House of Representatives

Explanatory Memorandum

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

Chapter 13 - Amendments to allow global method of asset valuations in loss integrity measures

Outline of chapter

13.1 This chapter explains amendments to Subdivisions 165-CC and 165-CD of the ITAA 1997 that will allow assets of a company to be valued globally ( in globo ) in calculating the companys unrealised net loss (for Subdivision 165-CC purposes) and its adjusted unrealised loss (for Subdivision 165-CD purposes). This is referred to as the global method.

13.2 Subdivision 165-CD will also be amended by the inclusion of a special value shifting rule to ensure that the use of the global method in that Subdivision cannot lead to duplication of unrealised losses. The amendments explained in this chapter are contained in Schedule 14 to this bill.

Context of reform

13.3 Subdivisions 165-CC and 165-CD were introduced into the ITAA 1997 during 1999 and 2000 in the New Business Tax System (Integrity and Other Measures) Act 1999 and in the New Business Tax System (Miscellaneous) Act (No. 2) 2000 . They implemented recommendations in A Tax System Redesigned principally concerned with inappropriate access to, and duplication of, a companys realised and unrealised losses. These recommendations were Recommendations 6.10 and 6.9(a).

Subdivision 165-CC

13.4 Specifically, Subdivision 165-CC ensures that where a company has a change of ownership or control (a changeover time), capital losses or deductions later obtained in respect of assets held at the changeover time, to the extent of the companys unrealised net loss balance (if any) at the changeover time, can only be accessed by the company if it passes the same business test. Subdivision 165-CC may also impact on the ability of a company to access losses that have been deferred by Subdivision 170-D on assets held by the company before the changeover time. The Subdivision applies to changes of ownership or control from 11 November 1999.

Subdivision 165-CD

13.5 Subdivision 165-CD prevents the realised and unrealised losses of a company that has had an alteration time (usually a change of ownership or control) from being duplicated for income tax purposes in respect of significant equity or debt interests that entities other than individuals have in the company. Subdivision 165-CD applies to alteration times from 11 November 1999.

Individual asset market valuations required

13.6 In calculating unrealised gains and unrealised losses on assets for Subdivision 165-CC purposes, and in calculating unrealised losses on assets for Subdivision 165-CD purposes, the existing law requires that the market values (or other specified values) of individual assets be determined. Unrealised gains are not relevant for the operation of Subdivision 165-CD which adjusts only the reduced cost bases (and other tax attributes used for calculating losses) of equity or debt interests in a loss company. This produces the correct outcomes in terms of the policy aims of the Subdivisions.

13.7 However, in particular cases compliance costs (especially valuation costs) might be less if assets could be valued together (i.e. globally) rather than individually.

13.8 The rules will therefore be refined to allow, as an option, the use of the global method of valuing assets.

13.9 The integrity currently achieved by Subdivision 165-CD is maintained by including a special value shifting rule in that Subdivision. This will ensure that where the unrealised gain value of a company is captured in a global asset valuation at an alteration time, and the value is later removed from the company, it will not be possible to duplicate the companys unrealised losses at that alteration time on realisation of an equity or debt interest in the company.

Summary of new law

Global method can be used in Subdivisions 165-CC and 165-CD

13.10 Subdivisions 165-CC and 165-CD are being amended to allow the optional use of global asset valuations to determine the amounts of unrealised net loss or adjusted unrealised loss under those Subdivisions. As the method is optional and could not disadvantage taxpayers compared with the current law, it may be chosen in respect of changeover times and alteration times that happen from 11 November 1999.

Choice for global method in Subdivisions 165-CC and 165-CD

13.11 Broadly, it will be possible for the company calculating an unrealised net loss or an adjusted unrealised loss to make a choice to use a global method in respect of changeover or alteration times happening to it from 11 November 1999. The choice may be made on or before the day the company lodges its income tax return for the income year in which the relevant changeover time or alteration time occurred, or such later day as the Commissioner allows. If the changeover or alteration time happens before the day on which this bill receives Royal Assent, the choice need not be made until 6 months after that day.

Special value shifting rule in Subdivision 165-CD if interest realised at a loss after global method used

13.12 Subdivision 165-CD will contain a special value shifting rule. It will apply where the global method has been used in calculating an adjusted unrealised loss of a company at an alteration time, and a significant equity or debt interest in that company is later realised. If that realisation would (but for the rule) realise a loss for income tax purposes, and it would duplicate what would have been an amount of the companys adjusted unrealised loss if only unrealised losses on assets had been determined at that time, the realised loss is adjusted. This is achieved by treating the company as having an amount of adjusted unrealised loss at the alteration time for the purposes of making adjustments under section 165-115ZA in respect of the interest.

