Consolidation Reference Manual

C2 Assets

C2-4 Worked examples - cost setting on entry

Entry Step D (adjust for over-depreciated assets)

C2-4-640 Reduction for over-depreciated assets (step D) - administrative short cuts

Description

This example shows how the tax cost setting amount for over-depreciated assets may be calculated (step D of cost setting process) using either one of two administrative short cuts.

Commentary

After the joining entity's allocable cost amount (ACA) is allocated among its reset cost base assets in proportion to their market values, and any necessary reductions are made for revenue-like assets (step C of cost setting process), a further reduction may be required for each over-depreciated asset (step D).

This further reduction is required where all of the following tests are satisfied for the particular asset:

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the asset is over-depreciated at the joining time

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the head company's tax cost setting amount (as calculated so far) is more than the joining entity's terminating value for the asset (its tax written down value at the joining time)

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the joining entity paid an unfranked or partly franked dividend during the period from when it acquired the asset to the joining time

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an amount representing the unfranked or partly franked dividend had not been further distributed as a dividend before the joining time to a recipient that was not entitled to the inter-corporate dividend rebate, and

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the dividends were paid out of profits that were sheltered from income tax, at least in part, by over-depreciation of the asset.

The amount of the reduction is the least of:

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the over-depreciation amount - this is the lesser of the excess of market value of an asset over its adjustable value just before the joining time (tax written down value at the joining time), and the excess of the asset's cost over its adjustable value at that time

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the amount of income that continues to be sheltered from tax, or

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the amount by which the tax cost setting amount would, apart from this provision, exceed the joining entity's terminating value of the asset.

This reduction prevents an increase in the adjustable value of a depreciating asset where there has been a tax deferral resulting from its over-depreciation. The potential for indefinite deferral arises where a company holds an over-depreciated asset at the joining time, and the income sheltered from tax by the over-depreciation was distributed as an unfranked dividend to a recipient who was entitled to the inter-corporate dividend rebate.

A worked example showing how to calculate the over-depreciation adjustment for each asset is provided separately. → 'Reduction for over-depreciated assets (step D)', C2-4-610

In many cases taxpayers will not have sufficient information available to work out the reduction for over-depreciation on an asset-by-asset basis or in strict accordance with former section 705-50. In other cases, taxpayers may be able to work out the amount of reduction accurately, but with significant costs of compliance. For these reasons, the administrative short cut methods outlined in Figure 1 may be used to work out the reduction amounts for over-depreciated assets. These short cut methods give a reasonable approximation of the reduction required by former section 705-50 and will be accepted by the ATO.

These administrative short cut methods have been discussed in draft form with representatives of business and the accounting profession to ensure they achieve the legislation's policy objectives and also meet the needs of the user. If these short cut methods are not suitable for your circumstances and you would like to use another administrative approach, contact the ATO for guidance.

The administrative short cut methods are summarised in Figure 1, which is followed by four examples that demonstrate how they work.

Examples

Example 1 demonstrates the Aggregate Method and Example 2 demonstrates the Annual Method. Both are based on the same facts where the joining entity has no profits at the joining time.

Example 3 demonstrates how to estimate the proportion of unfranked dividends paid by listed public companies that reach entities not entitled to the inter-corporate dividend rebate.

Example 4 demonstrates both the Aggregate Method and the Annual Method where a joining entity has retained profits that are not accrued to the joined group. This can occur where an entity joins an existing group as a result of a 100% acquisition by the group. In this case, there is no step 3 amount as there is no retained profit accrued to the group.

Notes to Figure 1, Aggregate Method

This is the simplest method for calculating the over-depreciation reduction and will minimise the cost of compliance. Broadly, this approach compares book and tax written down values at the joining time and draws some conclusions as to how the difference has given rise to prior unfranked dividends or untaxed profits that are attributable to over-depreciation.

