House of Representatives

Taxation Laws Amendment Bill (No. 6) 2003

Explanatory Memorandum

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

Chapter 3 Consolidation: refinements

Outline of chapter

3.1 Schedules 3 to 8 to this bill make the following refinements to the consolidation regime:

·
cost setting rules for linked assets;
·
cost setting rules for partners and partnerships;
·
membership rules for subsidiaries of MEC groups held through an interposed non-resident entity; and
·
minor technical amendments and number sequencing.

3.2 All references to sections, Divisions and Parts are references to sections, Divisions and Parts of the ITAA 1997 unless otherwise stated.

Context of amendments

3.3 With the introduction of the consolidation regime, a number of refinements, mentioned in paragraph 3.1, are being made to further clarify, among other things, the consolidation cost setting rules and the membership rules.

Summary of new law

Linked assets and liabilities

3.4 Schedule 3 to this bill amends the cost setting rules to enable a netting-off treatment of assets and liabilities if the accounting standards set-off those assets and liabilities against each other and only record the net value in the balance sheet.

Cost setting rules for partnerships

3.5 Schedule 4 to this bill provides special rules for setting the tax cost of assets where an entity that is a partner in a partnership becomes a member of a consolidated group and where a partnership becomes a member of a consolidated group. These rules ensure that the cost setting rules apply appropriately taking into account the different treatment of partnerships (compared to companies) under the income tax law.

MEC groups and foreign-held membership structures

3.6 Schedules 5, 6 and 7 to this bill amend the membership rules contained in Division 719 to limit the circumstances in which non-resident entities can be interposed between members of a MEC group.

3.7 Broadly, only those MEC groups that consolidate with effect before 1 July 2004 are eligible to have non-resident entities interposed between members of the group. Further, there are on-going rules that restrict what entities can join a MEC group and ensure that members of a MEC group continue to satisfy the membership requirements whilst a member of the group.

Number sequencing of Parts 3-90 and 3-95

3.8 A technical amendment is made to correct the placement of Parts 3-90 and 3-95.

Comparison of key features of new law and current law

New law Current law
The tax cost setting rules net-off some assets and liabilities if the accounting standards only bring their net value to account in the balance sheet. Assets and liabilities that are set-off against each other in the balance sheet are treated as separate assets and liabilities at the joining time.
Special cost setting rules apply where an entity that becomes a member of a consolidated group is a partner in a partnership and where a partnership becomes a member of a consolidated group. These rules recognise the different taxation treatment of partnerships. The existing cost setting rules do not contain special rules for partnerships.
Only those MEC groups that consolidate with effect before 1 July 2004 may have non-resident entities interposed between the members of the group. Further, subsidiary members of such groups may only be held by interposed non-resident entities where such holdings were in place at the time of formation of such groups. Generally, an entity may qualify as a subsidiary member of a MEC group where there are one or more entities interposed between it and the head company of the group irrespective of the date that the group consolidates.
Part 3-90 will be placed before Part 3-95. Part 3-95 is placed before Part 3-90.

Detailed explanation of new law

Linked assets and liabilities

3.9 Schedule 3 to this bill amends the tax cost setting rules to enable a netting-off treatment of assets and liabilities if the accounting standards set-off those assets and liabilities against each other and only record the net value in the balance sheet.

3.10 In some circumstances the Australian accounting standards require an asset and a liability to be set-off and only the net amount recorded in the balance sheet (e.g. see AASB 1014, section 9). In broad terms, these cases involve both a legally recognised right of set-off, so that only the net amount has to be paid or received, and an intention to settle the asset and the liability at the same time. For example, the accounting standards would apply the set-off rules if 2 parties agreed to provide services to each other throughout a period, with the net debtor paying only the difference at the end of the period.

3.11 In most respects, the consolidation regime treats these linked assets and liabilities as if they were separate things. So, for instance, they would be treated as separate things when an entity left a consolidated group and the tax cost of the group's interest in the entity was worked out. [Schedule 3, item 3, section 705-58]

3.12 However, there are special rules for setting the tax cost of a joining entity's assets if, immediately before it joins a consolidated group, it has a set of linked assets and liabilities that must be set-off against each other under the accounting standards. [Schedule 3, item 3, subsection 705-59(1)]

3.13 A set of linked assets and liabilities consists of at least one asset and at least one liability that the accounting standards (or statements of accounting concepts) require to be:

·
set-off against each other in preparing an entity's statement of financial position; and
·
presented in that statement as a net amount.

[Schedule 3, item 3, subsection 705-59(2)]

3.14 The special rules for linked assets and liabilities start by comparing the amount of the liabilities to the value of the asset. In doing that, they don't use the raw amount of the liabilities. Instead, they use the amount that step 2 of the rules for working out the ACA would take into account for the liabilities if you ignored both the special rules for linked assets and liabilities and the accounting standards that apply to them. This modified amount is called 'the available amount'. [Schedule 3, item 3, paragraphs 705-59(3)(a) and (5)(a)]

3.15 The available amount can differ from the raw amount of the liabilities because it relies on step 2 of the ACA rules, which factors in future tax effects (see section 705-75) and differences in timing between accounting and the tax law (see section 705-80).

Reset cost base assets

3.16 The rules distinguish between cases where the liabilities are being set-off against a single reset cost base asset and cases where they are being set-off against more than one asset. They are not affected by whether there is only one liability or several.

Only one linked asset

3.17 In cases where there is only one linked asset that is a 'reset cost base asset' (i.e. almost any asset that isn't a retained cost base asset), a table explains the effect on the ACA and the asset's tax cost.

3.18 If the asset's market value is less than or equal to the total available amount of the liabilities:

·
the asset's tax cost setting amount is its market value; and
·
only any excess amount of the liabilities is included at step 2 of the rules for working out the ACA.

[Schedule 3, item 3, paragraph 705-59(3)(b), item 1 in the table]

3.19 The asset in that case does not share in the distribution of the ACA and does not affect how the ACA is distributed among the other assets of the joining entity. [Schedule 3, item 3, paragraph 705-59(3)(b), item 1 in the table]

Example 3.1: The value of a reset cost base asset is less than an available amount Antigonas Enterprises has to work out its ACA when it joins a consolidated group. It has a reset cost base asset with a market value of $5,000 which is being set-off in its balance sheet against a liability that has an 'available amount' of $7,000.The special rules about linked assets and liabilities will set the asset's tax cost at its $5,000 market value and increase the ACA by the $2,000 excess available amount. The asset will not share in that ACA, which will be apportioned among the joining entity's other assets.

3.20 Essentially, what is happening here is that, instead of increasing the ACA to be distributed generally among the entity's reset cost base assets, the linked liability is being dedicated first to setting the tax cost of the asset to which it is linked. Only the excess is added to the ACA for use in increasing the tax cost of other assets. This limits the transfer of value to or from the linked assets, and so prevents the distortion that is the target of these special rules.

3.21 If the linked asset's market value is greater than the total available amount of the liabilities:

·
the asset's tax cost setting amount is worked out as if the asset's market value were equal to the difference, then increased by the available amount; and
·
nothing is included for the liability at step 2 of the ACA rules.