13.13 Broadly, the rule will operate if:

•

an equity or debt interest would, but for the rule, be realised at a loss for income tax purposes;

•

it was a significant equity or debt interest in a company immediately before an alteration time for which the global method was used; and

•

the alteration time was the latest when the equity or debt interest was a significant equity or debt interest in the company.

The realised loss will not be allowed to the extent that the company has paid dividends, returned capital, or otherwise shifted value while the interest remained a significant equity or debt interest in the company unless it can be shown that this removal of value is:

•

not reasonably attributable to unrealised gain value on assets acquired for at least $10,000 at the alteration time; or

•

has not given rise to a reduction to the reduced cost base of the interest.

13.14 The rule is structured in this way to focus on readily observable transactions and events that may signal that unrealised losses at the alteration time when the global method was used have been exposed. An examination of these matters will enable a more ready assurance that loss duplication has or has not been exposed than would a less direct methodology. These matters are specifically required to be examined. There may be circumstances, however, where relevant value has been shifted but the realised loss itself does not, to some extent, reasonably relate to an amount of adjusted unrealised loss that the company would have had at the alteration time if individual loss assets had been identified. For example, it may relate to a loss of the company that accrued after the alteration time. To that extent the realised loss will not be adjusted. This may be demonstrated by any reasonable approach or methodology, including one where the companys asset values for tax purposes at the alteration time are compared with the net value of the company at the realisation time (as discussed in Example 13.6). It does not require that individual loss asset values be known or determined. The test is that it must reasonably be concluded that the realised loss on the interest could not duplicate unrealised losses at the alteration time.

Transitional rule

13.15 A special transitional rule will apply for an alteration time (for which the global method is used) before the day this bill receives Royal Assent. In respect of those alteration times, there is no requirement to consider specifically the effect of distributions or other value shifted while the interest was a significant equity or debt interest in determining whether the loss on the interest may be affected. Instead, the entity that would otherwise realise the interest at a loss may directly choose to use any other approach to conclude reasonably that the loss could not duplicate an unrealised loss on an asset at the alteration time.

Choice to use transitional approach if interest realised at a loss for Subdivision 165-CD purposes

13.16 A choice to use a transitional approach if an interest is realised at a loss for Subdivision 165-CD purposes must be made by the entity that owns the equity or debt interest concerned. The choice must be made by the later of the time an income tax return is lodged for the income year in which the realisation event happened, or by such later time as the Commissioner allows, or 6 months after the relevant alteration time when the global method was used happened, but not in any event within 6 months after the date this bill receives Royal Assent.

Notice requirements

Extension of notice period

13.17 A general extension of the notice period for the purposes of section 165-115ZC is given because of the amendments made to the method of determining the amount of adjusted unrealised loss. It is not limited to situations where the global method is chosen. This extension is relevant for alteration times that happen before this bill receives Royal Assent . In such cases, a notice required under subsection 165-115ZC(4) or (5) must now be given within 6 months after the day this bill receives the Royal Assent. If a notice has already been given, and because of amendments made by this bill, the notice no longer complies with the requirements in section 165-115ZC, a further notice may be given varying the original notice (including by providing further information) as long as it is done within 6 months after this bill receives Royal Assent or within a further period allowed by the Commissioner.

Interest realised at a loss after the global method used

13.18 There are no notice requirements where an interest is realised at a loss after the global method has been used and an amount, or extra amount, of adjusted unrealised loss is taken to have existed at the alteration time.

Detailed explanation of new law

Amendment of guides to reflect availability of the global method of valuing assets

13.19 The guide material in Subdivisions 165-CC and 165-CD is updated to show that a company can now choose, in calculating its unrealised net loss or its adjusted unrealised loss, to work out the market value of each of its assets individually, or the market value of all of its assets together. [Schedule 14, item 1, subsection 165-115AA(2) and item 6, subsection 165-115GC(5)]

13.20 The guide material has also been rationalised generally by dividing it into more sections and by correcting a minor error in relation to describing the application of the $5 million net asset test which excludes companies from having to count unrealised losses. Consistently with the operation of section 152-15, the guide now reflects the fact that a net asset value of $5 million, or below that amount, will satisfy the test. [Schedule 14, item 1, subsection 165-115AA(1), sections 165-115 and 165-115AA and item 6, sections 165-115GA, 165-115GB and 165-115GC]

