House of Representatives

Explanatory Memorandum

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

Appendix 1C

Detailed example

1C.1 Alpha Co was incorporated in 1993. The structure of Alpha Co is as follows:

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Beta Co has a 60% ordinary shareholding acquired in 1993 for $6 million. Market value of the shares at 5 September 2000 is $3.6 million.

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Gamma Co (with a wide range of investments) has a 60% ordinary shareholding in Beta Co acquired on 1 July 1993 for $4.8 million. Market value of the shares at 5 September 2000 is $2.16 million.

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Gamma Co has an 80% ordinary shareholding in Epsilon Co acquired in January 2000 for $7 million. Market value of the shares at 5 September 2000 is $6.5 million.

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Epsilon Co (which has a wide range of investments) has a 40% ordinary shareholding in Beta Co acquired in 1995 for $2.304 million. Market value of the shares at 5 September 2000 is $1.44 million.

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Epsilon Co also has a 10% ordinary shareholding in Delta Co (an overall profitable company) which it acquired in 1999 for $2 million. Market value of the shares at 5 September 2000 is $4 million.

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Delta Co has a 5% ordinary shareholding interest in Alpha Co which it acquired in 1995 for $480,000. Market value of the shares at 5 September 2000 is $300,000.

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Gamma (an individual) has a 100% beneficial ordinary shareholding in Gamma Co acquired in 1993 for $17 million. Market value of the shares at 5 September 2000 is $20 million.

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Pi (an individual) has a 20% ordinary shareholding in Alpha Co acquired in 1993 for $2 million. Market value of the shares at 5 September 2000 is $1.2 million. Pi is Gamma's brother.

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Zeta Co, a sharetrader, acquired a 15% ordinary shareholding interest in Alpha Co on 30 December 1999 for $1.17 million to sell at a profit if Alpha recovers. Market value of the shares at 5 September 2000 is $900,000. Zeta accounts for the trading stock at cost for tax purposes. Gamma is able to direct the activities of Zeta Co through an arrangement he has with the company that controls Zeta Co.

1C.2 All the shares are ordinary shares and 1% = 1 share. There are no inter-company debts.

1C.3 At 5 September 2000 Alpha Co has the following losses:

1C.4 In addition, Alpha Co has an unrealised loss on an asset of $800,000 at 5 September 2000. This accrued during the notional income year 1 July 2000 to 5 September 2000.

1C.5 Consider what the position would be if on 5 September 2000:

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Beta Co transferred its shares in Alpha Co to Gamma Co for their market value;

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Beta Co sold the shares for their market value to an unrelated buyer;

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Gamma Co transferred its shares in Beta Co to Gamma;

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Gamma sells all his shares in Gamma Co to an unrelated buyer; or

•

What are the notice requirements in each of the above cases?

Beta Co transferred its shares in Alpha Co to Gamma Co for their market value

1C.6 Beta Co acquired the shares for $6 million and would sell them for $3.6 million. Apart from Subdivision 165-CD it would have a capital loss of $2.4 million.

Is there an alteration time?

1C.7 As a result of the sale of the shares, an alteration time occurs under section 165-115L. Although Gamma, through Gamma Co, continues to be able to control more than 50% of the voting power in Alpha Co, and to have rights to more than 50% of the company's dividends and capital distributions, he would not exercise that control or those rights through all the same interposed companies. Section 165-165 therefore applies and a change is taken to have occurred in the ownership of Alpha Co.

Is Alpha Co a loss company?

1C.8 Alpha Co is a loss company under section 165-115R, having prior year undeducted tax losses a prior year unapplied net capital loss at the beginning of the income year, a current year tax loss and an unrealised loss at the alteration time that has not been taken into account at a previous alteration time.

Are there relevant equity interests or relevant debt interests?

1C.9 Entities other than individuals had relevant equity interests in Alpha Co immediately before the alteration time. Beta Co had a controlling stake in its own right, since it held more than half of the ordinary shares in Alpha Co. The 60% shareholding it has is a relevant equity interest.

1C.10 Gamma Co is an associate of Beta Co under section 318(2) of the ITAA 1936 by virtue of the 60% of its ordinary shares it holds. Because of this associate relationship, Gamma Co is taken to have a controlling stake in Alpha Co. Through Beta Co it also has a relevant equity interest in Alpha Co, being a 36% indirect interest (60%

1C.11 Epsilon Co is an associate of Gamma Co, which holds the majority of its shares, under subsection 318(2) and through Gamma Co is also an associate of Beta Co. This gives Epsilon Co a controlling stake. By virtue of its shareholding in Beta Co, Epsilon Co has an interest of 10% or more indirectly in Alpha Co. It has a relevant equity interest in Alpha Co.