[Schedule 3, item 3, paragraph 705-59(3)(b), item 2 in the table]

Example 3.2: The value of a reset cost base asset exceeds an available amount Seleucus Grinding Machines is taken over by a consolidated group. At the joining time, it has a reset cost base asset with a market value of $8,000 that is set-off against a $6,500 liability. Its balance sheet records the $1,500 net asset value. It has other reset cost base assets with market values totalling $25,000 and an ACA that works out at $30,000.If the liability's available amount is the full $6,500, the asset's tax cost setting amount would be worked out as if its market value were equal to the $1,500 excess (i.e. $8,000 - $6,500). That would give it a $1,698 share of the ACA (i.e. $1,500 ? ($1,500 ? $25,000) ? $30,000), which would be increased by the $6,500 available amount to set the asset's tax cost at $8,198.

3.22 This is the other side of the coin. Here, the asset has a greater market value than the liability to which it is linked, so the full amount of the liability is dedicated to setting the tax cost of the asset. The asset also gets a proportionate share of the ACA but based only on the difference between its market value and the available amount of the liability rather than on its full market value. Again, for cases where the asset's accounting value is lower because of a liability to which it is linked, this appropriately limits any distortion from value moving between assets.

Multiple assets

3.23 There would usually be only one asset being set-off against one liability. However, the accounting standards are not limited to those cases. They also cover a set of several assets and liabilities.

3.24 If 2 or more assets (including at least one reset cost base asset) are linked to the liabilities, then a second table explains how the ACA and the assets' tax costs are affected.

3.25 If all the linked assets are reset cost base assets, and the total of their market values is less than or equal to the total available amount of the liabilities:

·
each linked asset's tax cost setting amount is its market value; and
·
only any excess amount of the liabilities is included at step 2 of the ACA rules.

[Schedule 3, item 3, paragraph 705-59(5)(b), item 1 in the table]

3.26 The linked assets do not share in the distribution of the ACA and do not affect how the ACA is distributed among the other assets of the joining entity. [Schedule 3, item 3, paragraph 705-59(5)(b), item 1 in the table]

3.27 This is just a variant of the case where there is only a single linked asset with a lower value than the liabilities to which it is linked. It produces exactly the same results.

3.28 If all the linked assets are reset cost base assets, and the total of their market values is greater than the available amount of the liabilities:

·
each linked asset's tax cost setting amount is equal to a proportionate share of the available amount (based on the assets' market values) plus a share of the ACA (based on a 'market value' equal to its actual market value reduced by its share of the available amount); and
·
nothing is included for the liabilities at step 2 of the ACA rules.

[Schedule 3, item 3, paragraph 705-59(5)(b), item 2 in the table]

Example 3.3: The value of multiple reset cost base assets exceeds an available amount Eumenes Financial Wizardry Pty Ltd joins a consolidated group. Its balance sheet sets off a number of liabilities against 2 reset cost base assets, and records only a single net figure for the whole set. The 'available amount' of the liabilities is $150,000. One of the linked assets is worth $120,000 and the other $240,000.As they are worth more than the liabilities, the assets will split the available amount of the liabilities between them in proportion to their market values. As it represents a third of the assets' total market values, the first asset will get $50,000 of the available amount (i.e. a third of $150,000) and the second asset will get the other $100,000.The first asset will also get a share of the ACA based on a 'market value' of $70,000 (i.e. its actual $120,000 market value less its $50,000 share of the available amount). The second asset will use a value of $140,000 (i.e. $240,000 - $100,000) in working out its share of the ACA.Each of the assets will have a tax cost equal to its share of the available amount plus its share of the ACA.

3.29 This is a variant of the case where there is only a single linked asset with a higher value than the liabilities it is linked to. In that case, the rules dedicated the liabilities to setting the tax cost of the asset and also gave the asset a share of the ACA based on the difference. In this case, the liabilities are dedicated to several assets in proportion to their market values. Each of the assets still also claims a share of the ACA based on the difference.

3.30 If some of the assets are retained cost base assets whose total tax cost equals or exceeds the available amount of the liabilities, the liabilities are factored into the ACA in the normal way, and the tax costs of both the retained and the reset cost base assets are determined normally. [Schedule 3, item 3, paragraph 705-59(5)(b), item 3 in the table]

3.31 This reflects the fact that all of the liabilities in the set of linked assets and liabilities should be dedicated to funding the tax cost of the retained cost base assets in the set and none used for the reset cost base assets. However, the normal rules for distributing the ACA (see section 705-35) already achieve that, so special rules are not necessary.

3.32 If some of the assets are retained cost base assets whose total tax costs are less than the available amount of the liabilities, then the same rules that apply if there are only reset cost base assets in the linked set are applied as if:

·
the set contained only the reset cost base assets; and
·
the available amount of the liabilities was equal to the excess of the actual available amount over the tax costs of the retained cost base assets.

[Schedule 3, item 3, paragraph 705-59(5)(b), item 4 in the table]

3.33 In effect, this recognises that removing the tax costs of the retained cost base assets from both the assets side and the liabilities side of a linked set will reduce the set to one of the cases dealt with in items 1 and 2 in the table, where there are only reset cost base assets.

Example 3.4: The available amount exceeds the value of retained cost base assets in a multiple assets set When Peithon Shoes Ltd joins a consolidated footwear group, it has a set of linked assets and liabilities. It is owed $12,000 (a retained cost base asset) and also has a reset cost base asset worth $7,000. These are offset in its balance sheet against a liability with an available amount of $15,000.Since the available amount of the liability exceeds the $12,000 tax cost of the retained cost base asset, the case is treated in the same way as one of a reset cost base asset worth $7,000 and a linked liability with an available amount of $3,000 (i.e. $15,000 - $12,000). In fact, that would be dealt with by item 2 in the table.

3.34 A further consequence in this case is that the retained cost base asset is not counted in distributing the ACA among the reset cost base assets [Schedule 3, item 3, paragraph 705-59(5)(b), item 4 in the table] . Normally, the ACA is applied first to funding the joining entity's retained cost base assets and only the remainder is available to set the tax costs of its reset cost base assets. However, in this linked asset case, the part of the linked liability counted towards the ACA has already been reduced by the amount of the retained cost base asset. To apply the ACA to funding that retained cost base asset would give the asset an inappropriate double effect.

Other tax cost setting provisions

3.35 Some other provisions limit the tax cost of some of an entity's assets when it joins a consolidated group. For example, the tax cost of trading stock cannot be set above both its market value and its 'terminating value' (essentially the trading stock value it had in the joining entity's hands).

3.36 Those provisions (sections 705-40, 705-45 and 705-50) are intended to prevent inappropriate tax benefits arising from consolidating. They are not affected by any of the rules about linked assets and liabilities. That means that a linked asset might have its tax cost initially set by the linked asset rules but then be reduced to conform to the limits imposed by those provisions. [Schedule 3, item 3, subsection 705-59(7)]

Retained cost base assets

3.37 The linked asset rules do not affect how the tax cost of retained cost base assets (essentially money and rights to money) is set. That is always done by section 705-25.

3.38 If a set of linked assets and liabilities only has retained cost base assets, the liabilities will be dealt with under step 2 of the allocable cost calculation in the normal way. That the liabilities are linked to the assets will not affect their treatment at all. [Schedule 3, item 3, subsection 705-59(4)]

3.39 In that case, there was no need to dedicate the liabilities to funding the tax costs of the retained cost base assets because the normal rules for distributing the ACA achieve the same result.

