Edited version of your written advice

Authorisation Number: 1012808229594

Ruling

Subject: Debt forgiveness within a consolidated group

Question 1

Will section 701-1 of the Income Tax Assessment Act 1997 (ITAA 1997) operate to prevent Division 245 of that Act from applying in relation to a debt owed by Debt Co Pty Ltd to Finance Co Pty Ltd that is forgiven?

Answer

Yes.

Question 2

Will a franking debit arise in Head Co Limited's franking account under section 197-45 of the ITAA 1997 as a result of the forgiveness of the debt mentioned in question 1?

Answer

No

Question 3

Will the amount of Debt Co Pty Ltd's debt that is forgiven be disregarded under subsection 711-45(1) of the ITAA 1997 when it ceases to be a member of the group?

Answer

Yes

This ruling applies for the following periods:

1 July 2014 - 30 June 2015

1 July 2015 - 30 June 2016

The scheme commences on:

The scheme is expected to commence before 1 July 2015.

Relevant facts and circumstances

1. Head Co Limited (Head Co) is the head company of an income tax consolidated group (Head Co TCG).

2. Head Co is seeking to dissolve Debt Co Pty Ltd (Debt Co), a non-operating subsidiary member, through the voluntary deregistration process under the Corporations Act 2001.

3. Debt Co has a debt of $Xm to Finance Co Pty Ltd (Finance Co), another subsidiary member of the Head Co TCG. It is proposed that this debt be forgiven prior to Debt Co's deregistration.

4. The structure of the Head Co TCG at the time of the debt forgiveness and prior to Debt Co's deregistration is as shown below:

Head co TCG structure

5. Debt Co will account for the forgiven debt as follows:

DR Payable - due to Finance Co [balance sheet]

CR Abnormal items - debt (related) forgiven [profit & loss account]

6. Finance Co will account for the forgiven debt as follows:

DR Abnormal items - debt (related) forgiven [profit & loss account]

CR Receivable - due from Debt Co [balance sheet]

7. The transaction will not involve the issue of new shares or the discharge of any obligation to pay the subscription price of previously issued shares.

8. As a result of the debt forgiveness, prior to deregistration, Debt Co will not have any liabilities recorded in its accounts.

9. The share capital accounts of Head Co and its subsidiary members are not tainted by a prior application of Division 197.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 6D (repealed)

Income Tax Assessment Act 1936 paragraph 6D(1)(a) (repealed)

Income Tax Assessment Act 1936 section 44

Income Tax Assessment Act 1936 Division 16K of Part III

Income Tax Assessment Act 1936 section 159GZZZP

Income Tax Assessment Act 1997 section 104-520

Income Tax Assessment Act 1997 Division 197

Income Tax Assessment Act 1997 subsection 197-5(1)

Income Tax Assessment Act 1997 section 197-45

Income Tax Assessment Act 1997 section 197-50

Income Tax Assessment Act 1997 section 197-55

Income Tax Assessment Act 1997 section 197-60

Income Tax Assessment Act 1997 paragraph 202-45(e)

Income Tax Assessment Act 1997 Division 245

Income Tax Assessment Act 1997 Subdivision 245-E

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 subsection 701-1(1)

Income Tax Assessment Act 1997 subsection 701-1(2)

Income Tax Assessment Act 1997 subsection 701-1(3)

Income Tax Assessment Act 1997 subsection 701-1((4)

Income Tax Assessment Act 1997 section 701-15

Income Tax Assessment Act 1997 subsection 701-55(5)

Income Tax Assessment Act 1997 section 701-60

Income Tax Assessment Act 1997 Subdivision 709-A

Income Tax Assessment Act 1997 section 709-60

Income Tax Assessment Act 1997 section 709-65

Income Tax Assessment Act 1997 section 709-70

Income Tax Assessment Act 1997 section 709-75

Income Tax Assessment Act 1997 section 711-15

Income Tax Assessment Act 1997 section 711-20

Income Tax Assessment Act 1997 section 711-25

Income Tax Assessment Act 1997 section 711-35

Income Tax Assessment Act 1997 section 711-40

Income Tax Assessment Act 1997 section 711-45

Income Tax Assessment Act 1997 subsection 711-45(1)

Income Tax Assessment Act 1997 subsection 711-45(1A)

Income Tax Assessment Act 1997 subsection 711-45(4)

Income Tax Assessment Act 1997 section 711-55

Income Tax Assessment Act 1997 section 975-300

Income Tax Assessment Act 1997 subsection 975-300(3)

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

Tax Laws Amendment (2006 Measures No. 3) Act 2006

Reasons for decision

Note: All subsequent legislative references are to the ITAA 1997 unless specified otherwise. References to the ITAA 1936 are references to the Income Tax Assessment Act 1936.

