Allocation does not satisfy the definition of 'assessable recoupment' in sections 20-20 to 20-30 and so is not included in XCo Limited's assessable income under Subdivision 20-A.

Detailed reasoning

Subdivision 20-A provides for the inclusion in a taxpayer's assessable income of an amount that is an 'assessable recoupment'. Subsection 20-15, in explaining how to use the Subdivision, states:

(1) First, read sections 20-20 to 20-30 to work out whether you have received an assessable recoupment. If not, you do not need to read the rest of the Subdivision.

(2) If you have received one or more assessable recoupments, sections 20-35 to 20-55 tell you how much is included in your assessable income for an income year.

…

Section 20-20 contains the definition of 'assessable recruitment'. However, that section must be read together with sections 20-25 and 20-30, as will become apparent.

Subsection 20-20(1) pre-emptively excludes any amount that is ordinary income or is statutory income under any provision outside Subdivision 20-A from being an assessable recoupment.

Subsection 20-20(2) states that an amount the taxpayer has received as 'recoupment' (as defined in section 20-25) of a loss or outgoing by way of insurance or indemnity is an assessable recoupment, provided that the taxpayer can deduct an amount for the loss or outgoing for the current year, or has or can deduct an amount for it in an earlier income year, under any provision of 'this Act' (which includes the ITAA 1936: see subsection 995-1(1)).

Subsection 20-20(3) further extends the definition to include an amount received as recoupment of a loss or outgoing (except by way of insurance or indemnity) where, under a provision listed in section 20-30, the taxpayer can deduct an amount for the loss or outgoing in the current year, or has or can deduct an amount for it for an earlier income year.

The ordinary meaning of 'recoup' according to the Macquarie Dictionary, is:

1. to obtain an equivalent for; compensate for: to recoup one's losses.

2. to regain or recover.

3. to yield in return; return an amount equal to.

4. to reimburse or indemnify: to recoup a person for expenses.

5. Law to withhold (a portion of something due) having some rightful claim to do so.

Subsection 20-25(1) extends the ordinary meaning of 'recoupment' of a loss or outgoing by including:

(a) any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however, described; and

(b) a grant in respect of the loss or outgoing.

Section 20-30 lists approximately 60 provisions from the ITAA 1997 and ITAA 1936 (not reproduced here) showing the deductions for which recoupments are assessable for the purposes of subsection 20-30(3).

In the present case, assuming that the exclusion in subsection 20-20(1) does not apply, the Intercompany Allocation is not a recoupment of a loss or outgoing by way of insurance or indemnity. Nor is it a recoupment of a loss or outgoing for which a deduction is available under any of the provisions listed in section 20-30.

Therefore, the Intercompany Allocation is not included in XCo Limited's assessable income under Division 20-A.

Question 4

Summary

No CGT events, apart from the residual CGT events D1 and H2, happen in relation to the receipt by XCo of the Intercompany Allocation. Neither of these events happens either. In the absence of a CGT event, no capital gain or capital loss can arise in relation to the Intercompany Allocation.

Detailed reasoning

Subsection 102-5(1) states that an entity's assessable income includes its net capital gain (if any) for the income year. The subsection contains a method statement for working out the net capital gain which, broadly, involves netting off capital gains and capital losses.

Section 102-20 states that you can make a capital gain or a capital loss if and only if a CGT event happens. Therefore, even if a taxpayer has a capital receipt, there must be an associated CGT event in order for a capital gain or capital loss to arise from the receipt. The gain or loss is made at the time of the event.

Section 102-25 specifies the order of application of CGT events. Subsection 102-25(1) directs a taxpayer to work out if a CGT event (except CGT events D1 and H2) happens to its situation, and if more than one can, to use the one most specific to that situation. Subsection 102-25(3) deals with the situation where no CGT event, except CGT events D1 and H2, happens. In that case, the taxpayer is to work out whether CGT event D1 happens, and use that if it does, and otherwise work out whether CGT event H2 happen, and use that if it does.

CGT event D1 happens if an entity creates a contractual or other legal or equitable right in another entity: subsection 104-35(1). However this is subject to a number of exceptions set out in paragraphs 104-35(5)(a) - (e). In particular, there is an exception in paragraph 104-35(5)(c) where a company issues or allots equity interests as defined in Subdivision 974-C.

Subsection 974-70(1) states that a scheme gives rise to an equity interest in a company if it satisfies the equity test in subsection 974-75(1) and the interest is not a debt interest in the company under Subdivision 974-B. A scheme satisfies the equity test in relation to a company if, for example, it gives rise to an interest in the company as a member or stockholder of the company: subsection 974-75(1), table item 1. Another example would be if the company issued an interest that will, or may, convert into an equity interest in the company: table item 4 of that subsection.