Option to choose the individual asset method or the global method

Subdivision 165-CC

13.21 The individual asset method applies for working out the companys unrealised net loss in respect of a changeover time (the relevant time) unless the company chooses the global method. [Schedule 14, item 3, section 165-115E]

13.22 A choice to use the global method must be made on or before the day the company lodges its income tax return for the income year in which the relevant time occurred, or on or before such later day as the Commissioner allows, but not earlier than 6 months after the date this bill receives Royal Assent in a case where the changeover time happens before that date. [Schedule 14, item 4, subsection 165-115E(4) and item 16, section 165-115E of the IT(TP) Act 1997]

13.23 If the global method is chosen, the company does not have the choice of excluding assets acquired for less than $10,000. [Schedule 14, item 2, subsection 165-115A(1B) and item 4, section 165-115E(2)]

13.24 The global method of working out whether a company has an unrealised net loss is set out in a method statement. [Schedule 14, item 4, subsection 165-115E(2)]

Step 1

13.25 Step 1 of the method statement requires that the total market value of all CGT assets that the company owned at the relevant time using a valuation method that would generally be regarded as appropriate in the circumstances.

13.26 The law does not prescribe any particular valuation method, nor does it require that the valuation be undertaken by a qualified valuer . However, the method used must be one that qualified valuers would regard as appropriate for use in the particular circumstances to determine market value, having regard to the activities of the company, the particular types of assets it holds, and any other relevant matters. It must also be a valuation of the total market value of the assets, and not a valuation of the business of the company.

Step 2

13.27 Step 2 aggregates the cost bases of the CGT assets owned at the relevant time. Only if an assets cost base is less than the amount that, for an item of trading stock, would be compared with its market value under section 165-115F (i.e. on an individual asset basis) for calculating a notional revenue gain or notional revenue loss, or, for a revenue asset, would similarly be compared, is the trading stock or revenue asset amount used instead. This ensures that the unrealised net loss calculated under the global method could not be less than it would be under the individual asset method. [Schedule 14, item 4, subsection 165-115E(3)]

Example 13.1

If asset (A) has a reduced cost base of $2,000 and a cost base of $5,000 and asset (B) has a reduced cost base of $4,000 and a cost base of $4,500, then $5,000 and $4,500 are to be used in respect of these assets in determining the total of amounts for all assets of the company under step 2. Because the market value of individual assets are not known, and it is not known whether individually they are unrealised gain or unrealised loss assets, this approach ensures that if a net unrealised loss results from the global method, it could not be less than what would have been calculated had the individual asset method been used.

Step 3

13.28 If the step 2 amount exceeds the step 1 amount, the excess is the companys preliminary unrealised loss at the relevant time. Adding deferred losses or deductions (if any) under Subdivision 170-D referred to in paragraph 165-115A(1A)(b), gives the companys unrealised net loss at the relevant time.

Example 13.2

Y Co has a changeover time on 10 June 2000. Y Co has net assets at that time exceeding $5 million. Y Co chooses to use the global method of determining its unrealised net loss for that changeover time. Y Co has 3 assets (A), (B) and (C) with the following tax characteristics:

(A)

is trading stock (on hand at the beginning of the income year) with a Division 70 value of $15,000. Its cost base and reduced cost base are nil (because its acquisition cost is deductible for tax purposes);

(B)

is land held on capital account with a cost base and reduced cost base of $700,000; and

(C)

is a revenue asset which cost $100,000 and has a cost base and reduced cost base of $97,000.

Y Co values these assets globally at the changeover time and arrives at a market value of $580,000 (step 1 amount).

The step 2 amount is:

$15,000 + $700,000 + $100,000 = $815,000.


Y Cos preliminary unrealised net loss at that time is the excess of $815,000 over $580,000 (i.e. $235,000). Assuming no deferred Subdivision 170-D amounts are involved, $235,000 is also Y Cos unrealised net loss.

Subdivision 165-CD

13.29 The individual asset method applies for working out the companys adjusted unrealised loss in respect of an alteration time unless the company chooses the global method. [Schedule 14, item 11, subsection 165-115U(1)]

13.30 A choice to use the global method must be made on or before the day the company lodges its income tax return for the income year in which the alteration time occurred, or on or before such later day as the Commissioner allows [Schedule 14, item 11, subsection 165-115U(1D)] . If the alteration time happens before this bill receives Royal Assent, the choice does not have to be made earlier than 6 months after the day of Royal Assent [Schedule 14, item 16, section 165-115U in the IT(TP) Act 1997] .

