House of Representatives

Explanatory Memorandum

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

Chapter 12 - Consolidation: technical amendments

Outline of chapter

12.1 This chapter explains:

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the rule that determines, for the purposes of the consolidation membership rules in Division 703 of the ITAA 1997, the time at which beneficial ownership of shares in a company changes when its shares are bought or sold by a consolidated group;

•

technical amendments to provisions in Division 703 of the ITAA 1997 that relate to the period within which a choice to consolidate must be notified to the Commissioner; and

•

amendments to the ITAA 1936 to ensure that the existing provisions in the income tax law to encourage investment in R & D interact properly with the consolidation provisions.

The amendments are in Schedules 2, 3 and 23 to this bill.

Context of reform

Beneficial ownership timing rule

12.2 Under the consolidation rules, a company becomes a member of a consolidated group when all its shares are beneficially owned, directly or indirectly, by the head company.

12.3 Concern was expressed about potential uncertainty as to when shares in a company become or cease to be beneficially owned, and therefore as to when the company joins or leaves a consolidated group as a result of becoming or ceasing to be 'wholly-owned'

12.4 The potential for uncertainty arises because the time at which full beneficial ownership is transferred is a matter of interpretation. For example it is arguable that the vendor and purchaser may come to a different conclusion about the time at which it has occurred. This could potentially create uncertainty about when a company joins or leaves a consolidated group, or leaves one consolidated group and joins another. Certainty is important because upon a company joining a consolidated group, the head company becomes liable for its income tax liabilities.

12.5 In response, the timing rule has been developed in consultation, to deal with the majority of cases. This rule provides added certainty about the time at which a company joins or leaves a consolidated group, and generally accords with commercial practice as to when beneficial ownership of shares changes.

Period for notifying a choice to consolidate

12.6 This bill contains amendments to the membership rules for ordinary consolidated groups to rectify a technical deficiency relating to the timeframe within which the Commissioner must be notified of a choice to consolidate an eligible group of entities.

Research and development

12.7 The income tax law contains a number of provisions to encourage companies to invest in R & D activities. The September Consolidation Act made some amendments to ensure that this intention was not frustrated simply because a company was part of a consolidated group or because it joined or left such a group. This bill contains further such amendments. They aim to preserve the policies behind both regimes to the greatest extent possible.

Summary of new law

Beneficial ownership timing rule

12.8 A change in beneficial ownership of the shares in the company will be taken to have occurred at the time the vendor ceased to be entitled, and the purchaser became entitled to be registered as holder of the shares. This rule will apply where beneficial ownership changes as a consequence of an arm's length transaction between non-related parties.

Period for notifying a choice to consolidate

12.9 Amendments will ensure that subsection 703-50(3) of the ITAA 1997, which describes the period within which a choice to consolidate can be notified to the Commissioner, is consistent with the underlying policy intent.

Research and development

12.10 The amendments prevent the possibility of 2 balancing adjustments applying when an asset used for R & D activities is lost or disposed of. They also modify the balancing adjustment that does apply, to ensure that it brings the correct figure to account in consolidation cases.

12.11 The amendments also make a number of minor amendments to correct errors in the current law or made by the September Consolidation Act.

Detailed explanation of new law

Beneficial ownership timing rule

12.12 A change in beneficial ownership of the shares in the company as a consequence of an arm's length contract between non-associated parties will be taken to have occurred at the time the vendor ceased to be entitled, and the purchaser became entitled to be registered as holder of the shares. This rule will apply for the purposes of determining when a company becomes or ceases to be a member of a consolidated group (including a multiple entry consolidated group). [Schedule 2, item 1, section 703-33]

12.13 The rule provides a timing overlay to section 703-30 of the ITAA 1997 in certain circumstances, while maintaining the policy intention of that section. It will not apply unless there has been a change in beneficial ownership of the relevant shares.

12.14 That is, beneficial ownership will remain the test for whether an entity is a wholly-owned subsidiary of another entity. Where beneficial ownership in shares of a company has changed as a result of a contract, the rule dictates at what point of time the change took place, for the purposes of determining the point in time at which the company began or ceased to be a member of a consolidated group.