Excluded assets

3.40 Excluded assets in a set of linked assets and liabilities are ignored in working out the tax costs of the other assets in the set. So, for example, a set of linked assets and liabilities that contained a reset cost base asset and an excluded asset would be treated as if it only contained the reset cost base asset. [Schedule 3, item 3, subsection 705-59(6)]

3.41 'Excluded assets' are assets that do not have a tax cost set for them. Essentially, they are rights to future tax benefits (e.g. a right to a tax deduction). Those tax benefits can affect tax liability but the rights themselves do not, so those rights do not need a tax cost and should not affect the ACA available for distribution to assets that do need a tax cost. Excluded assets are described in subsection 705-35(2).

Consequential amendments

CGT event L3

3.42 CGT event L3 provides for a capital gain equal to the excess of the tax cost setting amounts of a joining entity's retained cost base assets (mostly, rights to receive money) over its ACA. In short, it aims to bring to account immediately any part of the tax cost of the entity's assets that cannot be funded from the ACA.

3.43 A problem can arise here, if a retained cost base asset is linked to a liability, because the full tax cost setting amount of the asset is counted in the CGT event L3 calculation even though the linked liability is not fully counted towards the ACA.

Example 3.5: An inappropriate result under CGT event L3 Craterus Pty Ltd joins a consolidated group. It has a set of linked assets and liabilities with one retained cost base asset (worth $10,000), one reset cost base asset (worth $6,000) and one liability (of $12,000). The group might have paid $4,000 for Craterus (which is its net value). Assuming that the 'available amount' of the liability is also $12,000, the ACA for Craterus would be $6,000 (i.e. the $4,000 purchase price + the $2,000 of the liability not used to set retained cost base asset's tax cost - see item 4 in the table in subsection 705-59(5)).CGT event L3 would now identify a $4,000 capital gain because the $10,000 tax cost setting amount of the retained cost base asset exceeds the $6,000 ACA by that much. That would be the wrong result because the tax cost of the retained cost base asset was fully funded by the linked liability, so there was no actual shortfall. The mismatch arises because the calculation counts the full amount of the retained cost base asset even though only $2,000 of the $12,000 liability has been counted towards the ACA.

3.44 The amendment changes the calculation of CGT event L3 to exclude the tax cost setting amount of retained cost base assets that are not taken into account in the process of working out the tax cost of reset cost base assets. [Schedule 3, item 1, paragraph 104-510(1)(b)]

3.45 That solves the problem because the linked asset provisions only exclude the amount of a retained cost base asset from that process if they also reduce the liability linked to it in working out the ACA (see item 4 in the table in subsection 705-59(5)).

Example 3.6: Solving the CGT event L3 problem Continuing from Example 3.5.The retained cost base asset is not counted in working out how much of the ACA is available to set the tax cost of the reset cost base asset (see item 4 in the table in subsection 705-59(5)). Therefore, CGT event L3 will not count that retained cost base asset in working out any capital gain when Craterus joins the group. As there are no other retained cost base assets in this case, there will be no capital gain.

Note for readers

3.46 A note is added to subsection 705-35(1) (which usually sets the tax cost for reset cost base assets) to draw readers' attention to the effect of the linked asset provisions on tax cost. It also notes that there can be a consequent effect for CGT event L3. [Schedule 3, item 2, note 1A to subsection 705-35(1)]

Dictionary signpost to a new definition

3.47 The income tax law's dictionary is amended to include a pointer to the place where the new term, 'linked assets and liabilities', is defined. [Schedule 3, item 4, definition of 'linked assets and liabilities' in subsection 995-1(1)]

Cost setting rules for partners and partnerships

3.48 Subdivision 713-E introduced in Schedule 4 to this bill contains special cost setting rules for partners and partnerships. These rules are explained under the following topics:

·
where an entity that is a partner in a partnership becomes a member of a consolidated group; and
·
where a partnership becomes a member of a consolidated group (this will occur where all the partners in a partnership are members of the consolidated group).

3.49 The object of Subdivision 713-E is to set the tax cost setting amount (hereafter referred to as 'tax cost') of certain types of assets that relate to a partnership. How this is achieved depends on whether at the joining time:

·
a partner in a partnership becomes a subsidiary member of the consolidated group; or
·
a partnership becomes a subsidiary member of the consolidated group (including because a partner also becomes a subsidiary member of the group at that time).

[Schedule 4, item 1, subsections 713-205(1) and (2)]

3.50 In either case the tax cost of these assets is set by applying specified cost setting provisions with some modifications, as contained in Subdivision 713-E. Those specified provisions are:

·
section 701-10, which is the core rule that sets the tax cost of assets that an entity brings into the group;
·
Subdivision 705-A, which provides the detailed rules to be able to work out at what amount an asset's tax cost should be reset; and
·
any other provision that modifies Subdivision 705-A.

[Schedule 4, item 1, subsection 713-205(3)]

3.51 A summary of the rules for partners and partnerships is contained in Table 3.1.

Table 3.1: Summary of cost setting rules for partners and partnerships
Where a partner becomes a member of a consolidated group (but a partnership does not) Where a partnership becomes a member of a consolidated group
How is the partnership treated when applying the cost setting rules?

· The partnership is not an entity for the purposes of applying the cost setting rules; and

· the head company becomes the partner for tax purposes (as a consequence of the single entity rule).

· The partnership is not an entity for the purposes of applying the cost setting rules; and

· the partnership ceases to be recognised for income tax purposes as a consequence of the single entity rule.

What assets are recognised in setting the cost for tax purposes of assets?
· The partner's individual shares in the assets of the partnership and in other assets that relate to the partnership. · The underlying assets of the partnership.
What assets are not recognised in setting the tax cost of assets?

· Assets consisting of membership interests in the partnership; and

· the underlying assets of the partnership.

· Assets consisting of membership interests in the partnership; and

· the partners' individual shares in the assets of the partnership from the time the partnership ceases to be recognised for tax purposes because of the single entity rule.

How is the tax cost of assets set?

Character rule:

·
The partner's individual shares in the assets of the partnership take on the character of the underlying assets of the partnership.

Allocation rules:

·
The partner's individual shares in retained cost base assets are treated as retained cost base assets (i.e. generally given their terminating value).
·
The partner's individual shares in trading stock and depreciating assets of the partnership in effect retain their existing tax value (i.e. given their terminating value).
·
The partner's individual shares in CGT assets (not dealt with above) and in other (non-CGT) assets are treated as reset cost base assets.

Character rule:

·
No character rule is required, as the underlying assets of the partnership become assets of the head company.

Aggregation rule:

·
The cost bases of existing partners' individual shares in each of the assets of the partnership are added together.
·
This summation becomes a global amount of tax cost (called the 'partnership cost pool') for allocation to the assets of the partnership.

Allocation rules:

·
The partnership cost pool is allocated across all assets of the partnership on the same basis as existing rules based on the type of asset (e.g. retained cost base asset or reset cost base asset) and where appropriate, on the basis of relative market values.

Do the general cost setting rules operate to limit the tax cost of certain assets?

· Section 705-40 (about limiting the tax cost of certain assets held on revenue account) may apply.

· The ACA for the partner is reduced in certain circumstances where underlying assets of the partnership are over-depreciated.

