Edited version of your written advice

Authorisation Number: 1012860954972

Date of advice: 26 August 2015

Ruling

Subject: Rights to Future Income - Deduction

Question 1

Do the pre rules apply to the arrangement pursuant to subitem 50(2) of Schedule 3 to the Tax Laws Amendment (2012 Measures No. 2) Act 2012?

Answer

Yes.

Question 2

Is Head Co entitled to a deduction under section 716-405 of the Income Tax Assessment Act 1997 (ITAA 1997) under the pre rules for the work in progress asset it acquired when Sub Co joined the consolidated group?

Answer

Yes.

Question 3

Is Head Co entitled to a deduction under section 716-405 of the ITAA 1997 under the pre rules in the 20XX income year?

Answer

Yes.

This ruling applies for the following period

Income year ended 30 June 20XX

The scheme commences on

1 September 20YY

Relevant facts and circumstances

Sub Co is a property development company. Head Co was a 50% equity owner of Sub Co.

In September 20YY Head Co acquired the remaining 50% shareholding in Sub Co and Sub Co joined the Head Co tax consolidated group.

Sub Co and Landowner entered into a development agreement in 20ZZ under which Sub Co as the developer incurs all project costs and is entitled to all sale proceeds from the sale net of disbursements to Landowner. Sub Co.'s right to the sale proceeds (and a recoverable debt) is contingent on the sale of the Lot. As at joining time there had been no sales of any lots under the development.

Costs incurred by Sub Co on the development at joining time included engineers, surveyors, development consultants, construction costs, advertising and marketing.

Sub Co was not the owner of the land who at all times was Landowner. Therefore, the land and development costs incurred were not treated as trading stock of Sub Co.

On entry into the Head Co consolidated group, the right of Sub Co to receive proceeds from the development was recognised as a separate asset and treated as a reset cost base asset with a tax cost setting amount (TCSA).

Relevant legislative provisions

Tax Laws Amendment (2012 Measures No.2) Act 2012 Part 1 - Pre rules of Schedule 3

Tax Laws Amendment (2012 Measures No.2) Act 2012 Item 50 of Schedule 3

Income Tax Assessment Act 1997 Subsection 701-55(5C)

Income Tax Assessment Act 1997 Section 701-63

Income Tax Assessment Act 1997 Section 716-405

Income Tax Assessment Act 1997 Section 716-410 and

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

Reasons for decision

Question 1

Subitem 50(2) states that the pre rules apply for the income year in respect of the joining entity for a joining time before May 20XX or the arrangement under which the entity joined the group commenced before February 20XX.

Sub Co joined the Head Co consolidated group in 20YY. Therefore, the pre rules apply pursuant to subitem 50(2).

Question 2

When Head Co acquired Sub Co, it acquired valuable rights to future income held by Sub Co from its development agreement with Landowner. This valuable right can give rise to a deduction for Head Co as the head company that acquires Sub Co, under section 716-405 of the ITAA 1997 of the pre rules.

Application of subsection 716-405(1) of the ITAA 1997

Subsection 716-405(1) of the ITAA 1997 provides that:

(1)  This section applies if:

(a)  an entity (the joining entity) became a subsidiary member of a *consolidated group at a time (the joining time); and

(b)  subsection 701-55(5C) applies in relation to the asset at the joining time.

Note: Subsection 701-55(5C) deals with assets covered by section 716-410 (Rights to amounts that are expected to be included in assessable income after joining time).

Sub Co became a subsidiary member of the Head Co consolidated group in 20YY so paragraph 716-405(1)(a) of ITAA 1997 is satisfied.

Paragraph 716-405(1)(b) of the ITAA 1997 requires subsection 701-55(5C) of the ITAA 1997 to apply in relation to the asset at the joining time. The asset that is referred to in section 716-405 is the right to future income amounts that are expected to be included in assessable income after the joining time.

Subsection 701-55(5C) of the ITAA 1997

Subsection 701-55(5C) of the ITAA 1997 states that:

If

(a)  the asset's tax cost is set because an entity becomes a *subsidiary member of a *consolidated group at the particular time; and

(b)  section 716-410 (rights to amounts that are expected to be included in assessable income) covers the asset at the particular time; and

(c)  the asset is not a *non-deductible right to future income;

the expression means that section 716-405 may apply in relation to the asset after the particular time.