Notices

13.31 A general extension of the notice period for the purposes of section 165-115ZC is given because of the amendments made to the method of determining the amount of adjusted unrealised loss . This is relevant for alteration times that happen before this bill receives Royal Assent . In such cases, a notice required under subsection 165-115ZC(4) or (5) must now be given within 6 months after the day this bill receives Royal Assent. If a notice has already been given, and because of amendments made by this bill, the notice no longer complies with the requirements in section 165-115ZC, a further notice may be given varying the original notice (including by providing further information) as long as it is done within 6 months after this bill receives Royal Assent or within a further period allowed by the Commissioner. [Schedule 14, item 16, section 165-115ZC of the IT(TP) Act 1997]

The global method

13.32 The global method of working out whether a company has an adjusted unrealised loss is set out in a method statement. [Schedule 14, item 11, subsection 165-115U(1B)]

Step 1

13.33 Step 1 of the method statement requires that the total market value of all CGT assets (including those acquired for less than $10,000) that the company owned at the relevant alteration time be worked out using a valuation method that would generally be regarded as appropriate in the circumstances.

13.34 As is the case with the global method in Subdivision 165-CC, the law does not prescribe any particular valuation method, nor does it require that the valuation be undertaken by a qualified valuer . However, the method used must be one that qualified valuers would regard as appropriate for use in the particular circumstances to determine market value, having regard to the activities of the company, the particular types of assets it holds, and any other relevant matters. It must also be a valuation of the total market value of the assets, and not a valuation of the business of the company.

Step 2

13.35 Step 2 requires a determination of the total of the cost bases of CGT assets owned at the alteration time. In certain circumstances a greater amount for a particular asset must be used . This is on the assumption that the alteration time was a changeover time for Subdivision 165-CC and that a greater amount than cost base would be compared with the assets market value under section 165-115F for a CGT asset as trading stock, or as a revenue asset.

13.36 That assumption is needed for 2 reasons. Firstly, an alteration time may not also be a changeover time, even though it often will be. Secondly, the individual asset method rules in Subdivision 165-CD do not have rules for calculating unrealised gains on assets, so these rules must be notionally borrowed for Subdivision 165-CD purposes.

13.37 The use of the greater amount ensures that in calculating an adjusted unrealised loss using the global method losses are not understated relative to what would be calculated under the individual asset method. [Schedule 14, item 11, subsection 165-115U(1C)]

Step 3

13.38 If the step 2 amount exceeds the step 1 amount, the excess is the companys adjusted unrealised loss at the relevant alteration time.

Other modifications to the operation of Subdivision 165-CD to accommodate the global method

13.39 Several modifications are made to Subdivision 165-CD to accommodate the use of the global method in that Subdivision. These are summarised as follows:

•

the rule in step 1 of the method statements for the individual asset method that ensures notional losses and trading stock decreases counted at an earlier alteration time are not counted again at a later alteration time, does not apply where the global method was used at the earlier alteration time because this does not provide for individual asset valuations [Schedule 14, item 11, subsection 165-115U(1A) and item 13, subsection 165-115W(1A)] ;

•

section 165-115T, which ensures that previously counted individual asset unrealised losses are not counted again as realised losses at a later alteration time, does not apply where the global method was used because it did not calculate individual asset unrealised losses [Schedule 14, item 9, subsection 165-115T(2)] ; and

•

the exclusion for non-economic unrealised losses on individual assets does not apply where the global method is used [Schedule 14, item 7, subsection 165-115R(6A) and item 8, subsection 165-115S(6A)] .

Repeal of subsections 165-115F(7) and 165-115V(8)

13.40 Subsections 165-115F(7) and 165-115V(8) which give the Commissioner express authority to give advice about asset valuation, including the grouping together of assets for valuation, to reduce compliance costs associated with the Subdivision, are repealed. The global method removes the need for such provisions. [Schedule 14, items 5 and 12]

Special value shifting rule in Subdivision 165-CD where the global method is used and interest is realised at a loss for income tax purposes

13.41 A special rule applies in circumstances where the global method has been used to calculate an adjusted unrealised loss at an alteration time and, after that time, an equity or debt interest that would have been a relevant equity or debt interest in the company immediately before the alteration time (assuming the company had an overall loss at that time) is realised at a loss for income tax purposes.