Question 1

Effect of single entity rule

Subsection 701-1(1) (the 'single entity rule') treats an entity that is a subsidiary member of a consolidated group for any period and any other subsidiary members of the group as being parts of the head company of the group, rather than separate entities, for that period.

However, this deeming has effect only for the 'head company core purposes' and 'entity core purposes' expressed in subsections 701-1(2) and (3) respectively (as 'deeming provisions are required by their nature to be construed strictly and only for the purpose for which they are resorted to', per Fisher J in FCT v. Comber (1986) 10 FCR 88 at 96; 65 ALR 451 at 458). These purposes are:

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

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

Subsection 701-1(4) lists all the sorts of loss as follows (all are terms defined in subsection 995-1(1) of the ITAA 1997):

• tax loss

• film loss

• net capital loss.

Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 states the consequences of the single entity rule in the following terms (at paragraph 7):

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

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

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

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

Application to the facts

In the present case, just before they are forgiven, the debt owed by Debt Co to Finance Co is an asset of Finance Co. The asset and liability are intra-group, and the single entity rule has the effect that they are not recognised for the head company core purposes or entity core purposes while Debt Co and Finance Co remain members of the group.

It follows that the forgiveness of the debt during this period can have no income tax consequences for the consolidated group or its members. In particular, the commercial debt forgiveness provisions in Division 245, which would normally have the effect (refer Subdivision 245-E) of reducing a tax loss, net capital loss or one or more categories of deductible expenditure of the relevant debtor entity, do not apply.

Question 2

The question concerns whether the accounting treatment of the debt forgiveness involves transferring an amount from an account of the relevant debtor company that is not a share capital account to its share capital account, as this potentially triggers the share capital account tainting rules in Division 197. As paragraph 4.4 of the Revised Explanatory Memorandum (Senate) to Tax Laws Amendment (2006 Measures No. 3) Bill 2006 explains, these 'are integrity rules designed to prevent a company from disguising a distribution of profits as a tax-preferred capital distribution by transferring profits into its share capital account and subsequently making distributions from that account.'

Effect of share capital account tainting rules

Such a transfer would (subject to exclusions that are not of present concern) cause Division 197 to apply to the transferred amount (refer subsection 197-5(1)), giving rise to a debit to the company's franking account under section 197-45, and also tainting the company's share capital account under section 197-50. Any subsequent distribution from the tainted share capital account would be treated as an assessable and unfrankable dividend. (This is because subsection 975-300(3) treats a tainted share capital account as not being a share capital account for the purposes of 'this Act' (a defined term which includes the ITAA 1936) except for specified provisions including Division 197 and paragraph 202-45(e). The exception in paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 therefore does not apply, so the distribution is subject to section 44 of the ITAA 1936, and paragraph 202-45(e) makes it unfrankable.)

The company can avoid that result by choosing to untaint the account under section 197-55, but so choosing makes it liable to untainting tax under section 197-60.

Effect of consolidation rules on franking accounts

The above treatment is modified by the rules in Subdivision 709-A, which apply to the franking accounts of subsidiary members of consolidated groups in a manner consistent with the single entity concept, as follows:

• On joining a consolidated group, section 709-60 operates such that the joining entity's franking surplus (if any) is transferred to the head company's franking account, or if the joining entity has a franking debit, it becomes liable to pay franking deficit tax as if the joining time were the end of its income year. Either way, the joining entity's franking account balance becomes nil.

• Section 709-65 renders the joining entity's franking account inoperable while it remains a subsidiary member of the group.

• Sections 709-70 and 709-75 have the effect that any franking credits or debits (respectively) that would (apart from section 709-65) have arisen in the entity's franking account arise in the head company's franking account instead.

Consequently, if a subsidiary member of a consolidated group transfers an amount to its share capital account from another account and Division 197 applies to the transfer, the franking debit that would (apart from section 709-65) have arisen in the subsidiary member's franking account under section 197-45 arises in the head company's franking account instead.

