Edited version of your private ruling

Authorisation Number: 1012502033667

Ruling

Subject : Entitlement to a deduction

Question 1

Will Company A be entitled to a deduction under subsection 716-405(2) of Part 1 of Schedule 3 to the Tax Laws Amendment (2012 Measures No. 2) Act 2012 in respect of each right to future income which is an unbilled income asset for the purposes of subsection 701-63(6) of Part 1 of Schedule 3 to the Tax Laws Amendment (2012 Measures No. 2) Act 2012 and which arises in respect of certain long term construction contracts which were held by the Company B income tax consolidated group at the time of joining the Company A income tax consolidated group?

Answer

No.

This ruling applies for the following periods:

Income tax year ending 31 March 200W.

Relevant facts and circumstances

Parent Company incorporated Company A in 200X to establish its Australian business hub to develop the business in Australia and some overseas countries.. Company A elected to form an income tax consolidated group (Company A group) from that date with itself as the head company.

Company B was a company which operated predominately in Australia, with some minor operations in other countries. Company B formed an income tax consolidated group (Company B group) with itself as the head company on the 1 January 200Y.

On 1 July 200Z Company A acquired 100% of the membership interests in Company B (from Company C) and the Company B group joined the Company A group

At the time of acquisition the assets of the Company B group included various ongoing long term construction contracts a number of which had positive work in progress amounts for accounting purposes under AASB 111 Construction Contracts (AASB 111).

For AASB 111 accounting purposes the Company B group determined the stage of completion for each construction contract by determining the proportion that contract costs incurred for work performed to date bore to the estimated total contract costs.

For income tax purposes the Company B group applied the estimated profits basis to recognise income from the long term construction contracts in accordance with Taxation Ruling IT 2450 (IT 2450), utilising the same percentage of completion for each contract as that determined under AASB 111. The Company A group, post acquisition, also applied the estimated profits basis to recognise income from the long term construction contracts in accordance with IT 2450.

The applicant agrees that due to the use of the IT 2450 estimated profits method by the Company B group it is not reasonable to expect that an amount attributable to the AASB 111 positive work in progress amount for each long term construction contract held by the Company B group at the joining time would be included in the assessable income of Company A (or any other entity) after the joining time.

It is, however, reasonable to expect that an amount arising under one or more of the long term construction contracts that is attributable to a right to future income under subsection 701-63(5) of Part 1 of Schedule 3 to the Tax Laws Amendment (2012 Measures No. 2) Act 2012 (TLAA 2012) will be included in the future assessable income of Company A as head entity of the Company A group (or of any other entity).

Relevant legislative provisions

Division 705 ITAA 1997

Subsection 701-55(5C) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-55(5C)(a) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-55(5C)(b) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-55(5C)(c) of Part 1 of Schedule 3 to the TLAA 2012

Subsection 701-63(1) of Part 1 of Schedule 3 to the TLAA 2012

Subsection 701-63(2) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(2)(a) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(2)(b) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(2)(c) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(3)(c) of Part 1 of Schedule 3 to the TLAA 2012

Subsection 701-63(4) of Part 1 of Schedule 3 to the TLAA 2012

Subsection 701-63(5) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(5)(a) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(5)(b) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(5)(c) of Part 1 of Schedule 3 to the TLAA 2012

Subsection 701-63(6) of Part 1 of Schedule 3 to the TLAA 2012

Subparagraph 701-63(6)(a)(i) of Part 1 of Schedule 3 to the TLAA 2012

Subparagraph 701-63(6)(a)(ii) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 701-63(6)(b) of Part 1 of Schedule 3 to the TLAA 2012

Section 716-405 of Part 1 of Schedule 3 to the TLAA 2012

Subsection 716-405(2) of Part 1 of Schedule 3 to the TLAA 2012

Section 716-410 of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 716-410(a) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 716-410(b) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 716-410(c) of Part 1 of Schedule 3 to the TLAA 2012

Paragraph 716-410(d) of Part 1 of Schedule 3 to the TLAA 2012

Subitem 50(1) of Part 4 of Schedule 3 to the TLAA 2012

Subitem 50(2) of Part 4 of Schedule 3 to the TLAA 2012

Subitem 50(3) of Part 4 of Schedule 3 to the TLAA 2012

Subitem 50(4) of Part 4 of Schedule 3 to the TLAA 2012

Subitem 50(5) of Part 4 of Schedule 3 to the TLAA 2012

Reasons for decision

Applicable rules - the pre rules

Subitem 50(1) of Part 4 of Schedule 3 to the TLAA 2012 (the application rules) states that the pre rules, interim rules or prospective rules will apply to an assessment of the head company of a consolidated group for an income year in respect of a joining entity in accordance with subitems 50(2), 50(3), 50(4) and 50(5) of the application rules. Subitem 50(2) of the application rules states that the pre rules will apply for an income year in respect of a joining entity if:

· the joining time is before 12 May 2010; or

· the arrangement under which the joining entity joined the group commenced before 10 February 2010.