· Section 705-40 (about limiting the tax cost of certain assets held on revenue account) and section 705-45 (about reducing the tax cost of certain assets entitled to accelerated depreciation) may apply.
How do you work out the pre-CGT factor for the relevant assets?
· Section 705-125 (about working out the pre-CGT factor for certain assets) is applied to the partner's individual shares in the assets of the partnership and other assets that relate to the partnership. · The pre-CGT factor is worked out for the assets of the partnership by reference to the pre-CGT factors determined when a partners' individual shares in those assets was recognised when the partners became members of the group.

3.52 The rules contained in this bill do not deal with the case where a partner leaves a consolidated group and as a consequence the partnership also leaves the group. Further refinements, consistent with the refinements made in this Subdivision, will be required.

What happens when an entity that is a partner in a partnership becomes a member of a consolidated group?

3.53 Where an entity becomes a member of a consolidated group the tax costs for the assets of the joining entity will generally be reset as a consequence of the core rules in Division 701 and the cost setting rules in Division 705. Special rules are contained in Subdivision 713-E to ensure that the general cost setting rules apply appropriately where the entity is a partner in a partnership. [Schedule 4, item 1, subsection 713-220(1)]

3.54 These special rules:

·
ensure that the partnership is not treated as an entity for the purposes of applying the cost setting rules;
·
specify what assets in relation to the partnership will have their tax cost reset (the 'partnership cost setting interests');
·
specify how the tax cost for the assets (being the 'partnership cost setting interests') is set; and
·
specify what modifications are made in determining and allocating the ACA, to take account of the entity being a partner in a partnership.

3.55 These special rules also apply where, as a consequence of an entity joining a consolidated group, a partnership in which that entity is a partner becomes a member of the consolidated group (see paragraph 3.97).

3.56 A partnership is not treated as an entity for the purposes of the cost setting rules and consequently no tax cost is set for membership interests in the partnership. This is consistent with the CGT approach to the taxation of partnerships. By not treating the partnership as an entity for the purposes of the cost setting rules, the ACA calculated for an entity (being the partner) is allocated to the entity's individual share in the assets of the partnership as well as any other assets of the entity. [Schedule 4, item 1, paragraph 713-220(2)(c)]

Example 3.7: A partner joins a consolidated group

Example of when a partner joins a consolidated group

If Head Co acquires all of the shares in Partner A Co then the cost setting rules (as modified by Subdivision 713-E) will apply to set the tax cost for the assets of Partner A Co including the assets consisting of the partner's individual share in the assets of the partnership. Consequently, Head Co will hold assets consisting of a partnership cost setting interest in each of the assets of the partnership (e.g. trading stock, depreciating asset and land).No tax cost is set for either the interest in the partnership as a whole (i.e. membership interests in the partnership) or the underlying assets of the partnership.

What assets are recognised for the purposes of cost setting?

3.57 The assets that are recognised and which consequently have their tax cost set are called 'partnership cost setting interests'. Partnership cost setting interests are identified in relation to a particular partnership in which an entity is a partner. These interests consist of:

·
an interest in an asset of a partnership; or
·
an interest in the partnership that is not an interest in an asset of the partnership.

However, an asset that consists of a membership interest in the partnership is not a partnership cost setting interest . [Schedule 4, item 1, section 713-210; item 2, definition of 'partnership cost setting interest' in subsection 995-1(1)]

3.58 An underlying asset of the partnership (as distinct from an interest in such an asset) is not a partnership cost setting interest. Consequently, where the tax cost of a partnership cost setting interest is reset it will have no effect on the tax cost of the underlying asset of the partnership.

3.59 The cost for the underlying assets of the partnership (e.g. trading stock, depreciating assets) are the costs that are relevant in determining the net income, exempt income or loss of the partnership. Resetting the costs of all underlying assets (other than retained cost base assets), whilst consistent with the operation of the general cost setting rules, would result in significant compliance costs as individual partners could consequently have different costs for assets of the partnership. This could require each partner to undertake separate calculations of net income, exempt income and partnership loss. For this reason, the cost for the underlying assets of the partnership are not reset.

3.60 The concept of 'partnership cost setting interest' draws upon the recognition for CGT purposes of CGT assets in paragraphs 108-5(2)(c) and 108-5(2)(d). However, the assets referred to in the definition of 'partnership cost setting interest' are not limited to CGT assets and can therefore comprise assets consisting of anything of economic value (as per the general cost setting rules).

3.61 Consistent with the CGT rules, a partner, such as the head company, can have more than one cost setting interest in an asset of the partnership. This may arise because of the incremental acquisition of partnership interests by the one entity or through the operation of the single entity principle (e.g. where more than one of the subsidiary members is a partner in the partnership).

Working out the terminating value of a partnership cost setting interest

3.62 In setting the tax cost for a partnership cost setting interest in a partnership it is often necessary to work out the interest's terminating value (e.g. in applying provisions which restrict the tax cost to an interest's terminating value). Section 713-215 has effect by modifying the general rule for working out the terminating value of an asset in section 705-30. [Schedule 4, item 1, subsection 713-215(1)]

3.63 The terminating value of a partnership cost setting interest at a particular time (e.g. the joining time) is:

·
where the partnership cost setting interest relates to an asset of the partnership - the partner's individual share of the terminating value of that asset (worked out by applying section 705-30 as though certain assumptions discussed below were made); or
·
in any other case - the terminating value of the interest worked out under section 705-30.

[Schedule 4, item 1, subsection 713-215(2)]

3.64 In the first instance mentioned above, section 705-30 is applied as though:

·
the joining time for the purposes of section 705-30 was the time the entity that is a partner in a partnership becomes a member of the group; and
·
the joining entity for the purposes of section 705-30 was the partnership in which the entity is a partner.

[Schedule 4, item 1, subsection 713-215(3)]

3.65 Section 713-215 also applies in working out the terminating value of a partnership cost setting interest in an asset that is over-depreciated (see paragraphs 3.76 to 3.80).

Example 3.8: Terminating value of a partnership cost setting interest Sheffield Co is a partner in United Partnership and has a 50% share in an asset of the partnership consisting of trading stock. The trading stock has a value for partnership purposes of $100. If Sheffield Co was to join a consolidated group then the head company would have a partnership cost setting interest in the partnership consisting of the head company's interest in the trading stock. The terminating value for the interest in the trading stock would be $50 consisting of the head company's individual share (being 50%) of the terminating value of the trading stock.

How is the tax cost of a partnership cost setting interest set?

3.66 Where an entity that is a partner in a partnership becomes a member of a consolidated group, the general cost setting rules which apply to set the tax cost for the assets of the partner will also set the tax cost for each partnership cost setting interest in that partnership. [Schedule 4, item 1, paragraph 713-220(2)(a)] .

3.67 The operation of section 713-220 will not set the tax cost for the 'underlying' assets of the partnership. However, where the partnership becomes a member of the consolidated group as a consequence of the entity joining the group the tax cost set for the partnership cost setting interests will be relevant in setting the tax cost for the underlying assets of the partnership (section 713-220 in these circumstances is applied having regard to the effect of section 713-235 (see paragraph 3.97)). [Schedule 4, item 1, paragraph 713-220(2)(b)]

3.68 The ACA for the joining entity is allocated amongst its assets (including those consisting of partnership cost setting interests) in accordance with the general cost setting rules subject to certain modifications. [Schedule 4, item 1, subsection 713-225(1)]

Character rule

3.69 The tax cost setting amount for each partnership cost setting interest is worked out as if the partnership cost setting interest was an asset of the same kind as the asset of the partnership to which it relates (being the underlying asset of the partnership). [Schedule 4, item 1, subsection 713-225(2)]

3.70 This rule enables the cost setting rules for partnership cost setting interests to be applied appropriately by reference to the nature of the underlying asset. For example, in setting the tax cost for assets it is necessary to determine whether an asset is of a type that should be treated as a retained cost base asset, a reset cost base asset that is held on revenue account, or any other reset cost base asset. Without the 'character rule' the cost setting rules may treat all partnership cost setting interests as reset cost base assets and therefore not achieve the appropriate allocation of ACA to the assets of the partner.

