House of Representatives

Explanatory Memorandum

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

Chapter 1 - Overview of consolidation

Outline of explanatory memorandum

1.1 Where a consolidated group is formed, the group is treated as a single entity for income tax purposes. Broadly, this means that the subsidiary entities lose their individual income tax identities and are treated as parts of the head company of the consolidated group (rather than separate entities) for the purposes of determining income tax liability during the period in which they are members of the group.

1.2 The consolidation regime will apply primarily to a wholly-owned group of Australian resident entities that chooses to form a consolidated group for income tax purposes. In general, such a group must be wholly-owned by an Australian resident company. Specific rules provide for the membership of certain resident wholly-owned subsidiaries of a foreign holding company (MEC group). Eligible wholly-owned groups will be able to choose to form a consolidated group from 1 July 2002.

1.3 Chapter 2 deals with the core rules of consolidation, such as the single entity rule, and their consequences. Chapter 3 explains the rules dealing with the formation and membership of a consolidated group, including rules about the types of entities that are eligible to join, and making the choice to form a consolidated group. Chapter 4 deals with the membership rules relating to MEC groups.

1.4 The subsequent chapters deal with other specific rules necessary for the implementation of the consolidation regime, including:

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setting of the cost of assets of entities that join or leave a consolidated group (including membership interests);

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the transfer and use of losses relating to a pre-consolidation period;

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the treatment of franking accounts in consolidated groups;

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applying the PAYG instalments regime to members of consolidated groups in an appropriate way;

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rules that apply where a head company fails to satisfy a group income tax related liability on time and which allow the recovery of that group liability directly from other members of the group; and

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removal, cessation or modification of the existing loss transfer and CGT asset rollover grouping provisions under the ITAA 1997.

1.5 The general principles for taxation of consolidated groups - single entity rule, membership, setting of cost bases and treatment of losses - were contained in the December 2000 exposure draft. These rules were refined and reflected in the subsequent February 2002 exposure draft. The measures introduced in this bill take into account further submissions and feedback received following the release of the exposure drafts.

1.6 Subsequent legislation to be introduced to implement the remaining aspects of the consolidation regime will include the following topics:

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further cost setting rules - including those applying to formation of a consolidated group, transitional rules, joining another consolidated group, MEC groups and trusts;

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core rules applying to MEC groups;

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life insurance;

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interaction of the consolidation regime with international tax provisions;

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treatment of attribution accounts and foreign tax credits;

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interposition of a non-operating head company;

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removal of the intercorporate dividend rebate;

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treatment of imputation exempting and former exempting companies;

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removal of grouping for thin capitalisation purposes; and

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other consequential amendments, including further consequential amendments to PAYG instalments.

Context of reform

1.7 To promote business efficiency, as well as tax system integrity, A Tax System Redesigned recommended that groups of wholly-owned entities be permitted to choose to be taxed as a single entity rather than on an entity by entity basis.

1.8 The existing grouping provisions of the ITAA 1997 and the ITAA 1936 (such as those relating to loss transfer and CGT rollover relief for asset transfers) and the intercorporate dividend rebate allow groups of companies to obtain the benefits of single entity treatment for some purposes. In other respects, however, the income tax system continues to require each entity to account separately for intra-group transactions and intra-group debt and equity interests.

1.9 Consolidation will address both efficiency and integrity problems existing in the taxation of wholly-owned entity groups, many of which arise from this inconsistent treatment. These include:

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compliance and general tax costs;

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double taxation where gains are taxed when realised and then taxed again on the disposal of equity;

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tax avoidance through intra-group dealings;

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loss cascading by the creation of multiple tax losses from the one economic loss; and

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value shifting to create artificial losses where there is no actual economic loss.

1.10 These problems will be addressed by ceasing to recognise multiple layers of ownership within a wholly-owned group and by treating wholly-owned groups as a single entity for income tax purposes.

1.11 The consolidation regime will therefore:

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assist in the simplification of the tax system;

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reduce both compliance costs and tax revenue costs associated with the existing tax treatment of company groups;

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improve the efficiency of business restructuring; and

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strengthen the integrity of the income tax system.