The application of subitem 50(2) of the application rules is subject to subitems 50(3) or 50(5) of the application rules. In the circumstances of this ruling neither of those subitems apply. As the Company B group joined the Company A group on the 1 July 200Z (before 12 May 2010) the pre rules apply.

Asset forming part of goodwill

Subsection 701-63(1) of the pre rules states that subsection 701-63(2) of the pre rules applies if an entity became a subsidiary member of a consolidated group at a time.

Subsection 701-63(2) of the pre rules states that for the purposes of Part 3-90 of the Income Tax Assessment Act 1997 (ITAA 1997):

(a) treat goodwill of a business of the joining entity as a single asset (paragraph 701-63(2)(a) of the pre rules); and

(b) treat an asset of that business of the joining entity that is an asset forming part of goodwill as being part of that single asset (paragraph 701-63(2)(b) of the pre rules); and

(c) as a result, do not treat an asset of that business of the joining entity that is an asset forming part of goodwill as a separate asset (paragraph 701-63(2)(c) of the pre rules).

Paragraph 701-63(3)(c) of the pre rules states that an asset forming part of goodwill means a non-deductible right to future income.

Meaning of non-deductible right to future income

Subsection 701-63(4) of the pre rules defines a non-deductible right to future income as a right to future income that is not an unbilled income asset.

Meaning of right to future income

Subsection 701-63(5) of the pre rules defines a right to future income as a valuable right (including a contingent right) to receive an amount for the performance of work or services or the provision of goods if:

(a) the valuable right forms part of a contract or agreement (paragraph 701-63(5)(a) of the pre rules); and

(b) the market value of the valuable right (taking into account all the obligations and conditions relating to the right) is greater than nil (paragraph 701-63(5)(b) of the pre rules); and

(c) the valuable right is neither a Division 230 financial arrangement nor part of a Division 230 financial arrangement (paragraph 701-63(5)(c) of the pre rules).

Unbilled income asset

Subsection 701-63(6) of the pre rules defines an asset that is a right to future income as an unbilled income asset if the asset:

(a) is in respect of work (but not goods) that has been performed, or partially performed, by an entity for another entity (subparagraph 701-63(6)(a)(i) of the pre rules); or

(b) is in respect of goods (other than trading stock) or services that have been provided, by an entity to another entity (subparagraph 701-63(6)(a)(ii) of the pre rules); and

(c) a recoverable debt has not yet arisen in respect of the work, goods or services (paragraph 701-63(6)(b) of the pre rules).

Tax cost setting amount exercise and rights to future income under the pre rules

On joining a consolidated group the assets brought into the group by the joining entity (subsidiary member) must be identified for the purpose of working out their tax cost setting amount under Division 705 of the ITAA 1997 and then setting this tax cost setting amount for the income tax purposes of the head company under the relevant subsection in section 701-55 of the ITAA 1997 (refer to subsection 701-10(4) of the ITAA 1997).

In identifying the assets brought into the Company A group by the Company B group for the purpose of Division 705 and section 701-55 of the ITAA 1997 regard must be had to section 701-63 of the pre rules.

The first step in applying section 701-63 of the pre rules is to determine whether one or more of the long term construction contracts held by the Company B group as at 1 July 200X joining time, qualify as a right to future income under subsection 701-63(5) of the pre rules. In the event one or more of these contracts meet the definition of a right to future income under subsection 701-63(5) of the pre rules the next step is to determine whether one or more qualify as an unbilled income asset under subsection 701-63(6) of the pre rules.