Excluded assets

3.71 A tax cost is not set for a partnership cost setting interests if in working out the tax cost for the underlying assets of the partnership the asset would be an 'excluded asset' under subsection 705-35(2). An asset is an excluded asset if an amount is deducted in respect of the asset in working out the ACA for a joining entity. [Schedule 4, item 1, subsection 713-225(3)]

3.72 The purpose of not attributing a tax cost to excluded assets is because the ACA calculation has already been reduced to take account of these assets. In order to ensure that ACA is not allocated to these assets in setting the tax cost for partnership cost setting interests it is necessary to determine whether an underlying asset of the partnership would be an excluded asset if those assets had their tax cost set.

Special rule for interests in underlying assets that are trading stock or depreciating assets

3.73 To reduce compliance costs partnership cost setting interests in the underlying assets of the partnership that are trading stock or depreciating assets are not treated as reset cost base assets but are instead treated as retained cost base assets and given a value equal to the partner's individual share of the underlying assets terminating value. The tax cost of these assets is not reset as the value of these assets in the books of the partnership is the relevant figure for determining the partnership's net income or net loss. The extent to which the partner is subject to residual CGT is limited by the operation of sections 118-24 and 118-25. Consequently, as there is limited scope for the reset tax cost to be relevant in working out the taxable income of the partner it is appropriate that these assets be treated as retained cost base assets. [Schedule 4, item 1, subsection 713-225(4)]

Interaction with general cost setting rules which adjust the tax cost of certain assets

3.74 Section 705-40 will apply in appropriate circumstances to restrict the tax cost for partnership cost setting interests in assets of the partnership that are held on revenue account by the partnership (as a consequence of the character rule in subsection 713-225(2)). The circumstances in which this restriction will arise will be limited because of subsection 713-225(4) which treats partnership cost setting interests in assets of the partnership that are trading stock or depreciating assets as retained cost base assets.

3.75 The operation of subsection 713-225(4) will also ensure that section 705-45 will not have application in adjusting the tax cost of a partnership cost setting interest in an asset of the partnership that is a depreciating asset because its tax cost cannot exceed its terminating value.

Special rule for partnership cost setting interests in an underlying asset that is an over-depreciated asset

3.76 Where an underlying asset of a partnership is an over-depreciated asset (within the meaning of section 705-50) then a special rule applies to reduce the group's ACA for the joining entity (being a partner in the partnership). A special rule is required because subsection 713-225(4) will ensure that section 705-50 does not have effect in adjusting the tax cost of a partnership cost setting interest relating to an asset of the partnership that is a depreciating asset because its tax cost cannot exceed its terminating value. [Schedule 4, item 1, subsection 713-225(5)]

3.77 The rationale for reducing the ACA in these cases is to ensure that the intent of section 705-50 is achieved where the over-depreciated asset is held by a partnership and a partner in that partnership becomes a member of a consolidated group. Section 705-50 applies under the general cost setting rules to reduce the tax cost setting amount of an over-depreciated asset to ensure that there is not indefinite tax deferral.

3.78 To determine whether a reduction in ACA will arise it is necessary to identify whether there are any partnership cost setting interests in over-depreciated assets. A reduction in ACA is only determined in respect of those interests. As a result of the character rule in subsection 713-225(2) a partnership cost setting interest in an asset may be taken to be an over-depreciated asset. [Schedule 4, item 1, subsections 713-230(1) and (2)]

3.79 The amount of the reduction in ACA is worked out in accordance with section 705-50 assuming certain modifications were made. The modifications require:

·
applying the cost setting rules as though there was no reduction for the over-depreciated assets [Schedule 4, item 1, paragraph 713-230(3)(a)] ;
·
the operation of subsection 713-225(4) which treats partnership cost setting interests in depreciating assets of the partnership as retained cost assets to be ignored [Schedule 4, item 1, paragraph 713-230(3)(b)] ;
·
the adjustable value and cost for the partnership cost setting interests in over-depreciated assets to be calculated by working out the partner's individual share of the underlying depreciating asset's adjustable value or cost [Schedule 4, item 1, paragraphs 713-230(3)(c) and (d)] ; and
·
the operation of subsection 705-50(4) (which relates to assets transferred with roll-over relief) to be ignored [Schedule 4, item 1, paragraph 713-230(3)(e)] .

3.80 In applying section 705-50 the reference to joining entity relates to the partner. Therefore, in determining whether one or more unfranked or partly franked dividends were paid it is necessary to examine the dividends paid by the partner (if any). It is also necessary to determine the extent to which dividends were paid out of profits that were sheltered from tax because of the deductions for decline in value which were available to the partnership and which reduced the partner's share of net income of the partnership or increased the partner's share of a net loss of the partnership.

Utilising the transitional cost setting rules

3.81 A consolidated group that forms during the transitional period (generally between 1 July 2002 and 1 July 2004) may elect to retain the existing tax values for the assets of a joining entity including those consisting of a partner's individual share in the assets of a partnership. This election will allow those entities that are partners in a partnership which want to reduce compliance costs to do so by not having to incur the costs of obtaining market valuations in respect of the partnership assets.

Modifications in working out ACA

3.82 The calculation of ACA for an entity that becomes a member of a consolidated group is modified where that entity is a partner in a partnership in the following manner:

·
step 2 of the ACA calculation is modified to include the partner's share of the liabilities of the partnership [Schedule 4, item 1, subsection 713-225(6)] ; and
·
step 7 of the ACA calculation is modified where the consolidated group, in effect, becomes entitled to deductions of the partnership through its share of the partnership net income or partnership loss [Schedule 4, item 1, subsection 713-225(7)] .

Modification to step 2 - liabilities of the joining entity

3.83 Step 2 operates on the basis of adding to the ACA calculation the amount of liabilities that can or must be recognised in a joining entity's statement of financial position in accordance with accounting standards or statements of accounting concepts made by the AASB.

3.84 As a partnership will not be treated as a joining entity, each partner therefore must add their share of the partnership liabilities to their ACA calculation. As it is possible for partnership liabilities to be reflected in either the books of account of the partners or the partnership (depending on the circumstances), subsection 713-225(6) only adds an appropriate share of those liabilities that would otherwise be recognised in the partnership's book of account at step 2 of the ACA calculation for the partner. [Schedule 4, item 1, subsection 713-225(6)]

Modification to step 7 - certain deductions to which the head company becomes entitled

3.85 Step 7 reduces the ACA by the joined group's 'owned' deductions and the tax benefit attaching to its 'acquired' deductions. Essentially, step 7 reduces the cost to the head company of acquiring an entity by the amount of certain deductions to which the head company will become entitled. This has the effect of denying the head company a double deduction for the one expense. It does this by preventing a head company getting an indirect deduction in the form of an inflated cost base for its assets, which reduces/increases any gains/losses on the disposal of those assets.

