Senate

Revised Explanatory Memorandum

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

Chapter 9 - Direct value shifting by creating a right over a non-depreciating asset

Outline of chapter

9.1 This chapter explains the consequences under new Division 723 where an underlying asset is realised at a loss, the loss is partly or wholly attributable to the existence of a right created over the asset in an associate, and the creation of the right was not itself fully brought to tax. This chapter explains amendments contained in Schedule 15 to this bill.

Context of reform

9.2 Recommendation 6.14 of A Tax System Redesigned recognises that value shifting can occur where rights are created over an underlying asset.

9.3 If a right is created over an underlying asset in a related party (e.g. an associate) and either no consideration, or less than market value consideration, is received for the right, current tax law does not universally require that the market value of the right be used to determine the tax consequences of the creation.

9.4 For example, CGT event D1 (section 104-35 of the ITAA 1997) does not have the effect that capital proceeds equal to market value are taken to have been received in circumstances where a right over an underlying asset is created in an associate and no capital proceeds are actually received in return for the right. Also, if a lease is granted and the lease premium for CGT event F1 is less than the market value of the lease, the market value substitution rule in the CGT provisions does not deem the market value to have been received (see section 116-25).

9.5 In certain circumstances, a right created over the asset may have reduced its market value, allowing it to be realised (e.g. disposed of) for a lower price than would have been received but for the creation and continuing existence of the right. In such a case, the realisation of the asset may lead to a loss that would not have arisen on the realisation of the underlying asset had the right not existed. It may also lead to a larger loss.

9.6 In circumstances where the current tax rules do not assess the creator of the right on its market value (less applicable costs), it is inappropriate that a loss or increased loss can be obtained on the realisation of the underlying asset because of the continued existence of the right.

Summary of new law

9.7 Broadly, if a right over an underlying asset (not being a depreciating asset) is created in an associate of the creator without realising the underlying asset in part, and the consideration for the right as calculated for tax purposes is less than its market value by more than $50,000, there may be consequences under new Division 723 if the underlying asset is realised (in full or in part) at a loss because of the right. The Division does not apply if the right was created upon death of the owner of the underlying asset, or is a conservation covenant over land.

9.8 There will only be consequences if, just before the time of realisation of the underlying asset at a loss, the right is still in existence and held by an associate of the entity realising the underlying asset. Broadly, any loss on realisation of the underlying asset:

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for the entity that created the right; or

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for an entity that acquired the asset from the creator of the right as a result of a roll-over, or series of roll-overs, for which, or for each of which, the transferor and transferee were associates,

is decreased by the lesser of 2 amounts reflecting:

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the extent to which the right suppresses the market value of the underlying asset at realisation; and

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the difference (if any) between the market value of the right when it was created and the consideration given for it at that time for tax purposes.

9.9 To prevent double taxation, the decrease amount is itself reduced by a gain realised for tax purposes (other than a disregarded gain) on the right before, at, or within 4 years after realisation of the underlying asset. The amount must be realised by an entity that was an associate of the entity realising the underlying asset just before the time of realisation. There are similar consequences where the underlying asset is realised at the same time the right is granted.

Detailed explanation of new law

Scope of Division 723

9.10 Division 723 may have consequences for a loss that would otherwise have been made on realisation (in whole or in part) of an underlying asset that is not a depreciating asset, where a right is, or has been, created by the owner of the asset in an associate. The Division may be attracted if the consideration given by the associate was less than the market value of the right and the existing tax law has not, or does not, deem the owner to have received market value consideration for creating the right. The Division may also have consequences for a loss that would otherwise have been made on realisation of replacement interests in some cases if the underlying asset is, or has been, subject to CGT roll-over, or if those replacement interests have themselves been subject to CGT roll-over.

9.11 The main purpose of the Division is, broadly, to reduce a loss that would otherwise be made for tax purposes on realisation of an underlying asset where the loss is attributable (in full or in part) to value shifted out of the underlying asset by the creation of the right, and the value has not been brought to tax either when the right was created or subsequently on realisation of the right. [Schedule 15, item 1, subsection 723-1]

9.12 Division 723 has a de minimis rule which requires that the difference between the consideration for tax purposes and the market value of the right when created must exceed $50,000 for the Division to apply [Schedule 15, item 1, paragraphs 723-10(1)(f) and 723-15(1)(d)] . This is subject to an exception where it is reasonable to conclude that multiple rights are created to take advantage of the $50,000 threshold [Schedule 15, item 1, section 723-35] .