1C.12 Zeta Co might reasonably be expected to act in accordance with Gamma's directions and on this basis is associated with Gamma under subsection 318(1). Gamma, as owner of Gamma Co, is in turn an associate of Gamma Co. Because of this association, Zeta Co is also associated with Gamma Co. This gives it a controlling stake. Zeta Co's 15% ordinary shareholding interest in Alpha Co is also a relevant equity interest.

1C.13 Gamma's brother Pi is an associate of Gamma and therefore of Gamma Co. However, as an individual, Pi does not have a relevant equity interest in Alpha Co. Delta Co, having only a 5% interest in Alpha Co also does not have a relevant equity interest.

1C.14 Because there has been an alteration time in respect of the loss company Alpha Co and several entities have relevant equity interests in the company, Subdivision 165-CD applies to adjust the reduced cost bases of those equity interests. In Zeta Co's case, the shares held in Alpha Co are trading stock their cost for the purposes of Division 70 and deductions in respect of outlays to purchase them are reduced under Subdivision 165-CD.

Adjustments to the values of relevant equity interests

1C.15 The following adjustments would be made in accordance with sections 165-115ZA and 165-115ZB.

Beta Co's 60% shareholding in Alpha Co

1C.16 Since this shareholding was acquired in 1993, all of the losses in Alpha Co were incurred during the period of Beta Co's share ownership. The overall loss in Alpha Co at the alteration time totals $4 million (the $300,000 non-economic loss incurred in 1996-1997 is disregarded because such a loss cannot be duplicated). The $4 million comprises the 1994 tax loss of $400,000, the 1997 tax loss of $600,000 (net of non-economic losses), the 1998 net capital loss of $1.2 million, the current year tax loss of $1 million, and the unrealised loss of $800,000.

1C.17 Applying the formula in subsection 165-115ZB(3), the adjustment amount is:

(60/100) * $4,000,000 = $2,400,000


1C.18 The reduced cost base of each of Beta Co's shares in Alpha Co would be reduced by:

$2,400,000 / 60 = $40,000


1C.19 The amounts are reasonable having regard to the object of the Subdivision, and so the formula result would stand.

Gamma Co's 60% shareholding in Beta Co

1C.20 This shareholding was also held throughout the whole period during which Alpha Co made its losses. The formula approach cannot be used because the interest in Alpha Co is indirect. Subsection 165-115ZB(6) applies in this case. Having regard to the matters listed, the reduced cost bases of Gamma Co's shares in Beta Co should be reduced by a total of:

(60/100) * (60/100) * $40,000,000 = $1,440,000


1C.21 The reduced cost base of each share would be reduced by $24,000.

Gamma Co's 80% shareholding in Epsilon Co

1C.22 The reduced cost bases of these shares must be adjusted because Gamma Co, through its association with Beta Co, also has a controlling stake in the loss company. However, Gamma Co acquired this interest in Epsilon Co in January 2000. Only $1.8 million of Alpha Co's overall loss arose after this acquisition date. The formula approach cannot be used because this is not a direct interest in Alpha and would not, in any case, produce a reasonable reduction. Applying the considerations in subsection 165-115ZB(6), the total adjustment amount is:

(80/100) * (40/100) * (60/100) * $1,800,000 = $345,600


1C.23 The reduced cost base of each share would be reduced by:

$345,600 / 80 = $4,320


Epsilon Co's 40% shareholding in Beta Co

1C.24 Epsilon Co acquired this shareholding in 1995. The adjustment to the reduced cost bases of the shares should not take into account Alpha Co's 1993-1994 tax loss of $400,000. Again the formula approach is not available, and the appropriate adjustment amount under subsection 165-115ZB(6) is:

(40/100) * (60/100) * $3,600,000 = $864,000


1C.25 The reduced cost base of each share would be reduced by:

1C.26 No adjustment is made to the reduced cost bases of Epsilon Co's shares in Delta Co, as Delta Co does not have a relevant equity interest in Alpha Co.

Zeta Co's 15% shareholding in Alpha Co

1C.27 $1.8 million of Alpha Co's losses were incurred after Zeta Co acquired its shareholding. The formula in subsection 165-115ZB(3) should be considered first, but in this case would result in an inappropriate adjustment amount because it takes no account of the fact that not all Alpha Co's losses were made after Zeta Co acquired its shares. Considering then the matters in subsection 165-115ZB(6) an adjustment amount of $270,000 would be determined in respect of these shares. As the shares are trading stock of Zeta Co, the adjustment amount is applied to reduce the cost of the shares, for the purposes of Division 70, by $18,000 per share. Although Zeta Co had claimed a deduction for the $1.17 million purchase price of the stock in the 1999-2000 income year, it will have to reduce that deduction by $270,000 to $900,000. Its closing value for the 1999-2000 year and its opening value for the 2000-2001 years would also be reduced by $270,000 to $900,000.