12.15 The rule provides an outcome that:

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provides greater certainty than 'time of change in beneficial ownership' alone. Different parties to a transaction might take differing views as when beneficial ownership is transferred in particular facts and circumstances; and

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is consistent with the policy intention of the consolidation membership rules, which is to consider only those interests that establish ownership.

12.16 Generally, the proposal provides the required certainty and aligns with commercial practice.

When does the timing rule apply?

Sale of shares in a company

12.17 The timing rule addresses concerns expressed in relation to the sale of shares in companies.

Between non-associates dealing at arm's length

12.18 Further, the timing rule will only apply to dealings at arm's length between parties that are not associates. This limitation protects against collusion between vendor and purchaser to effect a joining or leaving time that is not in accordance with the true transfer of ownership for other purposes.

12.19 If the parties to the contract are not dealing at arm's length, or are associates, the basic rule set out in section 703-30 will apply. The time of the change in membership status will be when beneficial ownership changed. This will be determined according to the particular facts and circumstances.

What is 'entitlement to be registered'?

12.20 'Entitlement to be registered' is a concept known to the law relating to companies, and refers to the ownership rights that give rise to the entitlement of a purchaser of shares in a company to be registered as holder of those shares in the company's register of members.

12.21 The concept has been used in the timing rule to ensure that a consolidated group is not required to bring the income of a target company into the group merely because, for example, it has signed a contract to purchase the shares in the company. Rather, that requirement commences when the vendor and the purchaser have done everything required under the contract to transfer ownership to the purchaser.

Things that do not prevent entitlement to be registered

12.22 Under this rule a member of a consolidated group will be entitled to be registered as the owner of shares in a purchased company notwithstanding that it has not, for example, paid the relevant stamp duty, or obtained any approval of the transfer that may be required from the directors of the target company.

12.23 So, for example, a member of a consolidated group could not claim that it is not 'entitled to be registered' (thus avoiding the company becoming a member of the group and the consequent obligations) for the purpose of section 703-33 by reason only of its failure to pay State stamp duty on the transfer of the shares. A purchaser who fails to take the steps necessary to take advantage of its entitlement to become registered on the company's register of members cannot argue that it is not so entitled.

Period for notifying a choice to consolidate

12.24 Subsection 703-50(3) of the ITAA 1997 describes the period within which a choice to consolidate is required to be notified to the Commissioner. Where the head company is required to lodge an income tax return for the income year in which the consolidated group comes into existence, the underlying policy intention is for the period to start on the day on which the group consolidates and end on the day that that return is given to the Commissioner.

12.25 In certain circumstances, the period for notifying the choice is unintentionally extended by subsection 703-50(3). In particular, this occurs where a choice is made for the group to come into existence on the last day of the head company's income year. Arguably in this case, the end of the period for giving the choice is extended to the day on which the return for the next income year is given to the Commissioner. Amendments are made to rectify this problem. [Schedule 3, item 1, subparagraph 703-50(3)(b)(i)]

Research and development

Balancing adjustments for R & D assets

12.26 The rate at which an asset depreciates for tax purposes does not necessarily reflect the actual decline in its value. Therefore, when the asset is sold for other than its depreciated value, the tax law brings an amount to account to reflect that difference. Sometimes, that amount is income and sometimes it is a deduction. In either case, the amount is called a 'balancing adjustment'.

12.27 The R & D provisions were amended in 2001 to apply a depreciation-like treatment to assets used for R & D activities. Until then, deductions had been allowed for expenditure on such assets. That older treatment applies to expenditure under contracts entered into before noon 29 January 2001 in the Australian Capital Territory and the new treatment applies afterwards. When an asset is sold, different balancing adjustments apply depending on which of those treatments applied to the asset.

12.28 Since the same asset cannot be covered by both of those treatments under the current law, only one of the balancing adjustments could apply when the asset is sold. However, in some consolidation situations it is possible for both treatments, and therefore both balancing adjustments, to apply.

12.29 The September Consolidation Act dealt with the possibility of deductions being claimed both under the old treatment and the newer depreciation treatment. It did not deal with concurrent application of the balancing adjustments.

Only one balancing adjustment applies

12.30 If both the expenditure, and the depreciation, balancing adjustments could apply, only the depreciation balancing adjustment will apply [Schedule 23, item 3, subsection 73BAG(1) of the ITAA 1936] . Section 73BF of the ITAA 1936 and section 40-292 of the ITAA 1997 provide for the depreciation balancing adjustment.