1.12 It is intended that the benefits to be achieved by consolidation as described above should therefore encourage wholly-owned groups to enter into the regime. Wholly-owned groups that choose to remain outside the consolidation regime will also lose entitlement to grouping rules which currently provide some of the benefits intended to be replaced by consolidation.

Comparison of key features of new law and current law

1.13 The following table summarises the key differences between the proposed tax treatment of consolidated groups and the treatment of wholly-owned groups under the current law.

Summary of new law

1.14 The following summarises the key principles of consolidation.

Detailed explanation of new law

1.15 The consolidation regime implements a set of recommendations made in A Tax System Redesigned . Those recommendations have led to the development of a set of rules that provide the basis on which groups are permitted to consolidate and be treated as a single entity for income tax purposes. The regime is underpinned by rules for the setting of cost of assets according to the asset-based model discussed in A Platform for Consultation and recommended by A Tax System Redesigned .

Key features of the foundations of the consolidation regime

Core rules

Single entity rule

1.16 Following a choice to consolidate, a group of wholly-owned entities is treated as a single entity for income tax purposes. Subsidiary members of the group are treated as parts of the head company rather than as separate income tax identities.

Inherited history rules

1.17 The head company inherits the income tax history of a subsidiary member when the latter joins a consolidated group. When a subsidiary member leaves a group, it takes with it only the income tax history that relates to the assets, liabilities and businesses it leaves with. This recognises that the entity is different from any entity that joined the group.

Cost setting rules

1.18 The cost setting rules set the cost for income tax purposes of assets of entities when they become subsidiary members of a consolidated group and of membership interests in those entities when they cease to be subsidiary members of the group.

1.19 These rules recognise that the head companys cost of becoming the holder of all of the assets is an amount, which reflects the cost to the group of acquiring the entity. When an entity leaves a group, the alignment of the head companys costs for membership interests in each entity and its assets is preserved by recognising the cost of those interests as an amount equal to the cost of the entitys assets at that time reduced by the amount of its liabilities.

Group membership and choice to consolidate

Ordinary groups

1.20 A consolidated group consists of an Australian resident head company and all of its Australian resident wholly-owned subsidiaries. The subsidiary members may be companies, trusts or partnerships. Separate rules may apply to foreign owned groups with no single Australian resident head company. In determining whether a subsidiary is wholly-owned for the purposes of the membership rules, ESAS shares are disregarded in certain circumstances.

1.21 The broad rationale underlying the rules that limit the types of entities that are eligible to be a member of a consolidated group is to ensure that consolidated groups receive a tax treatment like ordinary Australian resident companies and that relative concessional treatment is neither effectively gained by nor denied to entities by becoming a member of a consolidated group.

1.22 An eligible wholly-owned group becomes a consolidated group after notice of a choice to consolidate is given to the Commissioner. A decision to consolidate is irrevocable. Additional notification rules apply when an entity becomes, or ceases to be, a member of a consolidated group.

MEC groups

1.23 Specific rules allow certain resident wholly-owned subsidiaries of a foreign company to form a consolidated group known as a MEC group. Without this measure, wholly-owned resident subsidiaries of a foreign resident company would not be able to form a consolidated group in the absence of a single Australian resident head company unless they were restructured. The aim of this measure is to ensure that existing company groups that currently have access to grouping provisions (e.g. loss transfer and CGT rollover) will be able to form a consolidated group despite not having a single resident head company.

1.24 A MEC group consists of 2 or more eligible tier-1 companies of a foreign resident company and all the resident entities that are wholly-owned subsidiaries of those eligible tier-1 companies. Broadly, an eligible tier-1 company is the entity that is a foreign companys first tier of investment into Australia. A MEC group can be formed either by a choice being made to form a group or as a result of a consolidated group converting into a MEC group.

1.25 One of the eligible tier-1 companies in the MEC group will be treated as the head company of the group. The remaining members of the MEC group will be treated as subsidiary members of the group.