Application of paragraph 701-55(5C)(a) of the ITAA 1997

Under section 705-1 of the ITAA 1997, when Sub Co joins the Head Co consolidated group, the tax cost of its assets are set at a tax cost setting amount (TCSA) that is worked out in accordance with Subdivision 705-A of the ITAA 1997. This includes all of Sub Co's assets, including the right to future income. Therefore, paragraph 701-55(5C)(a) of the ITAA 1997 is satisfied.

Application of paragraph 701-55(5C)(b) of the ITAA 1997

Paragraph 701-55(5C)(b) of the ITAA 1997 requires section 716-410 of the ITAA 1997 to cover the asset at the joining time.

Section 716-410 of the ITAA 1997 covers an asset at a particular time if:

(a)  the asset is a *right to future income; 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; and

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

(d)  Division 230 does not apply in relation to the asset (disregarding section 230-455).

A 'right to future income' is defined under subsection 995-1(1) of the ITAA 1997 of the pre rules as the meaning given by subsection 701-63(5) of the ITAA 1997.

Subsection 701-63(5) of the ITAA 1997 states as follows:

A right to future income is 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; 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; and

(c)  the valuable right is neither a *Division 230 financial arrangement nor part of a Division 230 financial arrangement.

A 'right to future income' exists here for the following reasons:

• Under the contract entered into between Sub Co and Landowner, Sub Co has the valuable right to receive proceeds of sale of the property development for the performance of its work as the developer of the project.

• We accept that the market value of the right, taking into account all the obligations and conditions relating to the right, is greater than nil; and

• The right is neither a Division 230 of the ITAA 1997 financial arrangement nor part of a Division 230 financial arrangement since Division 230 does not mandatorily apply to Sub Co and Sub Co has not elected to have Division 230 apply to it.

Section 716-410 of the ITAA 1997 is satisfied and covers the asset for the following reasons:

• The asset is a 'right to future income' -paragraph 716-410(a);

• This right to future income is an asset that was held by Sub Co just before the joining time -paragraph 716-410(b);

• It is reasonable to expect that an amount attributable to the right will be included in the assessable income of Head Co after the joining time by way of the development fee income - paragraph 716-410(c).

• As discussed above, Division 230 of the ITAA 1997 does not apply to the asset - paragraph 716-410(d) of the ITAA 1997.

This means that section 716-410 of the ITAA 1997 covers the asset at the joining time and paragraph 701-55(5C)(b) is satisfied.

Application of paragraph 701-55(5C)(c) of the ITAA 1997

Paragraph 701-55(5C)(c) of the ITAA 1997 requires that the asset not be a 'non-deductible right to future income'. A 'non-deductible right to future income' is defined under subsection 995-1(1) of the ITAA 1997 of the pre rules as the meaning given under subsection 701-63(4) of the ITAA 1997. Under subsection 701-63(4) a 'non-deductible right to future income' is a right to future income that is not an 'unbilled income asset'.

An 'unbilled income asset' is defined under subsection 995-1(1) of the ITAA 1997 of the pre rules as the meaning given by subsection 701-63(6) of the ITAA 1997.

Subsection 701-63(6) of the ITAA 1997 states that:

An asset that is a right to future income is an unbilled income asset if:

(a)  the asset:

(i)  is in respect of work (but not goods) that has been performed, or partially performed, by an entity for another entity; or

(ii)  is in respect of goods (other than *trading stock) or services that have been provided, by an entity to another entity; and

(b)  a recoverable debt has not yet arisen in respect of the work, goods or services.

Therefore the definition of an unbilled income asset is firstly dependent on the asset being a 'right to future income'. As concluded above, Sub Co did hold at the joining time an asset that is a 'right to future income'. This right was in respect of work that had been performed by Sub Co for Landowner consisting of work as the developer from which it incurred costs such as on engineers, surveyors, development consultants, constructions costs, advertising and marketing.

In order for the asset to be an unbilled income asset, the work performed or partially performed by Sub Co for Landowner must not have given rise to a recoverable debt as at the joining time.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings discusses the term 'recoverable debt' and includes at paragraph 10 and 11 the following:

10. The term 'recoverable debt' is used to describe the point of time

at which a taxpayer is legally entitled to an ascertainable amount as the

result of having performed an agreed task.¹ A taxpayer may have a

recoverable debt even though, at the time, they cannot legally enforce

recovery of the debt.²

11. Whether there is, in law, a recoverable debt is a question to be

determined by reference to the contractual agreements that give rise to

the legal entitlement to payment, the general law and any relevant

statutory provisions.