While less precise than the Annual Method, the Aggregate Method is still considered to provide a reasonable estimate of the over-depreciation adjustment. Taxpayers should note that a different result will arise under the Annual Method. This could be higher or lower than the result under the Aggregate Method.

Step 1A: In some cases taxpayers may have assets with book written down values (BWDV) less than their tax adjustable values (TWDV); for example, where there have been write-downs of depreciating assets for accounting purposes. Where the difference is significant, inclusion of those assets in step 1A could materially impact on the result. If an asset's adjustable value (its tax written down value) is more than 1% of the joining entity's ACA and its TWDV is greater than its BWDV, that asset should be excluded from the calculation.

Step 1C variable b: Taxpayers should not include pre-1 July 1987 dividends in the variable 'b' amount. Ordinarily, those dividends pre-date the dividend imputation system, and taxpayers may be required to undertake a detailed analysis of those dividends to ascertain the extent to which they were paid out of untaxed profits. In the interests of minimising the costs of compliance, those dividends are not included in the Aggregate Method.

Step 1D: Where losses have been subtracted at step 5 in calculating the ACA they are not counted again in working out the reduction for over-depreciation. The relevant amount can be estimated by considering the ACA step 5 losses for each relevant year, and the difference between the total book and tax depreciation claim for that year. This information should be readily available in the joining entity's prior year income tax returns or working papers. Where only part of a loss for a year remains unused at the joining time, the component attributable to over-depreciation can be worked out by apportioning the remainder between over-depreciation and profits sheltered from tax for other reasons (e.g. R & D) on a pro-rata basis.

Step 1E amount (a): If ascertainable, exclude any such dividends paid before the acquisition date of depreciating assets held at the joining time. To maintain consistency with step 1C, only dividends paid from 1 July 1987 should be counted.

Step 1F: In order to keep compliance costs to a minimum, the Aggregate Method involves a proportional allocation of the overall over-depreciation adjustment amount based on the initial cost base step-up.

Notes to Figure 1, Annual Method

This approach considers over-depreciation on a yearly basis, but again by reference only to assets on hand at the joining time. Over-depreciation may have been recovered for assets sold before the joining time. In effect, this method 'reconstructs' the historical differences between book and tax depreciation. It also considers unfranked dividends and untaxed profits on a year by year basis.

This method also differs from the Aggregate Method in that it takes account of dividends paid out of pre-acquisition profits (step 2D). It also has regard to whether direct or indirect shareholders paid tax on unfranked dividends relating to over-depreciation (step 2F).

These additional steps mean that this method may more closely approximate the adjustment required by former section 705-50.

Step 2A: In some cases taxpayers may have assets with book written down values (BWDV) less than their tax adjustable values (TWDV); for example, where there have been write-downs of depreciating assets for accounting purposes. Where the difference is significant, inclusion of those assets in step 2A could materially affect the result. If an asset's adjustable value (TWDV) is more than 1% of the joining entity's ACA and its TWDV is greater than its BWDV, that asset should be excluded from the calculation.

Tip: The easiest way to work out the annual amounts may be to import details of all depreciating assets, along with the book and tax WDVs, depreciation rates and methods into a spreadsheet. Then reconstruct annual book and tax depreciation for each asset for each year.

Note: Reconstruction of book and tax WDV for assets on hand at the joining time results in a reasonably accurate calculation of the total over-depreciation amount. However this requirement may give rise to a significant compliance burden. As an alternative, companies may base the step 2A amounts on the actual difference between book and tax WDV year by year. This alternative may have the effect of over-stating the over-depreciation for a year, because its use could involve counting the difference for assets held in that year but not held at the joining time. However, this would have a trade-off in reduced compliance costs.

Step 2B: The percentage of 70% used here reflects the current general company tax rate. Even though different tax rates may have applied in the years leading up to the joining time, restatement of future tax liabilities at the new rates will release (or draw) profits such that the amount available for distribution will be aligned with the tax rate at the joining time.