9.13 The Division will not apply where the right created is a conservation covenant, or, broadly, where a right is created on the death of the asset's owner. [Schedule 15, item 1, subsections 723-20(1) and (2)]

9.14 Division 723 will also not apply where the creation of the right effects a part realisation or disposal in part of the underlying asset, or where a more specific provision of the tax law treats the granting of the right as a disposal of the underlying asset (e.g. CGT event F2, section 104-115 of the ITAA 1997 (which is about the consequences of granting a long-term lease).

9.15 Division 723 will not apply to transfers of the underlying asset within a consolidated group because such groups are treated as a single entity for tax purposes.

Key requirements

9.16 The following basic requirements must all be established for the Division to have consequences:

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there must be a loss that would, but for the Division, have been realised for income tax purposes from a realisation event happening to a CGT asset of the taxpayer:

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this asset, which may be held as a capital asset, as trading stock or as a revenue asset, is the 'underlying asset'. Division 723 does not apply if the loss is made on realisation of a depreciating asset;

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at, or before, the time of the realisation event (the 'realisation time'), the taxpayer (or, in limited circumstances a previous owner of the underlying asset - see paragraph 9.17) must have created in an associate a right in respect of the underlying asset:

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a right is created in this sense if it is created or otherwise conferred on or vested in the associate. The right need not be a form of property, but it must be a right of a legal or equitable nature that would be recognised by the courts. A right includes an option; and

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the meaning of associate is as provided for in section 318 of the ITAA 1936;

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where the right was created before the realisation of the underlying asset:

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immediately before that realisation time, the right must still be in existence and must be owned by an associate of the taxpayer; and

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a decrease in the underlying asset's market value must have occurred when the right was created, or since it was created, and must be reasonably attributable to the creating of the right;

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creating the right must have involved a CGT event (other than one happening to only part of the asset) whose capital proceeds are less than the market value of the right when created. The difference between the capital proceeds and that market value is referred to as the shortfall on creating the right. The shortfall on creating the right must generally be more than $50,000:

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a CGT event happens, and there can be capital proceeds, even if the CGT asset is also an item of trading stock or a revenue asset, and even though a capital gain may be disregarded in whole or in part;

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if the associate gives consideration of at least the market value of the right, the Division will not apply; and

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in some cases the market value substitution rule in section 116-20 of the ITAA 1997 may apply in respect of the creation of the right. There will then be no shortfall on creating the right - it is the capital proceeds for tax purposes rather than the actual proceeds that are relevant - and no consequences occur under Division 723. However, the market value substitution rule does not apply, for example, in terms of ascertaining a premium on the grant or renewal of a lease (CGT event F1) or if a right is created for the purposes of CGT event D1 in return for no actual capital proceeds; and

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the market value of the underlying asset when it is realised must be less than it would have been if the right no longer existed at that time, or less than it would have been if the right had not been created at the realisation time. Any difference is called the deficit on realisation :

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if the right is no longer in existence when the underlying asset is sold, there will be no deficit on realisation and no consequences under the Division for a loss that arises on realisation of the underlying asset.

[Schedule 15, item 1, subsections 723-10(1) and 15(1)]

9.17 The Division may also apply in limited circumstances where the entity realising the underlying asset is not the entity that created the right. Providing the entity realising the asset acquired it under a CGT roll-over, or series of CGT roll-overs, and immediately after each of the CGT events to which roll-over applied, the transferor and transferee were associated, Division 723 may apply.

Example 9.1

The trustee of V Trust creates a right over an underlying asset in D Co, its associate at the time, for no consideration and market value proceeds are not taken to have been received for tax purposes. The trustee of V Trust later transfers the underlying asset to a company, Z Co, in exchange for all the shares in Z Co, and roll-over is chosen under Subdivision 122-A. Z Co is an associate of V Trust immediately after the roll-over. If Z Co sells the underlying asset for a loss, Division 723 may have consequences.