If the scheme involves the issue of ordinary shares in the company to an entity, the scheme would pass the equity test, and would not be characterised as a debt interest (since, whilst there may be an expectation that the company would pay dividends to the entity, the expectation would not amount to an effectively non-contingent obligation on the company to provide a financial benefit: see paragraph 974-20(1)(c)). Similarly, if the scheme involves the issue by the company of interests that, whether or not subject to contingencies, convert into ordinary shares in the company, the scheme would pass the equity test and would not be characterised as a debt interest.

CGT event H2 happens if an act, transaction or event occurs in relation to a CGT asset that an entity owns that does not result in an adjustment being made to the asset's cost base: subsection 104-155. As with CGT event D1, there are a number of exceptions, one of which is that a company issues or allots equity interests in the company: paragraph 104-155(5)(c).

In working through the list of CGT events in section 104-5 in relation to the present case, it is apparent that no CGT event happens to XCo Limited in relation to the Intercompany Allocation.

● CGT event A1 does not happen, as XCo Limited is not disposing of a CGT asset.

● CGT event B1 is not applicable.

● CGT events C1 and C2 do not happen, as there is no intangible asset that XCo owns that is lost, destroyed or otherwise ends. CGT event C3 concerns options and is not applicable.

● None of CGT events D2, D3 or D4 are applicable.

● There is no trust over any CGT assets (such as shares in XCo Limited) that the Intercompany Allocation relates to. Therefore none of the CGT events in Subdivision 104-E happen.

● The CGT events in Subdivision 104-F are about leases and are not applicable.

● CGT event G1 does not happen, because although an Intercompany Allocation is paid to XCo Limited by XYCo, in which it owns shares, the payment is not in respect of those shares. CGT event G3 (about a liquidator or administrator declaring shares etc. worthless) is not applicable.

● CGT event H1 does not happen. In the event that a Participant's restricted equity become forfeit, the corresponding Intercompany Allocation, or part thereof, would revert to the subsidiary that paid it. There is no deposit that becomes forfeit.

● The CGT events in Subdivision 104-I are about Australian residence ending, and are not applicable.

● The CGT events in Subdivision 104-J are about CGT events relating to roll-overs: none of these are applicable.

● None of the event in Subdivision 104-K are applicable.

● The CGT events in Subdivision 104-L are concerned with various aspects of the cost setting process for assets of entities that become subsidiary members of consolidated groups and MEC groups: none of these are applicable.

It remains to consider whether either of CGT events D1 and H2 apply.

Regarding CGT event D1, whether or not XCo Limited creates a right in another entity, the issue by it of restricted equity (which gives rise to the Intercompany Allocation) constitutes an issue of equity interests. Therefore CGT event D1 does not happen.

CGT event H2 does not happen either because no act, transaction or event occurs in relation to a CGT asset that XCo Limited owns in connection with the Intercompany Allocation. In any case, the exception in paragraph 104-155(5)(c) applies.

Therefore, no part of the Intercompany Allocation is brought into the assessable income of XCo Limited due to the operation of section 102-5.

Question 5

Summary

The Intercompany Allocation is not a Division 230 financial arrangement, and therefore subsection 230-15(1) does not operate to include the Intercompany Allocation in XCo Limited's assessable income.

Detailed reasoning

Subsection 230-15(1) states:

Your assessable income includes a gain you make from a *financial arrangement.

Section 230-45 defines the term 'financial arrangement' for the purposes of Division 230. There is also an alternative definition in section 230-50, discussed later.

Subsection 230-45(1) states:

You have a financial arrangement if you have, under an *arrangement:

(a) a *cash settlable legal or equitable right to receive a *financial benefit; or

(b) a *cash settlable legal or equitable obligation to provide a financial benefit; or

(c) a combination of one or more such rights and/or one or more such benefits;

unless:

(d) you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e) for one or more of the rights and/or obligations covered by paragraph (d):

(i) the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

(ii) the right or obligation is not cash settlable; and

(f) the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

The right, obligation or combination covered by paragraph (a), (b) or (c) constitutes the financial arrangement.

That is, 'you' have a financial arrangement under section 230-45 if you have, under an arrangement, any of the things in paragraphs (a), (b) or (c) of subsection 230-45(1), unless all of the conditions in paragraphs (d), (e) and (f) of that subsection are satisfied.

'Arrangement' is broadly defined in subsection 995-1(1) as meaning 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.'

