Senate

Revised Explanatory Memorandum

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

Chapter 3 - Amendments to Subdivision 170-C

Outline of Chapter

3.1 Schedule 1 makes amendments to the provisions of Subdivision 170-C of the ITAA 1997. Subdivision 170-C applies to the transfers of net capital losses or tax losses within wholly-owned company groups. The proposed amendments will:

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ensure that in respect of an interest being a debt in a loss company, only its reduced cost base may be reduced following the transfer of a net capital loss;

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clarify certain factors considered in making an appropriate adjustment to the cost base or reduced cost base of an interest in a loss company or an income (or gain) company;

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ensure there can be no uplift in the cost base and reduced cost base of interests in the income (or gain) company unless there has been a reduction in the reduced cost base of at least one interest in the loss company;

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ensure that, in addition to the general limitation that an uplift to a cost base or reduced cost base for any interest in the income (or gain) company cannot exceed its increase in market value because of the economic loss component of a transferred loss, increases may be capped at a yet lower level having regard to the amount of reductions to the cost bases or reduced cost bases of interests in the loss company; and

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allow uplifts in the cost base and reduced cost base of interests in the income (or gain) company only to the extent that the loss transferred is an economic loss.

Context of Reform

3.2 The main purpose of Subdivision 170-C is to prevent the duplication of a tax loss or net capital loss transferred between companies in the same wholly-owned group when a direct or indirect interest in the loss company is realised. Loss duplication can occur by the making of a capital loss or by the reduction of a capital gain on the realisation of the interest whose value reflects the loss already used by the group.

3.3 Subdivision 170-C prevents loss duplication by requiring, in certain circumstances, reductions to be made to the cost base and reduced cost base of equity interests, or the reduced cost base of debt interests, held directly, or indirectly, in a loss company. In some cases cost base and reduced cost base increases are also required to interests held directly, or indirectly, in the company to which the loss is transferred (the 'income' or 'gain' company). These increases do not relate to loss duplication or attempt to match loss duplication reductions. The increases relate to, and are always limited by, any increases in the market values of the interests because of the transfer of a tax benefit from the loss company to the income or gain company (net of any payment by the income or gain company for it).

3.4 Following the introduction of Subdivision 170-C, it was recognised that addressing certain issues identified in the process of consultation would enhance the clarity of the law and help to ensure that its purpose is achieved. The following amendments address these issues.

Summary of new law

3.5 Schedule 1 proposes amendments to Subdivision 170-C to ensure that:

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in respect of an interest being a debt in a loss company, only its reduced cost base may be reduced following the transfer of a net capital loss;

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the factors considered in making an appropriate adjustment to the cost base or reduced cost base of an interest in a loss company or an income (or gain) company are clarified;

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there can be no uplift in the cost base and reduced cost base of interests in the income (or gain) company unless there has been a reduction in the reduced cost base of at least one interest in the loss company;

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in addition to the general limitation that an uplift to a cost base or reduced cost base for any interest in the income (or gain) company cannot exceed its increase in market value because of the economic loss component of a transferred loss, increases may be capped at a yet lower level having regard to the amount of reductions to the cost bases or reduced cost bases of interests in the loss company; and

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uplifts to the cost base and reduced cost base of interests in the income (or gain) company are limited to the extent that the loss transferred is an economic loss.

Detailed explanation of new law

3.6 Subdivision 170-C was inserted into the ITAA 1997 by the Integrity and Other Measures Act. The changes proposed in Schedule 1 make certain that the Subdivision operates as intended.

Debt interests may have only their reduced cost bases reduced following the transfer of a net capital loss

3.7 Under the current law, both the cost base and the reduced cost base of a debt may be reduced following the transfer of a net capital loss.

3.8 This is to be amended so that only the reduced cost base of a debt may be reduced following the transfer of a net capital loss. The amendment will correct a drafting error in the Integrity and Other Measures Act and achieve consistency with the adjustment rules for tax loss transfers. [Schedule 1, items 46 and 47, subsections 170-220(1), 170-220(2) and 170-220(3)]

Insertion of specific reference to objects clause and related matters in the factors to have regard to in making appropriate cost base and reduced cost base decreases or increases under Subdivision 170-C

3.9 It has been argued that, under the current law, regard may not be had to the statements of the objects of Subdivision 170-C in section 170-205in making appropriate adjustments under the Subdivision because the statements of objects are not specifically referred to as a factor to be considered in the provisions that require the adjustments.