[Schedule 15, item 1, subsection 723-10(2)]

Consequences of Division 723 for particular assets

9.18 The Division may have consequences for the realisation at a loss of underlying assets held on capital account, or as items of trading stock or revenue assets. If a CGT asset is also an item of trading stock, or a revenue asset, the Division applies to the asset in its character as a CGT asset and again in its character as an item of trading stock or as a revenue asset. [Schedule 15, item 1, section 723-40]

9.19 An asset is a revenue asset if, and only if, the profit or loss on your disposing of, ceasing to own, or otherwise realising, the asset would be taken into account, in calculating your assessable income or tax loss, otherwise than as a capital gain, trading stock, or a depreciating asset. [Schedule 15, item 19, section 977-50]

9.20 Division 723 only has consequences when a realisation event has happened and, but for the Division, a loss would have been realised for tax purposes. Chapter 12 discusses 'realisation event' and in what circumstances the event realises a loss for income tax purposes.

Prevention or reduction of a loss

9.21 If the requirements for the application of the Division are satisfied, the loss realised on the underlying asset is reduced by the lesser of the shortfall on creating the right and the deficit on realisation. The amount cannot exceed the difference, if any, between the market value of the right when created and the consideration for tax purposes (actual or deemed) determined in respect of the creation. [Schedule 15, item 1, subsections 723-10(3) and 15(2)]

9.22 The amount of reduction is itself reduced by the amount of any gain (other than a disregarded gain) that is realised on the right before, at, or within 4 years after the realisation time for the underlying asset, and is realised by an owner of the right that is, or was, an associate of the owner of the underlying asset when it was realised. [Schedule 15, item 1, subsections 723-10(3), (4) and 15(3)]

When is a gain realised for tax purposes by a realisation event?

9.23 New Division 977 should be referred to in working out a gain realised for tax purposes by a realisation event that happens to the right: see Chapter 12.

9.24 For a right that was held as a revenue asset or as trading stock, the amount of the gain worked out might vary according to whether Division 977 is applied to it in its character as a revenue asset, an item of trading stock or a CGT asset. Section 723-50 contains rules to determine which of the possible amounts is used in applying Division 723. Broadly, in such a case, if the asset is trading stock, the gain is that worked out under section 977-35 or 977-40, and if it is a revenue asset, it is the greater of the gain calculated under a CGT event (see section 977-15) and for a revenue asset (see section 977-55).

Example 9.2

X Co owns an asset (an underlying asset) with a cost base (and reduced cost base) of $40 million and a market value of $50 million. X Co grants a right to an associate (B Co) allowing B Co unrestricted and exclusive use of the underlying asset for a period of 6 years. No charge is made by X Co to B Co, whether on the initial granting of the right or during the period for which the right was granted. Existing tax rules do not impute a market value consideration to the creator of the right in this situation.

The existence of the right reduces the market value of the underlying asset by $15 million to $35 million. X Co sells the underlying asset sometime thereafter for $33 million; the further decrease in market value is attributable to the existence of the right in a changed economic environment.

But for the operation of Division 723, a capital loss of $7 million ($40 million less $33 million) would be made on the realisation of the asset.

This is inappropriate, taking into account that the market value of the created right was not subject to the operation of the tax rules, and that, bearing in mind the use of the asset secured by the entity associated with the owner of the underlying asset, no economic loss has actually been suffered by the owner of the underlying asset.

The effect of section 723-10 is that the capital loss of $7 million that would otherwise have arisen is reduced by $15 million that is, the lesser of the shortfall on creating the right ($15 million) and the deficit on realisation ($17 million). The capital loss is reduced to nil because a capital loss cannot be reduced below zero.

If B Co realised part of its right (before, at the time of, or within 4 years after X Co sells the underlying asset) and made for tax purposes an assessable gain of $12 million that was not disregarded, then the $7 million capital loss that would have been made but for Division 723 by X Co on the underlying asset, is reduced by only $ 3 million (i.e. reduced by $15 million less $12 million).

Realisation event that is only a partial realisation

9.25 The Division also applies when only some part of the underlying asset is realised (e.g. a disposal in part) or an interest is created in the underlying asset. [Schedule 15, item 1, section 723-25]

9.26 In determining by how much a loss arising on realisation of the underlying asset is to be reduced, the shortfall on creating the right and deficit on realisation are each multiplied by a fraction: the market value of the part realised or interest created as a proportion of the market value of the underlying asset. This has the effect that the adjustment to the loss incurred is based not on the whole reduction in value resulting from the earlier creation of a right over the asset, but only so much of that reduction in value as is reflected in the part of the asset realised, or in the interest created.