'Financial benefit' is also defined in broad terms in section 974-160(1) as follows:

(1) In this Act:

financial benefit:

(a) means anything of economic value; and

(b) includes property and services; and

(c) includes anything that regulations made for the purposes of subsection (3) provides is a financial benefit;

even if the transaction that confers the benefit on an entity also imposes an obligation on the entity,

(2) In applying subsection (1), benefits and obligations are to be looked at separately and not set off against each other.

(3) The regulations may provide that a thing specified in the regulations is a financial benefit for the purposes of this Act.

Currently, there is nothing in the regulations concerning this definition.

'Cash settlable' is defined in subsection 230-45(2), which states:

A right you have to receive, or an obligation you have to provide, a *financial benefit is cash settlable if, and only if:

(a) the benefit is money or a *money equivalent; or

(b) in the case of a right — you intend to satisfy or settle it by receiving money or a money equivalent or by starting to have, or ceasing to have, another *financial arrangement; or

(c) in the case of an obligation — you intend to satisfy or settle it by providing money or a money equivalent or by starting to have, or ceasing to have, another financial arrangement; or

(d) you have a practice of satisfying or settling similar rights or obligations as mentioned in paragraph (b) or (c) (whether or not you intend to satisfy or settle the right or obligation in that way); or

(e) you deal with the right or obligation, or with similar rights or obligations, in order to generate a profit from short-term fluctuations in price, from a dealer's margin, of from both; or

(f) none of paragraphs (a) to (e) applies but you satisfy subsection (3); or

(g) you are able to settle the right or obligation as mentioned in paragraph (b) or (c) (whether or not you intend to satisfy or settle the right or obligation in that way) and you do not have, as your sole or dominant purpose for entering into the arrangement under which you are to receive or provide the financial benefit, the purpose of receiving or delivering the financial benefit as part of your expected purchase, sale or usage requirement.

Subsection 230-45(3) states:

You satisfy this subsection if:

(a) the *financial benefit is readily convertible into money or a *money equivalent; and

(b) there is a market for the financial benefit that has a high degree of liquidity; and

(c) subsection (4) or (5) is satisfied.

Subsection 230-45(4) states:

This subsection is satisfied if, for the recipient of the *financial benefit, the amount of the money or *money equivalent referred to in paragraph (3)(a) is not subject to a substantial risk of substantial decrease in value.

Subsection 230-45(5) states:

This subsection is satisfied if your purpose, or one of your purposes, for entering into the arrangement under which you are to receive or provide the *financial benefit, is to receive or deliver the financial benefit:

(a) to raise or provide finance; or

(b) if paragraph (a) does not apply — so that it may be converted or liquidated into money or a money equivalent (other than as part of your expected purchase, sale or usage requirements).

'Money equivalent' is defined in subsection 995-1(1) to mean:

(a) a right to receive money or something that is a *money equivalent under this definition; or

(b) a *financial arrangement (within the meaning of section 230-45).

As mentioned, section 230-50 provides an alternative definition of 'financial arrangement', as follows:

(1) You also have a financial arrangement if you have an *equity interest. The equity interest constitutes the financial arrangement.

(2) You also have a financial arrangement if:

(a) you have, under an *arrangement:

(i) a legal or equitable right to receive something that is a financial arrangement under this section; or

(ii) a legal or equitable obligation to provide something that is a financial arrangement under this section; or

(iii) a combination of one or more such rights and/or obligations; and

(b) the right, obligation or combination does not constitute, or form part of, a financial arrangement under subsection 230-45(1).

The right, obligation or combination referred to in paragraph (a) constitutes the financial arrangement.

As is explained in Taxation Determination TD 2011/12 Income tax: where an equity interest is a financial arrangement which satisfies both subsection 230-45(1) and 230-50(1) of the Income Tax Assessment Act 1997, which provision applies?, it is the Commissioner's view that subsection 230-50(1) applies if an equity interest satisfies both subsections 230-50(1) and 230-45(1).

For the reasons given in TD 2011/12, the operation of Division 230 is substantially limited and modified in relation to financial arrangements under section 230-50. As the TD states at paragraph 9:

… a section 230-50 financial arrangement is not subject to the following methods for calculating gains and losses from a financial arrangement:

● accruals and realisation

● foreign exchange retranslation;

● hedging financial arrangements method (except to the extent it is a foreign currency hedge issued by you);

● fair value method for an equity interest which is issued by you;

● financial reports method for an equity interest which is issued by you.

That is to say, Division 230 applies to an equity interest only where it is:

● subject to the fair value method and is an equity interest you hold;

● subject to the financial reports method and is an equity interest you hold;

● subject to the hedging financial arrangements method and is an equity interest that you issue and is a foreign currency hedge.