Taxpayers may use a percentage based on the tax rate applicable for a particular year in this step, instead of using 70%, provided adjustments are made to the potential over-depreciation Figure to reflect the impact of changes in the tax rate on the deferred (or future) tax liability account and the consequential change to distributable profits in the year the tax rate changed.

Step 2C variable e: Variable 'e' in the formula could potentially include pre-1 July 1987 dividends, which pre-date the dividend imputation system. Taxation Determination TD 2004/4 confirms that dividends paid before 1 July 1987 are unfranked dividends for the purposes of former section 705-50 and therefore should be counted. Note, that this will not be the case where the entity has joined the group on or after 9 May 2007, as the head company will only need to look at five years of dividend history immediately before the joining time to determine whether an over-depreciation adjustment is required in relation to the joining entity's asset → Tax Laws Amendment (2010 Measures No. 1) Act 2010 (No. 56 of 2010). Given the removal of the inter-corporate dividend rebate for non-group public company shareholders from 1 July 2000, dividends after 30 June 2000 should not be counted in variable 'e' where the public company examined is not a wholly-owned subsidiary of another resident public company.

Variable 'e' should also include unfranked dividends paid by a transferor of a depreciating asset under a Subdivision 126-B rollover, to the extent the dividend was paid out of profits of the transferor that were sheltered from tax by over-depreciation of the transferred asset. If the annual method is also used to work out the over-depreciation adjustment for depreciating assets still held by the transferor when it joins the consolidated group, dividends related to rollover assets counted at variable 'e' in step 2C in the transferee's calculation should not be counted in steps 2C and 2H of the transferor's calculation. This will prevent double counting of those dividends.

Step 2D: To the extent that dividends paid out of profits sheltered from income tax because of over-depreciation have been subtracted at step 4 in calculating the ACA, they are not counted again in working out the reduction for over-depreciation. This amount should be subtracted at step 2D of the short cut process.

Step 2E: This is the same process as in step 1D.

Step 2F: Where unfranked dividends from profits sheltered from tax by over-depreciation have been paid as (or used to pay) unfranked dividends by a public company, it may not be possible for the consolidated group to work out the extent to which those dividends have ultimately reached the hands of recipients not entitled to the inter-corporate dividend rebate. Such a tracing exercise would also involve significant costs.

In those cases, an analysis of the public company's share register should be undertaken to estimate the breakdown between those shares for which it is clear the shareholder would not be entitled to the inter-corporate dividend rebate (e.g. an individual or non-resident), and those for which it is unclear who may be the ultimate recipient (e.g. a nominee). A methodology for estimating the step 2F amount, without the need for tracing, is explained in example 3.

Where a taxpayer is able to demonstrate that a higher percentage of dividends ultimately reaches beneficial shareholders who are not entitled to the inter-corporate dividend rebate, that higher percentage may be used at step 2F.

Step 2H amount (a): If ascertainable, excluding any such dividends paid before the acquisition date of depreciating assets held at the joining time. However, dividends paid by a transferor of an asset subject to a rollover under Subdivision 126-B that relate to over-depreciation of the asset in the hands of the transferor should be included.

If the annual method is also used to work out the over-depreciation adjustment for depreciating assets still held by the transferor when it joins the consolidated group, dividends related to rollover assets counted at variable 'e' in step 2C in the transferee's calculation should not be counted in steps 2C and 2H of the transferor's calculation. This will prevent double counting of those dividends.

Given the removal of the inter-corporate dividend rebate for non-group public company shareholders from 1 July 2000, dividends after 30 June 2000 should not be counted in amount 'a' where the public company examined is not a wholly-owned subsidiary of another resident public company.

Step 2I: The Annual Method uses a proportional allocation of the overall over-depreciation adjustment amount based on the difference between the book written down value (BWDV) and the tax adjustable value or written down value (TWDV). This is different to the allocation under the Aggregate Method, and more closely approximates the methodology required by former section 705-50.