12.31 The depreciation balancing adjustment was chosen because it will continue to operate into the future. The expenditure balancing adjustment (subsections 73B(23) and (24B) of the ITAA 1936) does not apply to any expenditure made under a contract entered into after 29 January 2001 (see subsections 73B(15AAA) and (15AAAA) of the ITAA 1936).

Amendments to the balancing adjustments

12.32 The balancing adjustment for R & D assets uses a modified version of the formula used for the balancing adjustment for normal depreciating assets, to reflect the fact that at least some of the depreciation would have been deducted at 125%.

12.33 The modified formula requires you to work out the proportion of the depreciation that was deducted at 125%. The same proportion of the normal balancing adjustment is then increased by 25% (see subsection 73BF(3) of the ITAA 1936 and subsection 40-292(4) of the ITAA 1997).

12.34 Because of the amendments made by the September Consolidation Act, the 125% deductions may be reduced by amounts of expenditure on the asset deducted under the old treatment. Therefore, the current amendments will increase the 125% depreciation deductions by the amount of those reductions, so that the formula correctly works out the proportion of the balancing adjustment that should be increased by 25%. [Schedule 23, item 8, subsection 73BF(3B) of the ITAA 1936]

12.35 However, the 125% depreciation deductions are only increased by those reductions for that purpose if:

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the balancing adjustment is a deduction rather than an amount of assessable income;

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the head company's aggregate R & D expenditure for the year is more than $20,000; and

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the asset had been used exclusively for carrying on R & D activities since the consolidation provisions set its tax cost.

[Schedule 23, item 8, subsection 73BF(3A) of the ITAA 1936]

12.36 Those preconditions reproduce the same preconditions that the current law imposes in deciding whether to increase the balancing adjustment for the old expenditure treatment by 25% (see paragraphs 73B(23)(c), (e) and (f) and (24B)(c), (e) and (f) of the ITAA 1936).

12.37 The only change to those preconditions is that the requirement for the asset to have been used exclusively for R & D activities is limited to the period after its tax cost was set by the consolidation provisions. That change is in accordance with the 'fresh start' approach that consolidation takes for depreciating assets generally.

Example 12.1: Deductible balancing adjustment

Janz Petrochemicals Ltd runs a laboratory and uses an electron microscope in its research. It acquired the microscope for $300,000 and had been writing off that expenditure under the old treatment. When the Masson Fuels group acquired Janz, only $100,000 remained to be deducted. The tax cost of the microscope was set at $450,000 in the hands of the Masson group. The group depreciates the microscope at a 20% rate on a straight-line basis.

In year 1, it claimed a $125,000 deduction under the old treatment (which is the last $100,000 of the original expenditure deducted at 125%). It also worked out a notional depreciation deduction of $90,000 under the new treatment but reduced it to nil because of the old treatment deduction (see section 73BAF of the ITAA 1936 in the September Consolidation Act). The other $10,000 of the expenditure deducted under the old treatment was carried over to year 2.

In year 2, it again worked out a notional depreciation deduction of $90,000. That was reduced to $80,000 because of the $10,000 carried over from year 1. At 125%, it claimed a deduction of $100,000. The microscope then had an adjustable value of $270,000 (i.e. $450,000 - (2 $90,000)).

If the group sold the asset at that time for $250,000, there would be a balancing adjustment deduction. This would start at the $20,000 difference between the sale price and the adjustable value but would be increased by 25% to the extent that the decline in value from $450,000 was eligible for 125% deductions. Assuming that the preconditions were satisfied, the calculation would also include the expenditure deducted under the old treatment after the group acquired the asset. The calculation would be:

(($80,000 + $100,000) / (2 * $90,000)) * $20,000 * 25 = %5,000


The $5,000 increase in the deduction here reflects the fact that, taking into account the expenditure that was deducted under the old treatment, all of the decline in the microscope's value was deductible at 125%.