Note that a balancing adjustment is not made under Subdivision 230-G in relation to a financial arrangement under section 230-50 at a time if neither the fair value method nor the financial reports methods apply to the arrangement immediately before that time: subsection 230-440(1).

In the present case, the relevant arrangement is that XCo Limited receives the Intercompany Allocation from XYCo in return for providing equity interests to employees of XYCo pursuant to the Plan.

The arrangement should be considered as a whole and not as two arrangements, one consisting of receiving the Intercompany Allocation and the other consisting of providing the equity interests. Viewed as such, the arrangement is not one that fits the definition of a financial arrangement under either of subsections 230-50(1) or (2). It remains to consider whether the arrangement is a financial arrangement under subsection 230-45(1).

When XCo Limited grants restricted equity to an employee of XYCo pursuant to the Plan and the relevant Award Agreement, it is providing a financial benefit to the employee as it is obliged to under the Plan and Award Agreement. Upon making the grant, it has a right to receive a financial benefit, being the corresponding Intercompany Allocation, from XYCo.

The right to receive the Intercompany Allocation is cash settlable as the financial benefit is money, satisfying the condition in paragraph 230-45(2)(a). The obligation to provide the restricted equity does not satisfy any of the conditions in paragraphs (a) to (e) or (g) of subsection 230-45(2). The condition in paragraph 230-45(2)(f) is, however, satisfied if subsection 230-45(3) is satisfied.

However, the non-transferability clauses in the Award Agreements prevent the restricted equity being readily convertible into money or a money equivalent and in any case prevent there being any market for them. Therefore, subsection 230-45(3) is not satisfied, so the condition in paragraph 230-45(f) is not satisfied.

Therefore, the obligation on XCo to provide the restricted equity is not cash settlable.

In applying the definition of financial arrangement in subsection 230-45(1), then, XCo Limited has, in the first instance, a financial arrangement because under the arrangement described above, XCo Limited does have a cash settlable legal or equitable right to receive a financial benefit, being the Intercompany Allocation.

However, XCo Limited also has under the arrangement a legal or equitable obligation to provide something, being restricted equity, that is not cash settlable, and since the Intercompany Allocation equates (apart from associated costs) with the fair value of that restricted equity, the obligation to provide it is not insignificant in comparison with the right to receive the Intercompany Allocation.

Therefore, the arrangement is not a financial arrangement for the purposes of Division 230. Accordingly there can be no gain that is assessable under 230-15(1) in relation to the Intercompany Allocation.

Question 6

Summary

XCo Limited will not get a transfer pricing benefit in relation to the Intercompany Allocation where, regardless of whether or not the actual conditions referred to in section 815-120 differ from the arm's length conditions as defined in section 815-125, the Intercompany Allocation makes no difference to XCo Limited's taxable income, loss of any sort, tax offsets or withholding tax payable in respect of interest or royalties.

All the provisions which might plausibly have applied to bring the Intercompany Allocation into XCo Limited's assessable income, thereby affecting one or more of the above amounts, have been examined in answering Questions 1 - 5 above, and do not operate to produce that outcome.

Therefore no transfer pricing benefit arises as a result of the Intercompany Allocation.

Detailed reasoning

Subsection 815-120(1) states:

An entity gets a transfer pricing benefit from conditions that operate between the entity and another entity in connection with their commercial or financial relations if:

(a) those conditions (the actual conditions) differ from the *arm's length conditions; and

(b) the actual conditions satisfy the cross-border test in subsection (3) for the entity; and

(c) had the arm's length condition operated, instead of the actual conditions, one or more of the following would, apart from this Subdivision, apply:

(i) the amount of the entity's taxable income for an income year would by greater;

(ii) the amount of the entity's loss of a particular *sort for an income year would be less;

(iii) the amount of the entity's *tax offsets for an income year would be less;

(iv) an amount of *withholding tax payable in respect of interest or royalties by the entity would be greater.

It is not necessary to test the conditions in paragraphs 815-120(1)(a) or (b) if it can be shown that the condition in paragraph 815-120(1)(c) is not satisfied.

In the present case, as was stated in the Summary, all the provisions which might plausibly have applied to include all or part of the Intercompany Allocation in XCo Limited's assessable income, and thereby affected any of the amounts mentioned in subparagraphs 815-120(1)(c)(i) - (iv), have been examined in answering Questions 1 - 5. None of them include any amount in XCo Limited's assessable income, and that would not change regardless of whether or not the conditions that operate between XCo Limited and XYCo differ from the arm's length conditions. It is the character, not the amount, of the Intercompany Allocation that brings about this result: section 815-120 is concerned with amounts and not character.

Therefore, no transfer pricing benefit arises under section 815-120 in relation to the Intercompany Allocation.

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