Note 1: If Zeta Co had used market selling value (e.g. $1 million) as the closing value at the end of the 1999-2000 income year, then its cost would have been reduced by $270,000 to $900,000 as above. Without adjustment, this would cause Zeta Co to have assessable income of $1 million, leaving a net assessable position of Zeta Co of $100,000. This is inappropriate. Zeta Co is able to elect to value trading stock at its cost. Using the cost figure of $900,000 as the closing value, the assessable income of $900,000 offsets the revised cost of $900,000. The duplicate loss (based on a deduction for purchase of $1.17 million and market selling value on 5 September 2000 of $900,000) is eliminated.

Note 2: Subdivision 170-D may also apply to the transfer of Beta Co's shares in Alpha Co to Gamma Co. Subdivision 170-D will only operate if the conditions for its operation exist after making adjustments to the reduced cost bases of the transferred shares under Subdivision 165-CD.

Beta Co sold the shares for their market value to an unrelated buyer

Is there an alteration time?

1C.28 Following the sale of Beta Co's shares to an unassociated entity, Gamma would no longer have more than 50% of the voting power in Alpha Co, or the rights to more than 50% of any dividends or capital distributions Alpha Co might make. An alteration time has therefore occurred under section 165-115L.

Is Alpha Co a loss company?

1C.29 As before, Alpha Co has an overall loss under section 165-115R.

Are there relevant equity interests or relevant debt interests?

1C.30 Relevant equity interests and relevant debt interests are measured immediately before an alteration time. Immediately before the alteration time in this case companies had relevant equity interests in Alpha Co as set out in part (a) of this example. These same interests are adjusted if Beta Co sells its shares in Alpha Co to an unassociated entity.

Adjustments to the values of relevant equity interests

1C.31 The adjustments for this part of the example are the same as in part (a).

Note: Subdivision 170-D does not apply to the transfer of the shares to an unassociated entity, but this does not affect the operation of Subdivision 165-CD.

Gamma Co transferred its shares in Beta Co to Gamma

Is there an alteration time?

1C.32 In this scenario, again, Gamma continues to be able to control more than 50% of the voting power in Alpha Co, and to have rights to more than 50% of the company's dividends and capital distributions. However, the shares that Gamma owns and through which he can control the voting power, and from which the rights to dividends and capital distributions are derived, are now shares in Beta Co rather than shares in Gamma Co. Section 165-165 applies and an alteration time is taken to have occurred.

Is Alpha Co a loss company?

1C.33 As before, Alpha Co has an overall loss under section 165-115R.

Are there relevant equity interests or relevant debt interests?

1C.34 Yes, as previously.

Adjustments to the values of relevant equity interests

1C.35 The adjustments shown in part (a) would be made to the reduced cost bases and other tax values of the equity interests.

Gamma sells all his shares in Gamma Co to an unrelated buyer

Is there an alteration time?

1C.36 Following the sale of his shares in Gamma Co to an unassociated entity, Gamma would no longer have more than 50% of the voting power in Alpha Co, or the rights to more than 50% of any dividends or capital distributions Alpha Co might make. An alteration time has therefore occurred under section 165-115L.

Is Alpha Co a loss company?

1C.37 Yes, as outlined previously.

Are there relevant equity interests or relevant debt interests?

1C.38 Yes, as outlined previously.

Adjustments to the values of relevant equity interests

1C.39 The situation is the same as for the previous scenarios. It should be noted that Subdivision 165-CD does not require any adjustment to be made to the reduced cost bases of Gamma's shares in Gamma Co: as an individual not acting in the capacity of trustee, Gamma does not have a relevant equity interest (as described in section 165-115X) in Alpha Co.

1C.40 Gamma would realise a capital gain on the sale of his shares in Gamma Co. The market value of the shares would reflect the losses incurred by Alpha Co and as a result, the capital gain is less than it might otherwise have been.

1C.41 The adjustments to reduced cost bases and other tax values required under Subdivision 165-CD would apply to any later disposal by Gamma Co, Epsilon Co, Beta Co and Zeta Co of their direct or indirect interests in Alpha Co.

What are the notice requirements in each of the above cases?

1C.42 Section 165-115ZC requires notices to be given by an entity that had a controlling stake in the loss company without taking into account any of its associates' interests. In this case, Gamma Co had a controlling stake in its own right, and no other entity (apart from an individual) has a controlling stake in it. Gamma Co is required to give notices, within 6 months after the alteration time, to each of its associates that had relevant equity interests, containing information sufficient to assist each associate to determine the effect of Subdivision 165-CD on the tax values of its own equity interests. Gamma Co notifies Alpha Co within 2 months after the alteration time that it proposes to give a notice to its associates.

1C.43 Information required to be included in the notices is set out in subsection 165-115ZC(5).