3.86 The double deduction can also arise in partnership cases, regardless of whether the partnership or partner becomes a subsidiary member of the group. The double deduction can be realised at the partner level because, given the flow-through nature of partnerships, each partner effectively recognises those deductions through a reduced share of the partnership's net income or an increased share of the net loss (under section 92 of the ITAA 1936). As such, a proportion of those deductions will be realised by the head company whenever a partner joins the group.

3.87 An interest in a deduction will be of the same kind as the underlying deduction, both in the sense that the interest would take on:

·
the attributes of the deduction necessary to be classified as an 'owned' or 'acquired' deduction; and
·
the context in which the deductions to the partnership arose (e.g. in terms of whether the amount was a general or specific deduction or whether the deduction added to an element of the cost base of an asset).

Working out the pre-CGT factor for partnership cost setting interests

3.88 Where a partner in a partnership becomes a subsidiary member of a consolidated group, the assets of the entity consisting of partnership cost setting interests in the partnership (in addition to the other assets of the entity) may receive a pre-CGT factor through the operation of section 705-125. The character rule in subsection 713-225(2) also applies to ensure that a pre-CGT factor is only worked out for partnership cost setting interests in an underlying asset that is not a current asset in accordance with the accounting standards.

What happens when a partnership becomes a member of a consolidated group?

3.89 A partnership will become a subsidiary member of a consolidated group when all of the partners of that partnership are members of the same consolidated group (see item 2 in the table at subsection 703-15(2), section 703-30 and Subdivision 960-G). A consequence of the partnership becoming a subsidiary member of the group is that the single entity rule in section 701-1 will not require the partnership to lodge partnership returns for periods when the partnership is a subsidiary member of the group.

3.90 The cost setting rules, however, will not apply where all partnership interests held outside the group are acquired directly by the head company of a consolidated group. This is because under the approach of recognising a partner's individual share of the assets of the partnership, the head company has not acquired the remaining interests in the partnership as a joining entity, but rather directly acquired interests in each of the partnership assets.

Example 3.9: A partnership joins a consolidated group

Example of when a partnership joins a consolidated group

This example follows on from Example 3.7.Assume Head Co and Partner A Co are members of a consolidated group. The partnership may become a subsidiary member of the consolidated group in a number of ways, for example as a result of the head company acquiring the 40% interest in the partnership held by Partner B Co directly or alternatively through acquiring all of the shares in Partner B Co.As a consequence of the partnership joining the consolidated group the head company ceases to recognise the partnership cost setting interests in the partnership (i.e. the interest in each of the underlying assets) and instead recognises the underlying assets of the partnership. Cost setting where a partner joins the consolidated group at the same time as the partnership In setting the tax cost for the underlying assets it is first necessary to set the tax cost for any partnership cost setting interests in the partnership that are held by an entity that joins the consolidated group. For example, if the head company acquires all of the shares in Partner B Co then the partnership will join the group and before setting the tax cost for the underlying assets of the partnership it is necessary to set the tax cost for the partnership cost setting interests in the partnership. The tax cost for the underlying assets is determined by reference to the tax cost set for the partnership cost setting interests in the assets of the partnership. Cost setting where a head company acquires an interest in a partnership from a partner directly and the partnership joins the consolidated group If Head Co acquires the 40% interest in the partnership held by Partner B directly then the partnership cost setting interests in the partnership that are acquired do not have their tax cost reset but instead have a tax cost that arises under the CGT provisions. It is still, however, necessary to determine the tax cost for the underlying assets by reference to the tax cost set for the partnership cost setting interests in the assets of the partnership.

Setting the tax cost of assets of the partnership

3.91 Where a partnership becomes a member of a consolidated group, the underlying assets of the partnership become assets of the head company and the partnership ceases to be recognised as a separate entity for income tax purposes. The tax cost for the underlying assets of the partnership (other than 'excluded assets') is set in accordance with the general cost setting rules as modified by section 713-240 [Schedule 4, item 1, subsection 713-235(1) and paragraph 713-235(2)(b)] .

3.92 In working out the tax cost for the underlying assets of the partnership you do not work out an ACA for the partnership. Instead a 'partnership cost pool' is worked out based on the cost base/tax costs for the partnership cost setting interests in the partnership. [Schedule 4, item 1, paragraph 713-235(2)(a)]

3.93 A tax cost is also not set for an asset of the partnership that is an excluded asset under subsection 705-35(2) on the assumption that the general cost setting rules were applied without the modifications that apply because of section 705-240. [Schedule 4, item 1, subsection 713-235(3)]

3.94 The partnership cost setting interests in the partnership that are held by the head company cease to be recognised once the partnership becomes a subsidiary member. These interests are, however, relevant in setting the tax cost for the underlying assets to which they relate as they are included in working out the partnership cost pool.

3.95 In setting the tax cost for each asset (other than an excluded asset) of a partnership that becomes a subsidiary member at the joining time:

·
first, add up all the tax costs for partnership cost setting interests in the partnership (the result is the partnership cost pool ):

-
this includes partnership cost setting interests in the partnership that became held by the consolidated group when an entity that was a partner in the partnership became a subsidiary member of the group before the joining time;
-
as well as partnership cost setting interests that are held by an entity that becomes a subsidiary member at the joining time; and
-
as well as partnership cost setting interests that did not have their tax cost set by the cost setting rules, for example, because they were acquired by the head company of a consolidated group directly;

·
second, work out the tax cost for assets that are retained cost base assets (in accordance with section 705-25); and
·
lastly, allocate the remaining partnership cost pool (after subtracting the amount allocated to retained cost base assets) to work out the tax cost for the remaining assets in accordance with certain rules.

[Schedule 4, item 1, subsection 713-240(1)]

Adding up the tax costs for interests in the underlying partnership assets - the aggregation rule

3.96 Each cost base/tax cost for the partner's individual share in the assets of the partnership is effectively a store of tax cost. Once the partnership becomes a member of the consolidated group the underlying assets of the partnership which are taken to be assets of the head company have their tax cost reset. This is achieved by aggregating:

·
the cost base for all the partnership cost setting interests which were acquired directly by the head company; and
·
the tax cost setting amounts for each of the partnership cost setting interests which were acquired indirectly by the head company when an entity that was a partner in the partnership joined the consolidated group.

The total represents the partnership cost pool. [Schedule 4, item 1, paragraph 713-240(1)(a)]

3.97 In the case where a partnership becomes a subsidiary member of a consolidated group because a partner in that partnership becomes a subsidiary member of the group, then it is necessary to first determine the tax cost for the assets of that entity (including the tax cost of the entity's individual share in the assets of the partnership). Consequently, it is necessary to apply the rules discussed in paragraphs 3.53 to 3.87 to set the tax cost for the partnership cost setting interests in the partnership. This process is required even though those partnership costs setting interests will cease to be recognised and only the underlying assets of the partnership will be ultimately recognised as assets of the head company. [Schedule 4, item 1, paragraph 713-240(1)(a)]

3.98 Only partnership cost setting interests in the partnership at the joining time are taken into account. Where, before joining a consolidated group the partnership has disposed of an underlying asset in which the group had a partnership cost setting interest that related to the underlying interest, then this interest will not exist at the joining time.