12.38 Another amendment reduces the asset's adjustable value for the purposes of working out the balancing adjustment. A depreciating asset's 'adjustable value' is its cost less its decline in value for tax purposes. The amendment reduces the adjustable value by the amount of expenditure on the asset that was deducted under the old treatment (after the entity joined the consolidated group) but has not yet been used to reduce the notional depreciation deductions under the new treatment. [Schedule 23, item 3, subsection 73BAG(2) of the ITAA 1936]

Example 12.2: Variation to adjustable value

Suppose the group in the previous example had sold the microscope for $380,000 at the end of year 1. Its adjustable value at that time would have been $360,000 (i.e. the $450,000 less the $90,000 depreciation for the year). However, $10,000 of the deductible expenditure under the old treatment remained to be offset against depreciation in future years. That would be applied to reduce the adjustable value to $350,000, increasing the balancing adjustment from $20,000 to $30,000.

12.39 This amendment reflects the fact that, whenever the expenditure that is deductible under the old treatment exceeds the depreciation deduction, it is effectively bringing forward future depreciation. The decline in the asset's value won't catch up with that until the excess that is carried forward has been used up. If the asset were sold before then, the excess would never be used up, so the balancing adjustment would never recognise the depreciation that was brought forward. The amendment corrects that by reducing the asset's adjustable value by the amount of future depreciation that has not yet been caught up.

12.40 Some minor amendments are needed to ensure that the balancing adjustment can apply at all when deductions are also being claimed under the old expenditure treatment. The balancing adjustments are only triggered when deductions are claimed under section 73BA of the ITAA 1936 (see paragraph 73BF(1)(b) of the ITAA 1936 and paragraph 40-292(1)(b) of the ITAA 1997). The 25% modification can only apply if at least one deduction was claimed under that section at the 125% rate (see subsection 73BF(2) of the ITAA 1936 and subsection 40-292(3) of the ITAA 1997).

12.41 If deductions are claimed under the old expenditure treatment, deductions under the new depreciation treatment are reduced (see section 73BAF in the September Consolidation Act). If that reduces the depreciation deductions to nil, the preconditions for the balancing adjustment would not be satisfied. Therefore, the amendments ensure that the preconditions are satisfied if they would have been satisfied but for those reductions. [Schedule 23, items 4, 7, 10 and 11, paragraph 73BF(1)(b) and subsection 73BF(2) of the ITAA 1936 and paragraphs 40-292(1)(b) and (3)(b) of the ITAA 1997]

Minor research and amendment amendments

12.42 Some notes are added to existing provisions to inform readers of the effect of the substantive R & D amendments. [Schedule 23, items 1, 2, 6 and 12, subsections 73B(23), (24B) and 73BF(1) of the ITAA 1936 and section 40-292 of the ITAA 1997]

12.43 Paragraph 73BF(1)(b) of the ITAA 1936 incorrectly refers to 'section 73BI' as the provision under which a company can choose a tax offset instead of its R & D deductions. The provision it should refer to is 'section 73I' and the amendments make that change. [Schedule 23, item 4, subparagraph 73BF(1)(b)(i) of the ITAA 1936]

12.44 Subsection 701-55(2) of the ITAA 1997 lists some depreciation provisions and explains how they apply when an asset's tax cost has been set by the consolidation regime. The amendments add sections 73BA and 73BF of the ITAA 1936 to the list because they also provide for depreciation. [Schedule 23, item 13, subsection 701-55(2) of the ITAA 1997]

12.45 The September Consolidation Act amended the TAA 1953 to provide an administrative penalty when a former subsidiary fails to advise its former head company that it has recouped an amount for which the head company had claimed an R & D deduction (see item 15 of Schedule 11 to that Act). The penalty is one penalty unit for each 28 day period that the former subsidiary fails to provide that advice. No limit was imposed on the maximum amount of that penalty. To be consistent with similar penalties, the amendments limit the penalty to a maximum of 5 penalty units. [Schedule 23, item 14, paragraph 286-80(2)(b) of Schedule 1 to the TAA 1953]

Application and transitional provisions

12.46 These amendments will take effect on 1 July 2002, along with other aspects of the consolidation measure.

Consequential amendments

Research and development

12.47 An amendment to section 73BF provides that the term 'aggregate research and development amount' has the same meaning in that section as it has in section 73B [Schedule 23, item 9, subsection 73BF(7)] . This term is used in section 73BF for the first time because of the amendment discussed in paragraph 12.35