House of Representatives

Explanatory Memorandum

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

Chapter 2 Value shifting: transitional exclusion for certain indirect value shifts relating mainly to services

Outline of chapter

2.1 Schedule 2 to this bill will amend the IT(TP) Act 1997 to modify the general value shifting regime so that, as a transitional measure, the consequences arising under that regime do not apply to most indirect value shifts involving services where those value shifts occur before:

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the beginning of a losing entity's 2003-2004 income year; or

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if a losing entity's 2002-2003 income year ends before 30 June 2003, the beginning of the losing entity's 2004-2005 income year.

Context of amendments

2.2 The general value shifting regime applies mainly to equity and loan interests in certain companies and trusts that are affected, directly or indirectly, by value shifting arrangements. The regime contains separate rules for direct value shifts and indirect value shifts.

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A direct value shift arises mainly where there is a value shift involving equity and loan interests in a single entity.

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An indirect value shift arises mainly where there is a value shift between entities that have not dealt with each other at arm's length.

2.3 The general value shifting regime generally applies to value shifts that happen on or after 1 July 2002. However, the regime does not affect interests in consolidated group members that are reconstructed under the consolidation rules.

2.4 Therefore, to facilitate the transition to consolidation, most indirect value shifts involving services will be excluded from the general value shifting regime where those value shifts occur before:

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the beginning of a losing entity's 2003-2004 income year; or

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if a losing entity's 2002-2003 income year ends before 30 June 2003, the beginning of the losing entity's 2004-2005 income year.

2.5 The amendments will:

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ensure that groups that consolidate during the exclusion period do not incur compliance costs associated with setting up systems to identify significant service related indirect value shifts when those systems will not be needed after consolidation; and

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allow groups that do not consolidate extra time to establish systems to track service related indirect value shifts that may require adjustments under the general value shifting regime.

Summary of new law

2.6 Most indirect value shifts where at least 95% of the market value of the benefits provided by the losing entity are services will be excluded from the consequences of the general value shifting regime if those value shifts occur before:

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the beginning of a losing entity's 2003-2004 income year; or

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if a losing entity's 2002-2003 income year ends before 30 June 2003, the beginning of the losing entity's 2004-2005 income year.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7 Division 727 of the ITAA 1997 contains rules to regulate the impact of indirect value shifts. Broadly, a scheme results in an indirect value shift from one entity (the losing entity) to another entity (the gaining entity) if the total market value of the economic benefits that the losing entity has provided to the gaining entity in connection with the scheme (the greater benefits) exceed the total market value of the economic benefits that the gaining entity has provided to the losing entity in connection with the scheme (the lesser benefits).

2.8 Where there is an indirect value shift that leads to inappropriate tax outcomes, Division 727 requires adjustments either to the adjustable value of interests held by affected owners or to losses or gains arising when the interests are realised.

2.9 A wide range of transactions and dealings are excluded from Division 727. This ensures that the indirect value shifting rules are appropriately targeted with a view to identifying only significant and material value shifts, while at the same time containing compliance costs. In particular, there are 2 specific exclusions for indirect value shifts involving services.

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The first exclusion relates to benefits consisting of services provided by a losing entity to a gaining entity for a price equal to at least the direct cost to the losing entity of providing the services. The exclusion applies where at least 95% of the market value of the economic benefits provided by the losing entity consist of services.

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The second exclusion relates to services that are not reasonably considered to be overcharged (that is, the services must be considered to be provided for no more than a commercially realistic price). The exclusion applies where at least 95% of the market value of the economic benefits provided by the gaining entity consist of services.

2.10 The services covered by these 2 exclusions are defined in section 727-240 of the ITAA 1997 and include, among other things:

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doing work (including professional work and giving professional advice or any other kind of advice); and

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lending money or providing any other form of financial accommodation (such as providing interest free loans).

2.11 The amendments broaden the exclusions from the indirect value shifting rules for services where the 'IVS time' for the scheme that results in the indirect value shift is before:

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the beginning of a losing entity's 2003-2004 income year; or

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if a losing entity's 2002-2003 income year ends before 30 June 2003, the beginning of the losing entity's 2004-2005 income year.

[Schedule 2, item 1, subsection 727-230(1)]

2.12 The 'IVS time' is defined in subsection 727-150(2) of the ITAA 1997 to mean, broadly, the time when all the parameters of the indirect value shift under a scheme are known.

2.13 The amendments ensure that the indirect value shifting rules do not apply to indirect value shifts where the 'IVS time' happens during this exclusion period and at least 95% of the market value of the benefits provided by the losing entity to the gaining entity (the greater benefits) consist entirely of services. [Schedule 2, item 1, subsection 727-230(1)]

2.14 Division 727 also applies to presumed indirect value shifts. A presumed indirect value shift arises in circumstances that are similar to an indirect value shift and is determined on the basis of certain specified assumptions (see Subdivision 727-K of the ITAA 1997). These assumptions will be modified so that they reflect the transitional provisions to broaden the exclusion from the indirect value shifting rules for services. [Schedule 2, item 1, subsection 727-230(2)]

2.15 In order to qualify for the transitional exclusion the affected entities must be capable of determining that the greater benefits under the scheme include services that comprise at least 95% of the total market value of the benefits. That is, as the transitional exclusion provides that the indirect value shift does not have any consequences, the affected entities must be able to establish that there is an indirect value shift that satisfies the conditions for the transitional exclusion.

2.16 However, if an indirect value shift or presumed indirect value shift results from a scheme that is entered into or carried out for the sole or dominant purpose of obtaining a tax benefit under the transitional exclusion, then Part IVA of the ITAA 1936 may apply to the scheme to cancel that tax benefit.

Example 2.1

Two controlled companies that are not part of a consolidated group enter into a scheme prior to 1 July 2003 which involves a service agreement and interest free loan arrangement. More than 95% of the market value of the greater benefits under the scheme consist entirely of rights to have services provided directly by the losing entity to the gaining entity.

The service agreement and interest free loan arrangement are normal commercial arrangements that would have been entered into in the same way if the transitional exclusion had not existed. Therefore, the transitional exclusion will ensure that there will be no requirement to make adjustments to reflect any indirect value shifts arising under the scheme.

Example 2.2

A wholly-owned group of companies that has not consolidated is contemplating the sale of a subsidiary company to a related party. Prior to the sale, the group saddles the subsidiary with obligations under various agreements to provide services with nominal returns to group members over a 5 year period. This depresses the market value of the subsidiary company's shares with the result that it can be sold at a loss.

A dominant reason for entering into the service agreements was to obtain the benefit of the transitional exclusion to avoid any value shifting adjustment so that the loss on sale would arise. Therefore, Part IVA of the ITAA 1936 may apply to this arrangement to cancel the tax benefit of the loss.

Application and transitional provisions

2.17 The amendments apply where the 'IVS time' for the scheme that results in the indirect value shift is before:

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the beginning of a losing entity's 2003-2004 income year; or

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if a losing entity's 2002-2003 income year ends before 30 June 2003, the beginning of the losing entity's 2004-2005 income year.

[Schedule 2, item 1, paragraphs 727-230(1)(c) and (d)]