Only that part of a subsection 701-63(5) right to future income that qualifies as an unbilled income asset under subsection 701-63(6) of the pre rules may be recognised as a separate reset cost base asset for the purposes Division 705 of the ITAA 1997. The part of the right to future income that does not qualify as an unbilled income asset is, in accordance with subsection 701-63(4) of the pre rules, a non deductible right to future income and is treated, by paragraph 701-63(3)(c ) of the pre rules, as forming part of goodwill for the purposes of Division 705 and section 701-55 of the ITAA 1997. This means only that part of a subsection 701-63(5) right to future income that qualifies as a subsection 701-63(6) unbilled income asset is capable of having a tax cost setting amount worked out under Division 705 of the ITAA 1997 as an asset separate from goodwill. Relevantly therefore only a subsection 701-63(6) unbilled income asset is capable of having a tax cost setting amount that may be set under subsection 701-55(5C) of the pre rules and deducted by the head company under section 716-405 of the pre rules.

A long term construction contract held by a joining entity at the joining time with a positive work in progress amount in accordance with subparagraph 42(a) and paragraph 43 of AASB 111 at this time, would, subject to this amount excluding any amount for costs incurred in advance of work performed at this time, appear to satisfy the requirements of subsection 701-63(5) and subsection 701-63(6) of the pre rules.

A construction contract is defined in AASB 111 as one for (or directly related to) the construction of an asset (such as a bridge, building, dam, pipeline, road, ship or tunnel). As noted by AASB 102 Inventories and paragraph 12 of IT 2450 an AASB 111 construction contract is not one for the (construction) sale and supply of trading stock. Rather an AASB 111 construction contract is one for the rendering of (skilled) services, such as those provided by project managers, builders and architects, in the construction of an asset. Such a contract, or the AASB 111 positive work in progress amount recorded in respect of it at the joining time, is also not a financial arrangement as defined in section 230-45 of Division 230 of the ITAA 1997 (is not capable of being a Division 230 financial arrangement) as the right to receive the AASB 111 amount is contingent on performance and billing by the entity.

To the extent the Company B group beneficially held long term construction contracts with positive work in progress amounts in accordance with subparagraph 42(a) and paragraph 43 of AASB 111 at the joining time, then those contracts (subject to excluding any amounts for costs incurred in advance of work performed) would qualify as subsection 701-63(6) unbilled income assets and would be treated as reset cost base assets for tax cost setting amount working out purposes under Division 705 of the ITAA 1997.

The market value of the long term construction contract unbilled income asset, for the purpose of Division 705 of the ITAA 1997, must not exceed the AASB 111 positive work in progress amount (excluding any amounts for costs incurred in advance of work performed) recorded in respect of the asset at the joining time.

Setting the tax cost of an asset under subsection 701-55(5C) of the pre rules

In order for subsection 701-55(5C) of the pre rules to apply in relation to an asset, such that the tax cost setting amount of the asset may be deducted by the head company under section 716-405 of the pre rules:

(a) the asset must have its tax cost set because an entity became a subsidiary member of a consolidated group at the particular time (paragraph 701-55(5C)(a) of the pre rules); and

(b) the asset must be covered at the particular time by section 716-410 (paragraph 701-55(5C)(b) of the pre rules); and

(c) the asset must not be a non-deductible right to future income (paragraph 701-55(5C)(c) of the pre rules).

Paragraphs 701-55(5C)(a) and 701-55(5C)(c) of the pre rules operate to reinforce the fact, as noted above, that only a subsection 701-63(6) unbilled income asset is capable of having a tax cost setting amount worked out under Division 705 of the ITAA 1997.

Whether a long term construction contract of the Company B group that qualifies as a subsection 701-63(6) unbilled income asset at the joining time may have its tax cost setting amount deducted by Company A under section 716-405 of the pre rules depends on whether the asset is covered by section 716-410 of the pre rules, as required by paragraph 701-55(5C)(b) of the pre rules.

Section 716-410 of the pre rules

Section 716-410 of the pre rules states that an asset will be covered by the section if:

(a) the asset is a right to future income (paragraph 716-410(a) of the pre rules); and

(b) the asset is held by an entity just before the time (the joining time) it became a subsidiary member of a consolidated group (paragraph 716-410(b) of the pre rules); and

(c) it is reasonable to expect an amount attributable to the asset will be included in the assessable income of the entity or any other entity after the joining time (paragraph 716-410(c) of the pre rules); and

Division 230 of the ITAA 1997 does not apply in relation to the asset (paragraph 716-410(d) of the pre rules).