3.99 If, at the joining time, the market value of the partnership cost setting interest is greater than or equal to its cost base, the cost base is the relevant amount for the purposes of working out the partnership cost pool. Otherwise, the relevant amount is the greater of the market value of the interest or the reduced cost base of the interest. [Schedule 4, item 1, paragraph 713-240(1)(a), subsection 713-240(2)]

3.100 The partnership cost pool (representing the store of tax cost) is then allocated to the underlying assets of the partnership in a similar manner to the general cost setting rules.

Setting the tax cost for retained cost base assets

3.101 Where the underlying assets of the partnership are retained cost base assets the asset's tax cost will be set in accordance with section 705-25. Consequently, these assets broadly have their tax cost set equal to the partnership's cost for those assets at the joining time. [Schedule 4, item 1, paragraph 713-240(1)(b)]

3.102 Where the total of the amount allocated to retained cost base assets exceeds the partnership cost pool then the head company of the consolidated group will make a capital gain equal to the excess. This is consistent with the result that occurs under the general cost setting rules. To achieve this outcome, section 104-510 (CGT event L3) is applied as though the reference to the group's allocable cost amount in that section was a reference to the partnership cost pool. [Schedule 4, item 1, subsection 713-240(4)]

Setting the tax cost for remaining assets of the partnership

3.103 The remaining assets have their tax cost set in accordance with the general cost setting rules in sections 705-35, 705-40 and 705-45. A number of assumptions are made in applying these sections to ensure that they apply appropriately. These assumptions are:

·
that the partnership was, at the joining time, the joining entity referred to in those sections;
·
those sections only apply to underlying assets of the partnership (other than 'excluded assets'); and
·
the ACA mentioned in paragraph 705-35(1)(a) was the partnership cost pool.

[Schedule 4, item 1, paragraph 713-240(1)(c) and subsection 713-240(3)]

3.104 Broadly, the consequences of these assumptions is that the amount remaining, after the allocation of the partnership cost pool to retained cost base assets, is allocated to the reset cost base assets in accordance with their relative market values. The reset cost of certain assets held on revenue account may be restricted under section 705-40 where the asset's tax cost exceeds the greater of the asset's market value and its terminating value. Also there may be a reduction in the tax cost for certain assets which are entitled to accelerated rates of depreciation where the tax cost would be greater than the asset's terminating value and the head company elects to retain access to accelerated depreciation.

Working out the pre-CGT factor for assets of the partnership

3.105 As discussed in paragraph 3.88 assets of an entity consisting of partnership cost setting interests in a partnership may receive a pre-CGT factor through the operation of section 705-125 when that entity becomes a member of a consolidated group.

3.106 Where a partnership joins a consolidated group then the underlying assets of the partnership are taken to be assets of the head company and these assets may be given a pre-CGT factor. A pre-CGT factor is determined for the underlying assets of the partnership (other than excluded assets) by identifying the partnership cost setting interests in the partnership relating to assets of the partnership which have a pre-CGT factor at the joining time. These interests are called the 'pre-CGT interests'. [Schedule 4, item 1, subsections 713-245(1) and (2)]

3.107 The pre-CGT factor for each of the underlying assets is determined by:

·
step 1 - for each pre-CGT interest, multiplying its market value at the joining time by its pre-CGT factor;
·
step 2 - adding up the results of step 1;
·
step 3 - adding up the market values of all the assets of the partnership at the joining time; and
·
step 4 - dividing the result of step 2 by the result of step 3.

[Schedule 4, item 1, subsection 713-245(3)]

Dictionary signpost to a new definition

3.108 The income tax laws dictionary is amended to include a pointer to the place where the new term 'partnership cost setting interest' is defined. [Schedule 4, item 2]

Changes to the MEC group membership rules regarding when non-resident entities can be interposed between members of a group

Introduction

3.109 Schedule 5 to this bill amends the membership rules contained in Division 719 of both the ITAA 1997 and the IT(TP) Act 1997 to limit the circumstances in which non-resident entities can be interposed between members of a MEC group.

3.110 Broadly, only those MEC groups that consolidate with effect before 1 July 2004 are eligible to have non-resident entities interposed between members of the group. Further, there are on-going rules that restrict the entities that can join a MEC group and ensure that members of a MEC group continue to satisfy the membership requirements whilst a member of the group.

3.111 Modifications to the membership rules for consolidated groups were made in the New Business Tax System (Consolidation and Other Measures) Act 2003 and provide the circumstances in which an entity may be eligible to be a subsidiary member of a consolidated or consolidatable group where there are one or more non-resident entities interposed between that entity and the head company of the group. Modifications were also made to the rules that set the tax cost of assets of those subsidiary members on joining and leaving a consolidated group.

3.112 The amendments contained in Schedule 5 to this bill align the membership rules for consolidated groups and MEC groups. This alignment ensures that the MEC membership rules reflect the same policy as that which applies to consolidated groups.

MEC group membership rules

3.113 The aim of this measure is to clarify the circumstances in which a foreign-held resident entity can become a member of a MEC group. Such entities will only be able to become members of a MEC group on formation of the group and that particular membership structure must be in existence as at the MEC group formation time. The formation time of the MEC group must be before 1 July 2004.

Example 3.10

Example of MEC group and interaction with outside groups

Assuming the MEC group consolidated with effect before 1 July 2004, its members would comprise the eligible tier-1 companies (these being Companies A and B) and the subsidiary members (these being Companies C, D and E as well as F Trust).If the MEC group consolidated on or after 1 July 2004, Company E and F Trust would not be able to join the group because Company G, being a non-resident entity owns Company E and F Trust.

Determining whether a foreign-held resident entity can be a member of a MEC group

3.114 In determining whether a foreign-held resident entity can be a member of a MEC group, there are two test times that must be considered, one on formation of the MEC group and an on-going rule that tests the entities to ensure that they remain eligible to be members of the MEC group.

First test time - formation of the MEC group

3.115 Because the rules allowing non-resident entities to be interposed between group members are transitional only, a group wishing to consolidate with such subsidiary members must do so with effect before 1 July 2004. If it does not consolidate until after that date it cannot include as a subsidiary member those entities that are held through non-resident entities. [Schedule 5, item 10, section 719-10]

3.116 As with consolidated groups, a subsidiary member of a MEC group that has non-resident entities interposed between it and other members of the group is either a 'transitional foreign-held subsidiary' or a 'transitional foreign-held indirect subsidiary'. These terms are defined in section 701C-20 of the IT(TP) Act 1997 and apply to MEC groups because of the application of section 719-2 of the IT(TP) Act 1997. [Schedule 5, item 4, note to section 701C-1; item 5, note to subsection 701C-10(1); item 6, note to subsection 701C-15(1)]

3.117 In brief, a transitional foreign-held subsidiary is a company that has one or more of its membership interests held by:

·
a non-resident company;
·
a non-resident trust;
·
a nominee of one or more entities each of which is a non-resident company or a non-resident trust; or
·
a partnership, where each of the partners is a non-resident company or a non-resident trust.

A transitional foreign-held indirect subsidiary is a company, trust or partnership that:

·
is not a transitional foreign-held subsidiary; and
·
has one or more of its membership interests held by:
·
an entity that is a transitional foreign-held subsidiary; or
·
an entity that is a foreign-held indirect subsidiary.