Example 1 - Aggregate Method

Facts

Sub Co was incorporated by Hold Co on 1 July 1995. Hold Co elects to form a consolidated group on 1 July 2002. Sub Co's financial position is as follows:

Sub Co's franking account has a credit balance on 20 June 2002 of $56. After adjusting for hypothetical payments etc. under subsection 705-90(4), the hypothetical balance is $56.

Sub Co's depreciation schedules for the year ending 30 June 2002 are shown in tables 2 and 3. In this case the market values (MV) of depreciating assets are equal to their book values at the joining time.

Sub Co incurs a tax loss of $640 in the year ending 30 June 2002. Tax deductions related to over-depreciation and R & D for that year are $378 and $26 respectively. As the total loss exceeds these tax deductions, $378 of the loss is treated as being attributable to deductions related to over-depreciation. But for the loss incurred in the year ending 30 June 2002, Sub Co would have had $99 in undistributed profits accrued to the head company able to be counted in ACA step 3.

Before the consolidated group was formed, Sub Co paid a total of $1,135 in unfranked dividends. These were partly attributable to profits sheltered from tax by over-depreciation and partly attributable to profits sheltered from tax by concessional deductions for research and development expenditure.

Calculation

Worksheet 1: ACA calculation

Retained cost base assets

Cash ($13,144) and trading stock ($6,693) retain their existing tax values. In this example Sub Co is a continuing majority owned entity, so items of trading stock are treated as retained cost base assets.

The remainder of the ACA after setting the tax cost of retained cost base assets is $33,763. This is allocated among the reset cost base assets (table 4). The tax cost setting amount (TCSA) for revenue-like assets, such as depreciating assets, is limited to the greater of their market value or terminating value (i.e. tax adjustable value at the joining time). Assets 11 to 19 are not revenue-like assets.

For assets 11 to 19 the amounts in the last column are the final TCSAs. For assets 1 to 10, further calculations are required (see tables 5 and 6).

Table 5: Adjustment for over-depreciation using the Aggregate Method ($)

Step 1F: The amount at step 1E is allocated in table 6 to each of the depreciating assets on a pro-rata basis according to the potential step-up of tax value.

Example 2 - Annual Method

Facts

The facts are the same as for example 1. The taxpayer wishes to use the Annual Method outlined in Figure 1 to estimate the total amount of reduction for over-depreciation.

Assets 1 to 5 were depreciated for tax purposes using the prime cost (PC) method. The TWDVs as at 30.6.01 were calculated by simply adding back the annual depreciation amount to the TWDV at 30.6.02. This method was used for each asset until its cost was reached. Note that no amount has been calculated for asset 2, as this asset had been written off for tax purposes before the joining time. Further work is necessary to work out the TWDVs for asset 2.

Assets 6 to 10 were depreciated using the diminishing value (DV) method. Asset 6's TWDV as at 30.6.01 was worked out by multiplying the TWDV at 30.6.02 by 100/80. The

Figure of 80 is 100 minus the depreciation rate of 20% - i.e. $1,024 x 100/80 = $1,280. For the next year back, the TWDV was worked out at $1,280 x 100/80. This method was used for each asset until its cost was reached.

Table 9 uses the same methods used in table 8 to calculate the BWDVs.

Table 9 shows asset 2 was acquired on 1.7.95. We can now go back and work out the TWDVs for that asset, working forward from the acquisition time calculated in table 9.

There were no undistributed profits at the joining time, so no amounts for 'd' and 'f' in the formula in table 13. Accordingly there is no adjustment for step 2C. The amounts for 'e' are based on an analysis of the unfranked dividends paid and summarised in table 14.

There were no distributions of profits subtracted at ACA step 4.

All of the unfranked rebatable dividends were retained by the head company in this example.

Step 2G totals the year-by-year results after step 2F, i.e. $2,488.