13.42 The special rule is designed to prevent the global method sheltering from adjustment, and allowing the duplication of, what would have been an amount of adjusted unrealised loss calculated at the alteration time using the individual asset method. The special rule only applies in circumstances where a relevant equity or debt interest is realised at a loss for income tax purposes and it cannot be demonstrated that the loss is either:

•

not attributable to the removal from the loss company of gain value on an asset owned by the company at the alteration time that sheltered an unrealised loss under the global method; or

•

does not reflect an amount of unrealised loss that would have been determined had the individual asset method been used.

13.43 The problem with which the special rule deals can best be demonstrated by example.

Example 13.3

X Co has a wholly-owned subsidiary Y Co. Post-CGT, X Co capitalised Y Co with $200 million. Y Co acquired 2 assets each costing $100 million.

A share issue at market value ($200 million) by Y Co to X Co causes an alteration time to happen for Y Co. At that time it has no realised losses, and in respect of its 2 assets (other than the $200 million invested), assume that, were the individual asset values to be known, one would have an unrealised gain of $60 million (market value $160 million), and the other an unrealised loss of $60 million (market value $40 million).

Y Co uses the global method and determines that at the alteration time (i.e. just before the share issue) the market value of all its assets is $200 million and that the cost bases for the assets is also $200 million.

Y Co does not, under the global method, have an adjusted unrealised loss and there would be no reductions to the reduced cost bases of X Cos shares in Y Co under section 165-115ZA. If the individual asset method had been used, the unrealised gain would not have been relevant, and the reduced cost base of X Cos (original) shares in Y Co would have been reduced by section 165-115ZA from $200 million to $140 million to prevent any subsequent duplication of the unrealised loss in Y Co of $60 million.

Following use of the global method, Y Co decides to sell the asset with the unrealised gain of $60 million and, after $18 million tax (at 30%), it pays the balance of $42 million as a franked dividend to X Co. Y Co is then worth only $340 million (on an asset basis, but ignoring any potential tax value of the unrealised loss). X Co then sells 20% of Y Co (using 40% of its original shareholding) for $68 million and would make a capital loss of $12 million (i.e. the reduced cost bases of X Cos shares in Y Co sold are $80 million (40% of $200 million).

That $12 million would duplicate part of the unrealised loss of $60 million on Y Cos asset at the alteration time. If the individual asset method had been used, the reduced cost bases of the later disposed of shares would have been reduced by $24 million (40% of $60 million) to $56 million and no capital losses would have been made (nor would capital gains have been made because the cost bases of the shares ($80 million) are not affected by Subdivision 165-CD adjustments).

Although the reduced cost bases of the shares are reduced by $24 million, the loss on realisation was only $12 million as a result of the dilution effect of issuing the new shares.

13.44 The approach by which the special rule addresses this problem is to treat the company as having a separate amount of adjusted unrealised loss that is relevant for determining the adjustments (or further adjustments) to be made by sections 165-115ZA and 165-115ZB in relation only to the equity or debt interest realised at a loss.

Main requirements

13.45 The 2 main requirements for the special rule to operate are:

•

a realisation event that realises a loss for income tax purposes (including a loss to which Subdivision 170-D applies) must happen to an equity or debt interest in a company . Whether a loss would be realised is determined without regard to any adjustments that the special rule may require. What constitutes a realisation event and realisation at a loss is set out in Division 977, and is discussed in Chapter 12.

•

the equity or debt must have been, or have been part of, a relevant equity interest (see section 165-115X) or a relevant debt interest (see section 165-115Y) in the company at an alteration time for it when the global method was used to determine the adjusted unrealised loss. If the global method was used, the company is taken to have been a loss company for these purposes. The alteration time must be the latest one for the company when both the global method was used and the equity or debt was a relevant equity or relevant debt interest in it immediately before that time. If the individual asset method is used for an alteration time of the company after the global method has been used, and the equity or debt is still, or is still part of, a relevant equity or debt interest in respect of that alteration time, any adjustments required in respect of that alteration time will remove the problem that the special rule seeks to overcome.