When is an amount transferred from one account to another account?

The Revised Explanatory Memorandum (Senate) to Tax Laws Amendment (2006 Measures No. 3) Act 2006 (the EM) answers this question as follows:

4.12 An amount is transferred from one account to another where that amount is moved from one account to another. This, in turn, requires the balance of the first account to be reduced, while the balance of the second account is increased by the same amount.

4.13 An amount is not transferred from one account to another where the particular accounting entries result in the balances of both accounts increasing in size. Accordingly, an accounting entry of the form 'debit asset, credit share capital account' does not represent a transfer in the relevant sense. Furthermore, a transfer to the share capital account will not arise if an expense account is debited at the same time that the share capital account is credited.

Definition of 'share capital account''

The term 'share capital account' is defined in subsection 995-1(1) as having the meaning given by section 975-300, which states:

(1) A company's share capital account is:

(a) an account that the company keeps of its share capital; or

(b) any other account (whether or not called a share capital account) that satisfies the following conditions:

(i) the account was created on or after 1 July 1998;

(ii) the first amount credited to the account was an amount of share capital.

(2) If a company has more than one account covered by subsection (1), the accounts are taken, for the purposes of this Act, to be a single account.

Note: Because the accounts are taken to be a single account (the combined share capital account), tainting of any of the accounts has the effect of tainting the combined share capital account.

(3) However, if a company's *share capital account is *tainted, that account is taken not to be a share capital account for the purposes [of] this Act, other than:

(a) …

(b) Division 197; and

(ba) paragraph 202-45(e); and

(c) …

…

As to what 'share capital' means, the EM comments:

4.10 The concept of share capital is not defined in the ITAA 1997. Under its ordinary meaning, share capital includes amounts received by a company in consideration for the issue of shares.

The case of Commissioner of Taxation v. Consolidated Media Holdings Ltd [2012] HCA 55; 2012 ATC 20-361; 84 ATR 1 and the cases leading up to it illustrate that it is not always straightforward to establish whether or not an account is a share capital account. In that case, the High Court examined what constitutes a 'share capital account' for the purposes of the share buy-back provisions in Division 16K of Part III of the ITAA 1936. The definition of that term at the relevant time was contained in former section 6D of the ITAA 1936, which was repealed by Tax Laws Amendment (2006 Measures No. 3) Act 2006 and replaced with the definition in section 975-300 reproduced above. The current definition is in almost exactly the same terms as before, but with updated references to provisions of the ITAA 1997 that had been rewritten from the ITAA 1936.

The High Court held that the purchase price for the share buy-back was debited against the share capital account of Crown Melbourne Limited (Crown) for the purposes of section 159GZZZP of the ITAA 1936 notwithstanding that Crown had established a separate general ledger account called 'Share Buy-Back Reserve Account' to record the buy-back. Prior to its establishment, Crown had established other accounts in its general ledger including those labelled 'Shareholders Equity Account' and 'Inter-Company Loan (Payable) Account'.

On 28 June 2002, the day that Crown established the Share Buy-Back Reserve Account, Crown debited $1 billion to it. The same day, it credited the same amount to the Inter-Company Loan (Payable) Account. No entry was made in the Shareholders Equity Account, which retained a constant credit balance throughout the year ended 30 June 2002 in excess of $2.4 billion. Crown's audited financial statements for the financial year ended 30 June 2002 showed a reduction in Crown's 'Contributed Equity' of $1 billion from an opening figure of just over $2.4 billion (corresponding with the balance shown in the Shareholders Equity Account) to a closing figure of just over $1.4 billion.

Their Honours stated (at paragraph 42):

… The reference in s 6D(1)(a) to "an account which the company keeps of its share capital (emphasis added) cannot … be confined … to the account "to which the paid up capital of the company was originally credited" or to "one in which a company ordinarily keeps its share capital on contribution" (emphasis added). Much less can it be confined … to an account which the company kept of its share capital on 1 July 1998.

… and further (at paragraph 44):

… it was sufficient for an account to answer the description in s 6D(1)(a) of "an account which the company keeps of its share capital" (emphasis added) that the account, whether debited or credited with one or more amounts, be either a record of a transaction into which the company had entered in relation to its share capital, or a record of the financial position of the company in relation to its share capital.