For further information about these entities see paragraphs 4.28 to 4.33 of the Explanatory Memorandum to the New Business Tax System (Consolidation and Other Measures) Bill (No. 2) 2002.

Example 3.11

Example of MEC group and interaction with non-resident interposed entities

Assuming the MEC group consolidated with effect before 1 July 2004, Company E is a transitional foreign-held subsidiary and Company F is a transitional foreign-held indirect subsidiary. Companies A and B are eligible tier-1 companies and Companies C and D are subsidiary members of the group (along with companies E and F).The non-resident interposed entities (Company G and H Trust) must be wholly-owned subsidiaries of the group and must satisfy the requirements found in subsections 701C-10(3) to (5) of the IT(TP) Act 1997.Of note, a transitional foreign-held subsidiary cannot be an eligible tier-1 company. This is because either it does not satisfy the definition of 'tier-1 company' found in paragraph 719-20(1)(b) (item 2, column 4 in the table) or, if it does, it will not satisfy the definition of 'eligible tier-1' found in section 719-15. Example 3.12

Example of MEC group and interaction with outside groups

Assuming the MEC group consolidated with effect before 1 July 2004, Company E is a transitional foreign-held subsidiary and F Trust is a transitional foreign-held indirect subsidiary. It does not matter that Company G does not wholly own Company E. To be a transitional foreign-held subsidiary, Company E merely must be a company that has one or more of its membership interests held by:

·
a non-resident company;
·
a non-resident trust;
·
a nominee of one or more entities each of which is a non-resident company or a non-resident trust; or
·
a partnership, where each of the partners is a non-resident company or a non-resident trust.

Companies A and B are eligible tier-1 companies and Companies C and D are subsidiary members of the group (along with Company E and F Trust).

3.118 Another amendment to section 719-10 is needed to achieve the desired outcome. Subsection 719-10(4) (resident companies that are held through interposed non-residents) and subsection 719-10(5) (resident trusts and partnerships that are held through interposed non-resident entities) have been repealed [Schedule 5, item 2, subsections 719-10(4) and (5)] . In their place reference has now been made to the transitional provisions dealing with the membership requirements for subsidiaries held through interposed non-resident entities [Schedule 5, item 1, subparagraphs 719-10(1)(b)(ii) and (iii)] . Further, references to subsections 719-10(4) and (5) found in subsections 719-10(1) and (6) have been repealed, these being replaced by a reference to the relevant transitional provisions [Schedule 5, item 1, subparagraphs 719-10(1)(b)(ii) and (iii) and item 3, paragraphs 719-10(6)(c) and (d)] .

Second test time - on-going rules

3.119 If a MEC group has consolidated with effect before 1 July 2004 and one or more of its members is a transitional foreign-held subsidiary or a transitional foreign-held indirect subsidiary, on-going rules must be satisfied to ensure that these subsidiaries remain eligible to be members of a MEC group. These rules are found in sections 701C-10 and 701C-15 of the IT(TP) Act 1997 and apply to MEC groups because of the application of section 719-2 of the IT(TP) Act 1997.

3.120 Section 701C-10 of the IT(TP) Act 1997 contains the relevant test that applies to transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries that are companies. Section 701C-15 contains the relevant test that applies to transitional foreign-held indirect subsidiaries that are trusts and partnerships.

3.121 If these tests are not satisfied at any time the entity will no longer remain eligible to be a member of the MEC group.

Rules that restrict entities joining a MEC group

3.122 The amendments made in this bill also clarify which entities that can join a MEC group, the objective being to prevent an entity from joining an existing MEC group where a new foreign-held membership structure is introduced to or created within the MEC group. For example, an entity will not qualify to be a member of an existing MEC group in the following circumstances where a MEC group:

·
acquires another MEC group or consolidated group that contains a foreign-held structure;
·
acquires another MEC group or consolidated group through a non-resident entity interposed between a subsidiary and the head company of the MEC group and the acquired group;
·
acquires linked entities where there is a foreign-held membership structure that forms part of the link. In this circumstance the link will be broken at the resident entity that owns membership interests in the interposed non-resident;
·
acquires a non-resident that wholly owns Australian resident subsidiaries;
·
changes it membership structure to create a foreign-held membership structure within the group. This could occur where a resident subsidiary becomes a non-resident entity, and that subsidiary holds membership interests in other subsidiaries; or
·
converts to a consolidated group and the MEC group had previously been formed including a foreign-held membership structure (see also paragraphs 3.123 to 3.124).

Conversion events

3.123 Following formation of a MEC or a consolidated group these groups may 'convert' to a consolidated or a MEC group respectively (see sections 703-55 and 719-40).

3.124 Allowing non-resident entities to be interposed between members of a MEC or consolidated group is transitional, and as such, on the occurrence a MEC group 'converting' to a consolidated group or a consolidated group 'converting' to a MEC group, such a structure will not be able to be included in the new group after 1 July 2004.

Technical amendment to sections 701C-30 and 701C-35 of the IT(TP) Act 1997

3.125 An error in sections 701C-30 and 701C-35 of the IT(TP) Act 1997 is corrected. The term 'transitional foreign-held entity' found in these sections should have read 'transitional foreign-held joining entity', in keeping with the description of the term found in section 701C-25. [Schedule 5, item 7, section 701C-30; item 8, note 2 to section 701C-30; item 9, section 701C-35]

Application of rules to MEC groups

3.126 Schedule 6 to this bill amends the ITAA 1997 and the IT(TP) Act 1997 to provide for the application of the rules to MEC groups.

3.127 Section 719-2 of the IT(TP) Act 1997 provides that, other than Divisions 703 and 719, Part 3-90 has effect in relation to a MEC group in the same way it has effect in relation to a consolidated group (for further information see paragraphs 2.7 to 2.13 of the Explanatory Memorandum to New Business Tax System (Consolidation and Other Measures) Bill (No. 2) 2002). This provision has been expanded so as to ensure that a reference in Part 3-90 (excepting Divisions 703 and 719) to a provision in Division 703 of the IT(TP) Act 1997 or Division 703 applies as if it referred instead to the corresponding provision in Division 719 of the IT(TP) Act 1997 or Division 719 [Schedule 6, item 1, subsection 719-2(3) of the IT(TP) Act 1997] .

3.128 This expansion of section 719-2 enables the MEC group equivalent found in subparagraph 719-10(1)(b)(ii) of the ITAA 1997 to be used instead of item 2, column 4, of the table in subsection 703-15(2) that is referred to in subsection 701C-10(1) of the IT(TP) Act 1997 (see the note that is found in Schedule 5, item 5 subsection 701C-10(1)). This enables the requirements in section 719-5 to be satisfied.

Application of amendments to the IT(TP) Act 1997

3.129 Schedule 7 to this bill amends the IT(TP) Act 1997 to ensure that amendments made by this bill apply on or after 1 July 2002. [Schedule 7, item 1, subsection 700-1(1)]

Number sequencing of Parts 3-90 and 3-95

3.130 A technical amendment is made to place Part 3-90 before Part 3-95, as originally intended. Part 3-95 was placed before Part 3-90 due to the commencement provisions of the New Business Tax System (Consolidation) Act (No. 1) 2002 and the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002. [Schedule 8, items 1 and 2]

Application provisions

3.131 The amendments discussed in this chapter will take effect on 1 July 2002, along with the other aspects of the consolidation regime. [Schedule 8, item 3]


Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).