[Schedule 14, item 15, subsection 165-115ZD(1)]

13.46 If these requirements are met, then certain amounts may, subject to specific exclusions, be treated as an amount (or extra amount) of, adjusted unrealised loss for the company in respect of that alteration time. This is used for adjusting the loss attributes (e.g. reduced cost bases) of the realised equity or debt. The amount of adjusted unrealised loss, or extra amount of adjusted unrealised loss, cannot exceed the amount of loss realised for tax purposes on the equity or debt. [Schedule 14, item 15, subsection 165-115ZD(4)]

13.47 The amount is then used for the purpose of making adjustments immediately before the alteration time in respect of the equity or debt under sections 165-115ZB and 165-115ZA. The adjustments are to be worked out and applied in accordance with subsection 165-115ZB(6) (the non-formula method) [Schedule 14, item 15, subsection 165-115ZD(3)] . Broadly, this will require reasonable adjustments to prevent loss duplication on the interest. This must take into account the fact that the amount of adjusted unrealised loss for the purpose of the special rule (see paragraph 13.48) is limited to the amount of realised loss on the interest and is not to be diluted because there are other interests in the company.

Amounts that may become, or may add to, an amount of adjusted unrealised loss

13.48 The amount of adjusted unrealised loss is worked out in a method statement [Schedule 14, item 15, subsection 165-115ZD(4)] . Broadly, the method statement operates as follows. Step 1 adds the distributions or value shifts from the company that could result in the exposure of unrealised losses at the alteration time. If this exceeds the loss actually realised for income tax purposes on the equity or debt, step 2 reduces the step 1 amount by the excess. A rule to deal with the case where the realised loss is less than or equal to the step 1 amount will be included in a later bill. Step 3 reduces further (if applicable) the step 2 amount by so much of the realised loss that is not reasonably attributable to unrealised losses on assets at the alteration time. This can be shown by any appropriate methodology whether or not individual asset losses are known. The net result is the adjusted unrealised loss for the purposes of the special rule.

Amounts for the purposes of step 1

13.49 The first amount for step 1 is the amount of dividends paid or other distributions of capital or income by the company during the period (relevant period) starting at the alteration time and ending at the realisation event [Schedule 14, item 15, subsection 165-115ZD(5), items 1 to 3 in the table] . If the equity or debt realised ceases to be part of a relevant equity interest or relevant debt interest in the company before the realisation event, the relevant period ceases instead immediately before that time.

13.50 The second amount for step 1 is the amount of any income tax the company becomes liable to pay at any time that is reasonably attributable to a realisation event happening during the relevant period to an asset owned by the company at the alteration time, other than an asset it acquired for less than $10,000. [Schedule 14, item 15, subsection 165-115ZD(5), item 4 in the table]

13.51 The third amount for step 1 is the amount of any outgoing or loss for which the company becomes liable at any time that is reasonably attributable to the realisation during the relevant period, of an asset owned by the company at the alteration time, other than an asset it acquired for less than $10,000 [Schedule 14, item 15, subsection 165-115ZD(5), item 5 in the table] . This would cover an incidental cost of selling the asset. Broadly, the second and third amounts for step 1 are intended to address the removal from the company of gain value at the alteration time that relates, generally, to the costs of realising and becoming liable for tax on that gain.

13.52 The fourth amount for step 1 is the amount of value shifted by the company to its associate by way of a CGT event happening to the asset during the relevant period in respect of which less than market value capital proceeds are obtained by the company. [Schedule14, item 15, subsection 165-115ZD(5), item 6 in the table and subsection 165-115ZD(7)]

Exclusions

13.53 The step 1 amounts do not include amounts that are not reasonably attributable or referable to value that was reflected in a notional capital gain or notional revenue gain that the company had at the alteration time in respect of the CGT asset, or, to avoid double counting, to the extent the transaction, dealing or event referred to in step 1 reduced the reduced cost base of the equity or debt. [Schedule 14, item 15, paragraphs 165-115ZD(5)(a) and (b)]

13.54 The reason for these exclusions is that the outlay, distribution or value shift would not have exposed an amount of adjusted unrealised loss that would have been taken into account at the alteration time if the individual asset method had been used, or the tax law otherwise adjusts for the exposure.

13.55 A simple example can demonstrate the operation of these rules.

Example 13.4

Continuing Example 13.3, but for the special rule, X Co would make a capital loss of $12 million on the realisation of its shares in Y Co. But, after the alteration time, Y Co paid tax of $18 million that was reasonably attributable to an unrealised gain on an asset owned at the alteration time, and also paid a dividend of $42 million similarly reasonably attributable to that unrealised gain. None of the exclusions applies, and it cannot reasonably be concluded that the loss that would otherwise be realised on the interest does not give duplicate tax recognition for the unrealised loss on Y Cos asset at the alteration time. Y Cos adjusted unrealised loss at the alteration time is taken to be $60 million for the purposes of applying sections 165-115ZA and 165-115ZB to the realised interests. In effect, their reduced cost bases are reduced by $24 million (40% of $60 million) to $56 million immediately before the alteration time. This prevents any duplicate capital loss from being realised.