3.10 Although a reading of the legislation as a whole makes such a reference unnecessary, it is proposed to insert in subsections 170-210(3) and 170-220(3) a specific reference to the object of the Subdivision and particularly the objects clause, section 170-205. [Schedule 1, items 37, 43, 48 and 54, paragraphs 170-210(3)(aa), 170-215(3)(aa), 170-220(3)(aa) and 170-225(3)(aa)]

3.11 This puts beyond any doubt that the objects of the Subdivision must be taken into account in determining what adjustments are appropriate in particular cases.

3.12 In addition, to prevent double counting, a reduction in the reduced cost base of an interest made under Subdivision 165-CD is also a factor to be taken into account in determining what reductions are to be made to the reduced cost base (but not to the cost base) of an interest under this Subdivision. [Schedule 1, items 38 and 49, paragraphs 170-210-(3)(ba) and 170-220(3)(aa)]

Extent to which a loss reduces the market value of a share or debt interests in the loss company

3.13 Following a tax loss or net capital loss transfer, one of the factors to be considered in deciding what is an appropriate amount to reduce the cost base or reduced cost base of a share, or the reduced cost base of a debt interest, in the loss company, is the extent to which the loss reduced the market value of the interest.

3.14 The reference to 'loss' is a reference to the outlay by, or loss of economic resources in, the loss company represented by the transferred tax loss. The impact of the loss on the market value of the share or debt interest will have occurred when the loss was suffered by the company, which will often be before the loss was transferred.

3.15 Unless the contrary could be shown, a loss or outlay of the company's economic resources reflected in a tax loss, or a net capital loss would normally be expected to have reduced the market value of interests in the company because the company would have been worth more but for the loss or outgoing.

3.16 In some cases, it can readily be shown that certain interests have not been affected. For example, the market value of preference shares or loans to the company may not be affected by a loss because its impact can be shown to have fallen exclusively on the market value of ordinary shares held in the company.

3.17 It is proposed to clarify the operation of this factor in certain cases. [Schedule 1, items 39 and 50, subsections 170-210(3A) and 170-220(3A)]

3.18 For the avoidance of doubt, in determining the extent to which a loss reduced the market value of a share or loan, that reduction is to be determined as if any other factors (including any benefits accruing to the company as a result of the loss or outlay of economic resources) that may have altered its market value did not occur. [Schedule 1, items 39 and 50, subsections 170-210(3A) and 170-220(3A)]

3.19 The legislation does not require that the market value of the shares must actually have fallen. The question is whether the loss when incurred, considered in isolation, reduced, or would have reduced, the market value of the share or debt.

3.20 The importance of looking at the effect of the loss in isolation is where a tax loss or net capital loss is incurred which results from a loss or outgoing of the company's economic resources but the presence of other factors result in a net increase in the market value of shares in the company.

Example 3.1

A company makes a tax loss of $100. This loss results from a loss or outlay of economic resources of the company. At the same time the company's goodwill increases by $250. The result is an increase in the market value of shares in the company by $150.

Despite the overall increase in the market value of the shares, cost base and reduced cost base reductions having regard to the $100 loss would be necessary to prevent loss duplication on realisation of the shares.

In this example, if the cost base of the shares were not reduced to reflect the loss, only $150 of the $250 increase in value of the company's goodwill would be captured on the realisation of the shares. The group would inappropriately access the transferred loss twice - once in offsetting income of the transferee, and again, because of reduced value shares, on the disposal of the transferor.

3.21 It is not essential that a realisation of the interest shelters from tax an unrealised accounting gain on assets of the loss company. It is enough that the loss reduced the market value of the interest and that there is asset value in the loss company that would have produced a gain on the interest were it not for the value reduction of the loss transferred.

Example 3.2

Company Y holds $700 of post-CGT equity in a wholly-owned subsidiary, Company X.

Company X makes a tax loss of $300. The tax loss represents a loss or outflow of economic resources of the company.

Company X transfers the $300 tax loss to Company Y. Company Y offsets the loss against income of $300.

Company Y then sells its shares in Company X for $700, being their market value.

Although the market value of the shares in Company X has not fallen, cost base and reduced cost base reductions would be required to the shares having regard to the economic loss of $300 transferred. Ignoring indexation, a capital gain of $300 would arise on the disposal of the shares. This result is appropriate because, but for the loss, the value of this asset would have been captured as a capital gain on the disposal of shares in the loss company.

Non-economic losses

3.22 It is not necessary to reduce the cost base or reduced cost base of an interest in a loss company to the extent the loss transferred is not an economic loss. An economic loss is a loss or outlay of a company's economic resources. In contrast a non-economic loss arises where a tax deduction or capital loss exceeds the economic resources outlaid or lost. An example of this is the additional 25% tax deduction provided for certain Research and Development expenditure.