The interpretive issue that arises here is whether the test in paragraph 716-410(c) of the pre rules is to be applied to the subsection 701-63(5) right to future income asset, being the long term construction contract in its entirety, or whether it is to be applied to the subsection 701-63(6) right to future income that is an unbilled income asset, being that part of the long term construction contract that qualifies as an unbilled income asset and receives a tax cost setting amount.

Although paragraph 716-410(a) of the pre rules prima facie refers to a right to future income asset under subsection 701-63(5) of the pre rules, the section can never apply to such an asset. The section is only enlivened by paragraph 701-55(5C)(b) of the pre rules or by the existence of a subsection 701-63(6) unbilled income asset with a tax cost setting amount. As a subsection 701-63(5) right to future income asset (the long term construction contract in its entirety) is incapable of having a tax cost setting amount to which paragraph 701-55(5C)(b) of the pre rules may apply it is incapable of enlivening section 716-410 of the pre rules. Therefore the test in paragraph 716-410(c) of the pre rules is to be applied to the subsection 701-63(6) unbilled income asset.

As noted above, a long term construction contract held by a joining entity at the joining time will qualify as a subsection 701-63(6) unbilled income asset to the extent it has a positive work in progress amount in accordance with subparagraph 42(a) and paragraph 43 of AASB 111 at that time, subject to this amount excluding any amounts for costs incurred in advance of work performed.

The AASB 111 positive work in progress amount is the amount by which costs incurred plus recognised profits (less recognised losses) in respect of the contract exceed progress billings at the joining time (AASB 111 paragraph 43). This amount is required to be presented as an asset for accounting purposes (AASB 111 subparagraph 42(a)). This AASB 111 positive work in progress or asset amount in respect of the contract (subject to this amount excluding any amounts for costs incurred in advance of work performed) also represents the maximum market value of the subsection 701-63(6) unbilled income asset for the purpose of working out its tax cost setting amount under Division 705 of the ITAA 1997.

The AASB 111 positive work in progress or asset amount (excluding amounts for costs incurred in advance of work performed) represents the amount by which the revenue returned in respect of the contract (the value of the work or services performed) exceeds progress billings made. It therefore represents a right to receive an amount for work or services performed but for which a recoverable debt has not yet arisen (thereby meeting the requirements of subsection 701-63(6) of the pre rules).

As noted above, the Company B group utilised the IT 2450 estimated profits basis to recognise income from the long term construction contracts for tax purposes, utilising the same percentage of completion for each contract as that determined under AASB 111. Absent the use of the IT 2450 estimated profits method by the Company B group, this AASB 111 or subsection 701-63(6) unbilled income asset would also represent a future assessable income amount. If the Company B group had been using the basic method (rather than the IT 2450 estimated profits method) to return income from long term construction contracts then it would be reasonable to expect that an amount attributable to the unbilled income asset would be included in the assessable income of Company A after joining time (as this would occur on billing or a recoverable debt arising for the amount after joining time). The IT 2450 estimated profits method however uncouples the taxpayer (the Company B group) from basic income derivation (and outgoing incurred) timing principles. It means that on a billing (or a recoverable debt arising) for the AASB 111 or 701-63(6) unbilled income asset after joining time no amount attributable to this asset will be included in the assessable income of the head company Company A (or any other entity) as the amount has already been recognised by the Company B group for income tax purposes before the joining time.

The applicant has also agreed that due to the use of the use of the IT 2450 estimated profits method by the Company B group, it is not reasonable to expect that an amount attributable to the AASB 111 asset (this being the subsection 701-63(6) unbilled income asset) will be included in the assessable income of Company A (or any other entity) after joining time.

Therefore any long term construction contracts of the Company B group that may qualify as subsection 701-63(6) assets at the joining time (and receive a tax cost setting amount under Division 705 of the ITAA 1997) will not be covered by section 716-410 of the pre rules as they will fail the test in paragraph 716-410(c) of the pre rules.

As the asset is not covered by section 716-410 of the pre rules as required by paragraph 701-55(5C)(b) of the pre rules the tax cost setting amount of the subsection 701-63(6) unbilled income asset may not be deducted under section 716-405 of the pre rules.

Conclusion

Company A will not be entitled to a deduction under subsection 716-405(2) of the pre rules in respect of each right to future income which is an unbilled income asset for the purposes of subsection 701-63(6) of the pre rules and which arises in respect of certain long term construction contracts which were held by the Company B group at the time of joining the Company A group.