Becoming a member of a consolidated group

13.56 If the global method has been used and an equity or debt interest is held by members of a consolidated group in an entity that joins the group, subsection 705-65(3A) as proposed in this bill may (by assuming a disposal of the equity or debt for market value consideration immediately before the joining time) have the effect that comparable adjustments to those already described have to be done for consolidation cost setting purposes. A similar approach applies in the formation case.

Example 13.5

Immediately before the joining time, members of a consolidated group have shares in a joining entity with a reduced cost base of $70 million and a market value of $30 million. At the joining entitys last alteration time for which the global method was used and the shares were part of a relevant equity interest in the company immediately before the alteration time.

An assumed disposal of the shares would realise a loss for income tax purposes of $40 million, so reductions to the reduced cost bases of the shares may be required as a result of subsection 165-115ZD(1) of the ITAA 1997 applying.

This ensures that the consolidation cost setting rules do not admit into allocable cost amounts representing duplicates of unrealised losses at an alteration time.

If the membership interest was a revenue asset, and a deduction for income tax purposes of $40 million (i.e. net loss on realisation) would have arisen for income tax purposes had it been disposed of immediately before the joining time, there would have been no capital loss (because of the operation of subsection 110-55(9) of the ITAA 1997) but the $40 million (as a loss on a realised revenue asset) would, via sections 705-65(3A), 165-115ZD and 165-115ZA result in a similar reduction to reduced cost base of the interest for consolidation cost setting purposes.

Transitional rule

13.57 There is a special transitional application of section 165-115ZD(1) for alteration times that happen before Royal Assent [Schedule 14, item 16, subsection 165-115ZD(1) of the IT(TP) Act 1997] . This can apply by choice in the general case where there is an actual realisation of an interest, and also for cost setting purposes under the consolidation rules.

13.58 A choice to use a transitional approach if an interest is realised at a loss for Subdivision 165-CD purposes must be made by the entity that owns the equity or debt interest concerned. The choice must be made by the later of the time an income tax return is lodged for the income year in which the realisation event happened, or by such later time as the Commissioner allows, or 6 months after the relevant alteration time when the global method was used happened, but not in any event within 6 months after the date this bill receives Royal Assent. [Schedule 14, item 16, section 165-115ZD of the IT(TP) Act 1997]

13.59 The main difference between the transitional and ordinary application of section 165-115ZD(1) is that under the transitional rule, there is no requirement to consider distributions or value shifts in ascertaining whether unrealised losses are exposed.

13.60 Broadly, any method or approach which, directly or indirectly, may allow a reasonable conclusion to be drawn or inferred, that a realised loss on an equity or debt interest could not duplicate an unrealised loss at the alteration time, can be used. (Such an approach can also be used in the non-transition case, but there is a specific requirement there to have regard to distributions or value shifted).

13.61 A way that a reasonable conclusion might be drawn is as follows. A comparison might be made between the equity or debts proportional share in the total of amounts calculated for the purposes of step 2 of the method statement in subsection 165-115U(1B) at the alteration time, and the equity or debts proportional share in the companys adjusted net asset value. The adjusted net asset value is an amount being the market value of all the companys assets at the realisation time less (plus) a net increase (decrease) in the companys liabilities between the relevant alteration time and the realisation time.

13.62 Without regard to changes in liabilities, an increase in the market value of assets may (inappropriately) be taken to have increased the value of shares and other interests in the company (e.g. if the increase in asset value is matched by an increase in borrowing), and a decrease in the market value of assets may (inappropriately) be taken to have decreased the value of interests (e.g. if liabilities have been repaid).

13.63 If it can be shown that the equity or debts proportional share in the companys adjusted net asset value is at least equal to its proportional share in the companys step 2 amount, no additional amount of adjusted unrealised loss would arise.

13.64 If the proportionate share is less then an amount of adjusted unrealised loss may be needed to prevent loss duplication, but this would depend on the extent to which adjustments had been made previously and other factors.

Example 13.6

XYZ Co is wholly-owned by ABC Co immediately before 12 December 2001. ABC Co acquired all its shares in 1998 for $63 million, and holds them on capital account.

XYZ Co, which has no realised losses, has a step 2 amount of $63 million at 12 December 2001.

Total market value of assets (using a generally accepted valuation approach) = $60 million.