3.23 It is specifically provided that a non-economic loss will include depreciation on an item of plant to the extent that tax recognition of the outlay (via depreciation deductions) happens in advance of economic depreciation or depletion of the plant.

3.24 These 'timing differences' for plant are to be calculated on an asset by asset basis. It is not necessary to track reversals of the difference.

3.25 Although the treatment of a non-economic loss was made clear in the explanatory memorandum to the Integrity and Other Measures Act, an amendment to the legislation puts that treatment beyond doubt. [Schedule 1, item 39 and 50, subsections 170-210(3B) and 170-220(3B)]

3.26 Where a company transfers only part of a loss incurred and the loss comprises both economic and non-economic elements it may choose the extent to which it has transferred the non-economic elements provided it maintains sufficient records to evidence its choice.

Example 3.3

A group company has a tax loss of $225,000 of which $25,000 relates to a deduction 25% greater than Research and Development expenditure actually incurred by the company. If the company transfers an amount of tax loss of $25,000 it may, if it chooses, treat this as relating wholly to the non-economic part of the tax loss provided it makes a record of its choice and the basis for it.

3.27 In circumstances where a loss (e.g. a tax loss for a prior income year) has been offset against income, and it is sought to transfer the remainder of that loss to another group company, the economic and non-economic elements of the loss are decreased proportionately to determine the economic and non-economic elements of the loss available for transfer.

No cost base uplifts unless cost base reductions are made following transfer of tax loss or net capital loss and amount of reductions are a limiting factor for uplifts

3.28 Under the current law, if a payment (a 'subvention payment') is not made by the gain or income company to the loss company for the tax benefit of a transferred tax loss or net capital loss a shift in value may occur from the loss company to the income company equal to the value of the tax benefit transferred (e.g. the corporate tax rate (say 34%) multiplied by the amount of transferred loss). For example, if a loss of $100 is transferred between 'sister' subsidiaries and no subvention payment is made, $34 value may be shifted from the loss company to the income or gain company.

3.29 The uplift under the current law on cost bases and reduced cost bases for interests in the transferee company reflects the value shifted and the fact that interest holders in the transferee would have made a smaller capital gain (or bigger capital loss) on the ultimate sale of their interests if the loss transfer had not occurred and the transferee company had been taxed on the income or gain.

3.30 Subdivision 170-C does not, however, require a reduction to cost bases or reduced cost bases for interests in the loss company to reflect any value shifted out of those interests by the actual transfer of the loss itself, except to the extent that this is indirectly effected by reductions made to remove loss duplication.

3.31 In the absence of loss duplication, and therefore the absence of reductions to cost bases and reduced cost bases for interests in the loss company under Subdivision 170-C to reflect the value shifted from the loss company, no cost base or reduced cost base increase should be made to reflect any value shifted to the income or gain company. This ensures symmetrical treatment.

3.32 It is therefore proposed to ensure that no cost base or reduced cost base uplifts can be made to interests held directly or indirectly in the income or gain company, unless a reduction is appropriate for at least one interest held directly in the loss company. [Schedule 1, items 41, 42, 52, 53, paragraphs 170-215(1)(h), 170-225(1)(g), 170-215(2)(h) and 170-225(2)(h)]

3.33 It is also proposed to ensure that, in addition to the general limitation that an uplift to a cost base or reduced cost base for any interest in the income (or gain) company cannot exceed its increase in market value because of the economic loss component of a transferred tax loss or net capital loss, an increase may be capped at a yet lower level having regard to the amount of reductions to the cost bases or reduced cost bases of interests in the loss company. [Schedule 1, items 43 and 54, paragraph 170-215(3)(ab) and paragraph 170-225(3)(ab)]

3.34 The total reductions made to cost bases or reduced cost bases in respect of interests held directly in the loss company will generally serve as an appropriate further limitation of the uplifts that can be made to cost bases and reduced cost bases of interests held in the income or gain company.

3.35 For example, if the total cost bases and reduced cost bases of direct equity and debt investments in the loss company is only $10, a $10,000 loss (which is an economic loss) is transferred to an income company, and no subvention payment is made by the income company, no increase could be made to any interest in the income company that exceeds $10 multiplied by the relevant corporate tax rate.