… and finally (at paragraph 46):

Crown's Share Buy-Back Reserve Account in which, as corrected, the only entry as at 30 June 2002 was a $1 billion debit was a record of the transaction by which Crown had on 28 June 2002 entered into an executory contract to reduce its share capital by that amount. As illustrated by the derivation of the figure for "Contributed Equity" later shown in Crown's audited financial statements, the financial position of Crown in relation to its share capital as at 30 June 2002 could only be understood by subtracting the $1 billion debit balance in its Share Buy-Back Reserve Account from the credit balance of just over $2.4 billion in its Shareholders Equity Account. On either basis, the Share Buy-Back Reserve Account answered the description of an account which Crown kept of its share capital within s 6D(1)(a). The Share Buy-Back Reserve Account was therefore a share capital account.

(Note: Former paragraph 6D(1)(a) of the ITAA 1936, referred to in the above quotation, had identical wording to paragraph 975-300(1)(a).)

Application to the facts

The present case is rather more straightforward than that of Consolidated Media Holdings. The accounting entries of Debt Co and Finance Co in relation to the debt forgiveness are conventional. Debt Co is merely transferring an amount from 'Payable', a balance sheet item, to 'Abnormal items' in profit-and-loss. The transfer is in no way a transfer to anything that can be regarded as a share capital account.

Accordingly, Division 197 is not brought into operation, and so section 197-45 in concert with section 709-75 will not apply to cause a debit to arise in the franking account of Head Co.

Question 3

Effect of liabilities of a leaving entity on the head company's tax costs of membership interests

Just before an entity ceases to be a subsidiary member of a consolidated group, the tax cost of each membership interest that the head company holds in it is set at its 'tax cost setting amount' under section 701-15. According to item 2 of the table in section 701-60, the tax cost setting amount is worked out under section 711-15 or section 711-55. (Section 711-55 covers multiple exits, which is not of present concern.) Subsection 701-55(5) then translates the effect of the cost setting for the purpose of applying the capital gains tax provisions in relation to the membership interests by setting the cost base or reduced cost base of each membership interest to its tax cost setting amount.

Section 711-15 states that to work out the cost base of each membership interest:

• the allocable cost amount (ACA) must be worked out for the leaving entity under section 711-20;

• if there is more than one class of membership interests, the ACA must be allocated to each class in proportion to the market value of all membership interests in the class; and

• the result is to be allocated to each of the membership interests (or membership interests in the class) by dividing the result by the number of those membership interests.

The table in subsection 711-20 provides a five step method for working out the ACA:

1. Work out the sum of the terminating values of the leaving entity's assets just before the leaving time in accordance with section 711-25;

2. Add to the result of step 1 the value of deductions inherited by the leaving entity not already reflected in step 1 just before the leaving time in accordance with section 711-35;

3. Add to the result of step 2 the amount of the liabilities owed by members of the consolidated group to the leaving entity at the leaving time in accordance with section 711-40;

4. Subtract from the result of step 3 the leaving entity's liabilities just before the leaving time in accordance with section 711-45;

5. If the amount remaining after step 4 is positive, it is the ACA, otherwise the ACA is nil.

However, if the amount remaining after step 5 is negative, a capital gain arises under CGT event L5 (refer section 104-520) equal to that amount.

In the present case, it is step 4 that is of interest.

Subsection 711-45(1) states that the step 4 amount is worked out by adding up the amount of each thing (an 'accounting liability') that, in accordance with the leaving entity's 'accounting principles for tax cost setting' is a liability of the leaving entity just before the leaving time. Those accounting principles are the accounting principles that the group would use if it were to prepare its financial statements just before the leaving time, disregarding the single entity rule: refer subsection 711-45(1A).

Subsection 711-45(4) states that if an accounting liability of the leaving entity is owed to a member of the group, the amount to be added for the liability is the market value of the corresponding asset of the member.

Application to the facts

When Debt Co leaves the group as a result of being dissolved, there are no other members of the group that will leave the group as a result (refer structure diagram at fact 4). Therefore section 711-15 (and not section 711-55) will apply to work out the tax cost setting amount of each of the membership interests that the head company holds in it.

Before the leaving time, Debt Co's debt to Finance Co will have been forgiven, so an accounting of its liabilities just before the leaving time would find that there is no liability to Finance Co. Even if there were, the market value of the corresponding asset in the hands of Finance Co would be nil. Either way, no amount will be added in relation to the debt at step 4 of the ACA calculation.