ABC Co sold 60% of its shares in XYZ Co to Acquirer Co, an associate, on 12 December 2001 for $36 million triggering a change in ownership of XYZ Co and an alteration time. ABC Co remains an associate of Acquirer Co. The global method was chosen for determining the adjusted unrealised loss in respect of that alteration time. An amount of $3 million was the companys adjusted unrealised loss at that time, and adjustments under section 165-115ZA were made on that basis. On these facts, the reduced cost base of ABC Cos entire 100% share holding would have been reduced by $3 million, from $63 million to $60 million. No capital loss would be obtained on the disposal of the 60% interest (sale proceeds $36 million and reduced cost base $36 million ($37.8 million less Subdivision 165-CD reduction of $1.8 million)).

In June 2002, a further parcel of shares held by ABC Co representing 10% of the equity in XYZ Co (and 25% of ABC Cos remaining holding in XYZ Co) was sold. This sale does not cause another alteration time for XYZ Co to happen.

Because the holding sold by ABC Co was a relevant equity interest in XYZ Co immediately before the initial alteration time, if the interest is disposed of at a loss, it would be necessary to examine whether further Subdivision 165-CD reductions are required in respect of it because of subsection 165-115ZD in relation to the initial alteration referred to above where the global method was used. Assume that ABC Co chooses to use the transitional rule because it has asset valuation data at the realisation time, and does not want to have regard to distributions and value shifts made since the alteration time.

If the 10% interest of ABC Co in XYZ Co were in fact sold at a small loss (e.g. because it is a minority interest), and if it can be concluded that the adjusted net asset value is at least $60 million (i.e. unchanged from the position on 12 December 2001) then, under the transitional rule relating to section 165-115ZD, no later reduction to reduced cost base under section 165-115ZA in respect of the earlier alteration time would be required in respect of the interest. The $0.3 million reduction already made at the alteration time is sufficient to prevent any unrealised loss at the alteration time being duplicated at the time the realisation event happens to the interest. Any loss arising on the disposed of the interest would not be duplicating an unrealised loss of XYZ Co at the alteration time.

However, if the adjusted net asset value has fallen to $50 million, it may be necessary to make further reductions (with effect from 12 December 2001) because of section 165-115ZD(1) in the IT(TP) Act 1997 under section 165-115ZA to the interest that was sold based on the difference between $1.3 million (i.e. 10% ($63 million - $50 million)) and the $0.3 million already factored into reductions (i.e. $1 million). On the facts available, it would prima facie be necessary to reduce the reduced cost base of the shares sold by ABC Co by a further $1 million, or if this does not produce a reasonable outcome the reduction would be based on the extent to which the total $10 million decrease in net asset value is reflected in the value of the disposed of interest.

Example 13.7

This example illustrates what happens when the proportional interest of a relevant equity interest in the assets of a loss company changes after an alteration time.

Assume a shareholder owns all of the issued shares in a company (100 shares) and it holds them on capital account. The total reduced cost base of the shares is $5 million.

An alteration time happens for the company and it uses the global method to ascertain that it had an adjusted unrealised loss of $2 million (total asset market valuation $3 million and step 2 amount $5 million).

As the shares are part of a relevant equity interest in relation to the alteration time, their total reduced cost base are reduced to $3 million.

Later, asset value of $1 million is removed from the company (for which there are no cost base or reduced cost base adjustments), but an additional 50 shares are issued contemporaneously to make up the deficiency (total extra capital contributed $1 million). This is not an alteration time.

A disposal then occurs of 10% of the equity that existed immediately before the alteration time. Assume this does not cause another alteration time to happen.

A capital loss of $100,000 (reduced cost base $300,000 less capital proceeds $200,000) would be made in respect of the disposal (subject to any adjustment required under section 165-115ZD of the ITAA 1997 or section 165-115ZD of the IT(TP) Act 1997 if the transitional rule is chosen).

Assume the transitional rule is chosen. Although total asset market values have remained unchanged ($3 million) since the alteration time, there has been a decline in the proportional asset value attributable to the disposed of interest (i.e. $300,000 reduced to $200,000 (10/150 $3 million)). Thus, there would need to be an additional adjustment amount under section 165-115ZA so that the reduced cost base of the disposed of interest is reduced by $100,000 and no capital loss is then made.

Application and consequential amendments

13.65 The amendments apply to a time at or after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999. [Schedule 14, item 19]

13.66 As a result of the amendments, the dictionary contains 2 new terms - global method and individual asset method . [Schedule 14, items 17 and 18]