As stated in paragraph 11 whether there is a recoverable debt is a question determined by reference to the contractual agreements that give rise to the legal entitlement to payment.

The development agreement between Sub Co and Landowner indicates that a recoverable debt in favour of Sub Co only arises upon sale of the Lot. Therefore, a recoverable debt is contingent upon the sale of the Lots. Based on the information provided, there were no sales of Lots prior to joining time. Therefore, a recoverable debt in respect of the work performed by Sub Co was not in existence as at joining time.  

Therefore the asset is an 'unbilled income asset' and paragraph 701-55(5C)(c) of the ITAA 1997 is satisfied.

In summary, subsection 701-55(5C) of the ITAA 1997 is satisfied such that section 716-405 of the ITAA 1997 may apply in relation to Sub Co's right to future income.

Under subsection 716-405(5), an entity qualifies for a deduction for an income year for the asset if it is the head company of the group and held the asset at a time in that income year (whether or not because of the operation of subsection 701-1(1) of the ITAA 1997 (the single entity rule).

Head Co satisfies subsection 716-405(5) of the ITAA 1997 and is qualified for a deduction under that subsection because it is the head company of the group and Sub Co is considered to be part of Head Co under the single entity rule during such time that Sub Co remains a subsidiary member of the group, such that Head Co can be regarded as the holder of the asset.

As discussed further in Question 3, the deduction in relation to the asset is worked out in accordance with subsection 716-405(2) of the ITAA 1997.

Question 3

The deduction that Head Co is entitled to is determined under subsection 716-405(2) of the ITAA 1997.

Subsection 716-405(2) of the ITAA 1997 states as follows:

An entity qualified for a deduction under subsection (5) for the asset for an income year ending after the joining time:

(a) if the entity is the *head company of the group and the entity expects that a recoverable debt will arise in respect of the work, goods or services mentioned in subsection 701-63(6) in relation to the asset within 12 months after the joining time-can deduct, for that income year, the *unexpended tax cost setting amount for the asset;

(b) if paragraph (a) does not apply and one or more recoverable debts arise, in that income year, in respect of the work, goods or services mentioned in subsection 701-63(6) in relation to the asset - can deduct, for that income year, the lesser of:

(i) the unexpended tax cost setting amount for the asset for that income year; and

(ii) the total of those recoverable debts; or

c) if paragraphs (a) and (b) do not apply - cannot deduct an amount under this section in respect of the asset for that income year

As discussed in Question 2, Head Co qualified for a deduction under subsection 716-405(5) of the ITAA 1997 in relation to the right to future income asset. What remains to be determined is whether paragraph 716-405(2)(a) or (b) or (c) applies.

Application of subsection 716-405(2) of the ITAA 1997

The meaning of recoverable debt has already been discussed in Question 2. To summarise, a recoverable debt arises at the point of time at which a taxpayer is legally entitled to an ascertainable amount for the work performed. In relation to Sub Co, a recoverable debt arises under the development agreement when there are proceeds from a sale of property. Information you provided indicates that Head Co expected that a recoverable debt would arise in respect of the work Sub Co provided within 12 months after the joining time. The general ledger confirms this expectation by showing that a recoverable debt actually arose before the end of the income year of the joining time -i.e. 30 June 20XX.

Therefore, paragraph 716-405(2)(a) of the ITAA 1997 applies and Head Co is entitled to deduct the 'unexpended tax cost setting amount' for the asset in the 20XX income year.

The 'unexpended tax cost setting amount' for the asset for an income year is defined in subsection 716-405(4) of the ITAA 1997 as:

….the tax cost setting amount for the asset, reduced by:

(a) the amounts (if any) of all deductions under this section in respect of the asset for previous income years ending after the joining time; and

(b) in determining the amount of a deduction under this section in respect of the asset for that income year for an entity that ceased to be a subsidiary member of the group in that income year - the amount (if any) that the head company of the group can deduct under this section in respect of the asset for that income year.

Therefore, Head Co is entitled to deduct the TCSA of the unbilled income asset under section 716-405 of the ITAA 1997 under the pre rules in the 20XX income year.

¹ Henderson v. FCT (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596

(Henderson's case); Henderson v. FCT 69 ATC 4049; (1969) 1 ATR 133.

² Barratt & Ors v. FC of T 92 ATC 4275; (1992) 23 ATR 339 (Barratt's case).