The maximum adjustment for over-depreciation is limited to the step 2H amount of $1,135. This amount is allocated to the depreciating assets in table 19.

Note that the over-depreciation adjustment must not reduce the TCSA below the depreciating asset's tax written down value (i.e. its adjustable value) at the joining time.

The method of apportionment in table 19 is different to that used in table 6, as the Annual Method provides more detailed information, allowing a better estimate of the reduction amount than is afforded by the Aggregate Method.

Example 3

Estimating the proportion of unfranked dividends paid by listed public companies that reach entities not entitled to the inter-corporate dividend rebate

For the purpose of working out the amount to be excluded at step 2F of the short cut method for calculating the over-depreciation reduction amount, the ATO will accept an estimate worked out as follows:

1. Examine the largest 20 shareholders named in the public company's annual report, determine the category (in table 20) that each falls into and apply the proportions set out in the table to the share percentage held by each of these top 20 shareholders to arrive at a ratio for the total shareholding of the top 20.

2. Apply the ratio worked out in step 1 for the top 20 shareholders to the remaining shareholders to arrive at an estimated breakdown between entitled and not entitled for those remaining shareholders.

3. Add step 1 and step 2 amounts.

Table 20: Ratios for different shareholder categories for use in determining proportions of unfranked dividends to be treated as reaching entities that are and are not entitled to the inter-corporate dividend rebate

The final percentage for all shareholders in the 'not entitled' category after step 3 is treated as being the proportion of unfranked dividends that ultimately reached beneficial owners not entitled to the inter-corporate dividend rebate. The balance is treated as the proportion not reaching such beneficial owners.

The results under this method for a sample financial year may be used for other years, provided there has been no significant change in the shareholder mix. Where there has been a significant change, sampling will be necessary either side of the period of abnormal trading to ensure the samples are more representative of the mix of shareholder categories for those years.

The proportion of life companies, other public companies, trusts, and nominees treated as being entitled to the inter-corporate dividend rebate has been based on statistical analysis of shareholder types, retention of profits rates, and varying entitlements to the rebate depending on the type of entity involved.

Where a taxpayer is able to demonstrate that a higher percentage of dividends ultimately reaches beneficial shareholders who are not entitled to the inter-corporate dividend rebate, that higher percentage may be used at step 2F.

Note: This method for estimating the step 2F amount is only available for dividends paid by listed public companies.

Facts

Company X is a listed public company. It elects to consolidate, with S Co as one of its wholly owned subsidiaries. It received unfranked rebatable dividends from S Co before consolidation, attributable to profits made by S Co that were sheltered from tax by over-depreciation. Company X used these funds to pay unfranked dividends. Company X is unable to work out precisely the extent to which these dividends reached beneficial owners not entitled to the inter-corporate dividend rebate. This is due primarily to large shareholdings by nominees. Company X's largest 20 shareholders are listed in table 21. Shareholder 5 is a life insurance company.

Calculation

The shareholders are first categorised according to entitlement to the inter-corporate dividend rebate (table 21).

Table 21: Estimating the amount to be subtracted under step 2F

Shareholdings have been split between the entitled and not entitled categories in the proportions stated above. After this adjustment, the top 20 (31.6%) consists of 7.23% entitled to the inter-corporate dividend rebate under former section 46 or former section 46A of the ITAA 1936, and 24.37% not entitled to the rebate. The same proportions are applied to the remaining shareholders to get proportions of entitled (22.88%), and not entitled (77.12%). Unfranked dividends in this latter category are not counted in the tax deferral amount for over-depreciation under step 2F.