3.36 Where paragraph 3.32 refers to an 'appropriate' reduction and paragraph 3.34 refers to reductions 'made' to the cost bases or reduced cost bases of interests in the loss company, it is not required that a 'reduction' has (or reductions have) actually been made at the times required by subsection 170-210(4) or 170-220(4). This occurs immediately before a CGT event happens to the relevant share or debt. It is sufficient that the need for the reduction has been identified. This means, for example, that an uplift will not be denied in the cost base or reduced cost base of an interest in the gain company just because a CGT event has not yet happened to an interest in the loss company.

Cost base uplifts allowed only to the extent that losses transferred are economic losses

3.37 Amendments are also proposed to ensure that cost base or reduced cost base uplifts can be made only to the extent that the loss transferred is an outlay or loss of any of the economic resources of the loss company. [Schedule 1, items 44 and 55, subsections 170-215(4A) and 170-225(4A)]

3.38 If, for example, a $20,000 tax loss were transferred, and $15,000 relates to amounts that do not represent an outlay or loss of any of the economic resources of the loss company, uplifts can only be made in respect of $5,000 of the amount transferred.

3.39 Subject to the requirement of not exceeding the market value increase of any single interest because of the economic loss component of the transferred loss, and assuming that there are cost base and reduced cost base reductions of at least $5,000 to direct interests in the loss company (see paragraph 3.34 above), the maximum total uplift possible for interests held directly in the transferee company would be an amount equal to $5,000 multiplied by the applicable company tax rate. The maximum total uplifts for interests held indirectly in the transferee company could not exceed the total uplifts obtained by the entities in which those particular investments were directly held.

Example: 3.4

A net capital loss of $50,000 is transferred to Gain Co, of which $20,000 is an economic loss. There are reductions of at least $20,000 to the cost bases or reduced cost bases of interests held directly in the transferor loss company. The 500 shares in Gain Co are held 50% (250 shares) by Holding Co 1 and 50% (250 shares) by Holding Co 2. Holding Co 2 owns all 100 shares on issue in Holding Co 1. All the companies are members of the same wholly-owned group.

Assuming a relevant company tax rate of 34%, and subject to any increasing adjustment not exceeding an increase in its market value as a result of Gain Co receiving the economic loss component of the loss, the maximum cost base and reduced cost base uplift for an interest (at any tier) in Gain Co, and for the total of those investments (at any tier) is $6,800. That is $20,000 (the economic loss component) x 34% = $6,800.

On the facts in this case, each share held directly in Gain Co (a tier of investment) would be expected to have an increased market value (based on the economic loss component) of the transferred loss of $6,800/500 shares = $13.60 per share. Thus, the maximum increase for each of Holding Co 1's 100 shares, and Holding Co 2's 100 shares, in Gain Co would be $13.60

The maximum increase for Holding Co 2's shares in Holding Co 1 would be limited to the maximum uplift obtained on Holding Co 1's shares in Gain Co. In this case, this is 250 shares x $13.60 = $3,400. Because Holding Co 2 holds all the shares in Holding Co 1, the maximum uplift on these shares would be $3,400/100 = $34 per share. Again, this does not exceed the increase in market value of any interest because of the (economic loss) component of the transferred loss.

Amendments to notes

3.40 The note after subsection 170-210(4) is repealed and a new note is substituted. The new note alerts readers to the fact that the expression 'deduction year' means the same as it does in the provisions dealing with the actual transfer of the tax loss. The note continues to alert readers to the relevance of subsection 170-210(4) for indexation. [Schedule 1, item 40, section 170-210 notes]

3.41 A note is inserted after section 170-215 to provide a cross-reference to the definition of 'deduction year.' This serves the same purpose as the note discussed in the preceding paragraph. A note is also inserted after section 170-220 to provide a cross-reference to the expression 'applicable year' which has the same meaning as it does in the net capital loss transfer provisions. [Schedule 1, items 45 and 52, sections 170-215 note and 170-220 note 3]

Application and transitional provisions

3.42 The amendments which provide that only the reduced cost base of a debt may be reduced following the transfer of a net capital loss and other clarifications to the making of cost base or reduced cost base adjustments, will apply to tax loss and net capital loss transfer agreements made on or after 22 February 1999, the commencement date for Subdivision 170-C [Schedule 1, subitem 68(4)] . These amendments help to achieve what has always been the intended application of the Subdivision.

3.43 The amendments to deny cost base and reduced cost base uplifts for interests in an income (or gain) company, if there are no cost base or reduced cost base reductions for interests in the loss company, to have regard to reductions as a limiting factor for appropriate increases, and also to limit the uplifts to the extent that a loss transferred is an economic loss, apply to loss transfer agreements made on or after 13 April 2000. [Schedule 1, subitems 68(4A) and 68(5)]

Consequential amendments

3.44 There are no consequential amendments relating to this measure.