Losses

1.26 This measure also deals with the transfer to and utilisation of losses by a consolidated group. When an entity becomes a member of a consolidated group, its unused carry forward losses are tested to determine whether they can be transferred to the group. Broadly, a loss can only be transferred to the head company of a consolidated group if the loss could have been used outside the group by the entity seeking to transfer it.

1.27 The utilisation of losses transferred to a consolidated group is subject to an annual limit that is determined by reference to the fraction of the groups income and gains considered to have been generated by the entity that transferred the losses. This is referred to as the available fraction method.

1.28 Two concessions are provided for certain company losses transferred to a consolidated group when it forms during the transitional period (i.e. 1 July 2002 to 30 June 2004). The first concession increases the available fraction. It is provided in recognition that, under the existing group loss transfer rules, an entity can use its losses to shelter not just its own income but also the income of another member of the same wholly-owned group. The second concession allows eligible losses to be used over 3 years instead of by reference to their available fraction. This alternative loss utilisation method is provided in recognition that the available fraction method departs from the method in Recommendation 15.3 of A Tax System Redesigned .

Franking accounts in consolidated groups

1.29 Special imputation rules will apply to consolidated groups. During the period of consolidation, the head company of the group will maintain a single franking account for the consolidated group and subsidiary members will have inoperative franking accounts during the period in which they are members of a consolidated group. At the time at which a subsidiary member joins a consolidated group, any surplus in its franking account is transferred to the head companys franking account. If, however, the subsidiarys franking account is in deficit at the joining time, the subsidiary will be liable to pay franking deficits tax (and the deficit is extinguished).

1.30 During the period that a subsidiary is a member of a consolidated group, any franking credits or debits that would otherwise have arisen in the franking account of the subsidiary member (i.e. were it not a member of a consolidated group with an inoperative account) are attributed to the franking account of the head company.

1.31 Special rules deal with the franking of distributions by a subsidiary member of a consolidated group to members holding certain kinds of interests including ESAS shares and non-share equity interests.

PAYG instalments

1.32 This bill also contains consequential amendments that set out how the PAYG instalments rules will apply to the members of a consolidated group. The rules will ensure that a head company of a consolidated group will pay PAYG instalments towards its income tax liability in much the same way as any single company does now. The rules also explain what happens when an entity joins or leaves a consolidated group.

1.33 There are also special rules which are necessary for the transitional period from formation of a consolidated group until the head company of the group is given an instalment rate, by the Commissioner, that is worked out from the head companys first assessment as the head company of that group. These rules essentially provide that, during the transitional period, each member of the consolidated group will continue to pay PAYG instalments as it does under the current law, that is, as if it were not a member of a consolidated group. Instalments payable by the subsidiary members of a consolidated group in the transitional period will be credited against the assessment of tax payable by the head company of the group.

Group income tax liability

1.34 This measure also contains rules for determining the income tax liability within a consolidated group in the event of default of income tax payments by the head company. In the event of the head companys default, the income tax liability will be recovered directly from the subsidiary members of the group.

Removal of grouping provisions

1.35 Amendments in this Bill also remove certain existing grouping provisions of the ITAA 1997. Those that allow the transfer of losses and CGT rollover relief for transfer of assets between wholly-owned company groups will cease to apply following the introduction of the consolidation regime. Consequently, wholly-owned groups that do not choose to consolidate will, in general, no longer have access to grouping rules outside of consolidation.

1.36 These rules will be retained in a limited form for certain transactions. Resident subsidiaries in a wholly-owned group will retain the ability to transfer losses where that loss transfer involves an Australian branch of a foreign bank.

1.37 Further, CGT asset rollover relief will be retained for wholly-owned groups where assets are transferred between non-resident companies, or a non-resident company and the head company of a consolidated group or MEC group. Rollover relief will also be retained where an asset is transferred between a non-resident and a company that is not a member of a consolidatable group.

Further detail about the consolidation regime

1.38 The above key features and other supporting concepts are discussed in detail in the following chapters.

Application and transitional provisions

1.39 The consolidation regime applies from 1 July 2002.