Example 4

Joining with retained profits but no step 3 amount using both methods

S Co is incorporated with contributed capital of $100,000 on 1 July 1998, and acquires various assets and operates a business. The company distributes all its retained profits in the each of the following years as franked and unfranked dividends, with the dividends franked to the extent of available franking credits. Unfranked dividends were rebatable to the shareholder under section 46 of Income Tax Assessment Act 1936 . S Co recognises deferred tax liabilities (DTL) in respect of its over-depreciated assets and no DTL is recognised in relation to the asset revaluation reserve created. On 2 July 2002, all of the shares in S Co are acquired by H Co, the head company of a consolidated group, for $112,040. S Co's financial position at the joining time is as follows:

The tax and accounting depreciation schedules, deferred tax liability, accounting profit and dividends paid out summaries at the joining time are provided in tables 28 to 32. For simplicity, any transactions of S Co that occurred on 1 July 2002 are ignored in this example.

*S Co is not a transitional entity, so subsection 705-70(1A) applies to the DTL. Its detailed calculation is not provided in this example. There are examples at CC2-4-242 detailing the application of subsection 705-70(1A) to DTLs.

Aggregate method in over-depreciation shortcuts

*The market value in this example is the same as book value.

**The OD (over depreciation) reduction column is from the following table (table 25), step 1F.

*** The TCSA 2 column amounts are the results of TCSA 1 amounts minus OD reduction amounts for relevant assets. The TCSA 2 amounts are the final TCSAs for the relevant assets.

*This is the amount of unfrankable retained profits as at the joining time. Of the retained profits $2,040, the liability to pay tax of $480 would mean $920 would not be frankable, had $2,040 been distributed.

**This is the total OD reduction. In Step 1F, it is apportioned according to the step up amounts for the relevant assets to calculate the reduction for each asset. For example, OD reduction for DA 1 = 889 x 1,573/3,101.

***The step up column amounts are the differences between the TCSA 1 column and the Tax AV column.

Annual method in over-depreciation shortcuts

*The figures in this column are from table 27, Step 2I.

**The TCSA 2 column amounts are the final TCSAs for the relevant assets.

* These amounts are from table 32.

** This is the total OD reduction. In step 2I, it is apportioned according to the Excess of book over tax value column amounts for the relevant assets to calculate the reduction for each asset. For example, OD reduction for DA 2 = 889 x 600/3,200.

*** TCSA 2 column amounts are the results of TCSA 1 amounts minus OD reduction amounts.

References

Income Tax Assessment Act 1936 ,former sections 46 and 46A

Income Tax Assessment Act 1997 , section 40-85

Income Tax Assessment Act 1997 , sections 705-50 , 705-70 , 705-75 , 705-100 ; as amended by:

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New Business Tax System (Consolidation) Act (No. 1) 2002 (No. 68 of 2002), Schedule 1

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New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002 (No. 90 of 2002), Schedule 2

Income Tax Assessment Act 1997 , section 705-80 ; as amended by New Business Tax System (Consolidation) Act (No. 1) 2002 (No. 68 of 2002), Schedule 1

Income Tax Assessment Act 1997 , Subdivision 126-B

Income Tax Assessment Act 1997 , subsection 705-90(10) ; as inserted by Tax Laws Amendment (2004 Measures No. 6) Act 2005 (No. 23 of 2005), Schedule 1, Part 7

Income Tax Assessment Act 1997 , section 705-50 and subsection 995-1(1) as amended by Tax Laws Amendment (2010 Measures No. 1) Act 2010 (No. 56 of 2010), Schedule 5, Part 6

Explanatory Memorandum to Tax Laws Amendment (2004 Measures No. 6) Bill 2004, paragraphs 1.135 - 1.148

Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 1) Bill 2010, paragraphs 5.180 - 5.186.

Taxation Determination TD 2004/4 - Income tax: Is a dividend paid before 1 July 1987 an unfranked dividend for the purposes of section 705-50 of the Income Tax Assessment Act 1997?

Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006 (No. 101 of 2006), which repealed sections 46 and 46A of the Income Tax Assessment Act 1936

History

Revision History

Section C2-4-640 first published 28 May 2003.

Further revisions are described below.

Current at 6 May 2011