Example 9.3

Using the facts in Example 9.2, but assuming that B Co did not realise any gain on the right:

If X Co had disposed of only 30% of the underlying asset for $9.9 million it would, but for Division 723, have made a loss of $2.1 million (i.e. $12 million reduced cost base less $9.9 million).

The shortfall on creating the right is recalculated as:

$15 million * $9.9 million / $33 million = $4.5 million.

The deficit on realisation is similarly recalculated to:

$17 million * $9.9 million / $33 million = $5.1 million.

As the lesser of these ($4.5 million) exceeds the loss on disposal of 30% of the asset, the loss is reduced to nil.

Consequences for replacement interests for rolled-over underlying assets

9.27 Where the underlying asset has been transferred to an associate under a replacement asset roll-over (e.g. Subdivision 122-A), Division 723 may also have consequences when interests received as consideration for the asset are realised at a loss. It may also apply to interests that replace those interests if they, in turn, are transferred under a replacement asset roll-over and the new interests are realised at a loss before the underlying asset is itself realised. The reason Division 723 may have such consequences is that the reduced cost base of interests received under a roll-over is derived from the reduced cost base of the underlying asset, and this creates the potential for the unrealised loss on the underlying asset to be mirrored in a duplicate loss on the interests.

9.28 If the Division affects an interest received on transfer of the underlying asset, the reduced cost base of the interest is reduced by applying a formula. The formula takes the amount by which a loss on the underlying asset would have been reduced under Division 723 if the underlying asset had been realised at that time, and apportions it across all the interests received as consideration for the transfer. The portion attributable to each interest is applied to reduce the reduced cost base of the interest. [Schedule 15, item 1, subsections 723-105(1) to (3)]

9.29 In some instances the formula may not accurately determine how much of the unrealised loss on the underlying asset is reflected in the value of the interest that was realised. When this happens, the reduced cost base of the interest is instead reduced by an amount that is appropriate taking into account the amount by which a loss on realisation of the underlying asset would have been reduced, and the number and extent of all other interests that the owner of the realised interest received under a roll-over arrangement, or successive roll-over arrangements, in connection with transfer of the underlying asset. [Schedule 15, item 1, subsection 723-105(4)]

Example 9.4

Assume that in Example 9.1, the trustee of V Trust sells the replacement shares in Z Co, rather than Z Co selling the underlying asset. The reduced cost bases of the replacement shares are to be reduced in accordance with the formula or, in unusual circumstances, by a reasonable amount, immediately before they are realised having regard to the amount by which any loss on the underlying asset would have been reduced if it, rather than the replacement shares, had been realised. This will also apply to the realisation of replacement assets for the shares if they, themselves, were the subject of a replacement asset roll-over.

9.30 As with realisations of the underlying asset itself, gains made on realisation of the created right may be taken into account.

9.31 Any adjustment required to the reduced cost bases of interests would generally be made when a particular interest is first realised after the transfer of the underlying asset. The reduced cost base of the interest would be reduced if a loss arises on that realisation, whether or not a CGT roll-over applies to the realisation event. Adjustments made at this time would then be taken into account in setting the reduced cost base of any further interests received as consideration for the transfer of the interest if a replacement asset roll-over applies to that transfer.

9.32 For the most part, the adjustments made on this first realisation of a particular replacement interest will be sufficient for the purposes of Division 723. No adjustments will be necessary to the reduced cost base of a further interest or interests received as consideration for a transfer, with CGT roll-over, of that replacement interest. Rarely, however, adjustments will be required in respect of these further interests to prevent a loss arising that duplicates the loss on the underlying asset. This could happen where no reduction was made on the initial realisation but there is a loss when the further interest is realised. Provision is made for reducing the reduced cost bases of the further replacement interests in such cases. [Schedule 15, item 1, section 723-110]

9.33 As noted in paragraph 9.22, the amount by which a loss on realisation of the underlying asset is reduced under Division 723 may take into account any gains made on realisation of the right up to 4 years after that time. If the right is realised after adjustments have been made to the reduced cost bases of interests that were received on transfer of the underlying asset, the Division does not permit this adjustment to be reviewed in the same way. This will be examined further once the measures are operating.

9.34 The Division does not apply to replacement interests that are realised at a loss after the underlying asset is realised. Measures in relation to interests realised after that time are under consideration.

Application and transitional provisions

9.35 This Division can apply to rights created on or after 1 July 2002. [Schedule 15, item 2 of the IT(TP) Act 1997]