House of Representatives

Explanatory Memorandum

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

Chapter 4 - Consolidation: transitional foreign loss makers

Outline of chapter

4.1 Schedule 5 to this bill makes amendments to the IT(TP) Act 1997 to allow certain entities with foreign losses to be excluded from a consolidated group for a transitional period.

Context of amendments

4.2 The consolidation regime allows groups of wholly-owned resident entities to elect to be treated as a single entity for income tax purposes. If a group consolidates, all of a head company's eligible subsidiaries must generally be included in the consolidated group.

4.3 Where an entity becomes a member of a consolidated group, an unused carry forward loss (including a foreign loss) may be transferred to the head company if it satisfies the relevant tests (e.g. continuity of ownership test, same business test) at the time of transfer.

4.4 Consolidation maintains the existing rule that a foreign loss incurred in respect of a particular class of assessable foreign income can only be offset against assessable foreign income of the same class.

4.5 The rate at which transferred losses (of any type) can be used by a head company is restricted by the joining entity's available fraction. The available fraction is basically the proportion that the loss entity's market value at the joining time bears to the value of the whole group at that time and serves as a proxy for the proportion of the group's income that would have been generated by the joining entity.

4.6 The available fraction is intended to ensure that the rate of loss recoupment inside consolidation approximates that which would have occurred in the absence of consolidation. However, the available fraction mechanism may impact harshly in situations where an entity with a particular class of foreign loss generates all, or most, of the group's foreign income of that class.

4.7 Providing more concessional rules for the recoupment of transferred foreign losses by consolidated groups would involve a significant cost to revenue and/or increase the complexity of the consolidation loss rules. Instead, a concession is provided to allow an entity that could become a subsidiary member of a consolidated group to utilise a foreign loss during a transitional period, rather than have the head company utilise the loss.

4.8 The amendments have retrospective effect to 1 July 2002 which is the date of commencement of the consolidation regime. As the amendments provide a concessional treatment for entities with foreign losses the amendments will have no adverse impacts.

Summary of new law

4.9 The amendments allow a subsidiary with an unrecouped foreign loss to be excluded from a consolidated group for up to 3 years, subject to certain conditions. An entity excluded from a consolidated group under this rule is defined as a transitional foreign loss maker.

Comparison of key features of new law and current law

Detailed explanation of new law

Object

4.10 The object of the provisions is to enable an entity that has foreign losses to remain outside a consolidated group for a period of up to 3 years, or until its foreign losses are utilised, rather than being subject to the loss utilisation restrictions of Subdivision 707-C. [Schedule 5, item 1, section 701D-1]

Eligibility

4.11 The head company of a consolidated group may elect to exclude from the group a subsidiary entity that has an unrecouped foreign loss incurred prior to the entity's 2002-2003 income year. The loss must be one that would have been transferred to the head company had the subsidiary become a subsidiary member of the consolidated group at its formation time (i.e., the relevant transfer tests contained in Division 707 must have been able to be satisfied at that time). [Schedule 5, item 1, subsection 701D-10(3)]

4.12 Additional eligibility conditions include:

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the consolidated group must come into existence before 1 July 2004 [Schedule 5, item 1, paragraph 701D-10(1)(a)];

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the entity must have been continuously wholly-owned by the head company from the start of 1 July 2002 (the continuous ownership condition) [Schedule 5, item 1, subsection 701D-10(2)] :

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this condition ensures that the measure only applies where the entity was a member of a group that existed prior to the commencement of the consolidation regime; and

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the entity must not hold a membership interest in another entity that, but for these provisions, would be a subsidiary member of the consolidated group (the no-subsidiary condition) [Schedule 5, item 1, subsection 701D-10(4)] :

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this condition ensures that the transitional foreign loss maker provisions can not exclude from a consolidated group an entity that does not itself meet the conditions to be a transitional foreign loss maker.

Effect of being excluded from a consolidated group

4.13 A transitional foreign loss maker may be excluded from a consolidated group for a maximum of 3 years from the time the group consolidates. The entity may become a member of the consolidated group before the end of the three year period if the relevant foreign losses are fully recouped (in which case the entity will become a member of the group at the commencement of its next income year), or if it fails the no-subsidiary condition at any time. A consequence of excluding a transitional foreign loss maker from a consolidated group is that when it subsequently becomes a member of the group it will not be eligible for transitional concessions that are only available in respect of entities that become members of a group at the formation time. [Schedule 5, item 1, section 701D-10]

4.14 Specific amendments are made to Subdivision 707-C of the IT(TP) Act 1997 to ensure that certain transitional loss rules (the 'value donor' rules and the option for a consolidated group to recoup certain transferred losses over 3 years) cannot apply where the transitional foreign loss maker is owned by an entity that exits to form a new consolidated group. [Schedule 5, item 2, paragraph 707-325(1)(c); item 3, paragraph 707-350(1)(d)]

4.15 While a transitional foreign loss maker is excluded from a consolidated group, it remains a member of the relevant consolidatable group. This means that a transitional foreign loss maker is not eligible for loss transfer, asset roll-over and thin capitalisation grouping concessions that are provided for groups that include certain non-resident entities. This is consistent with the policy that such grouping benefits should be denied where resident members of a group are eligible to consolidate but choose not to. [Schedule 5, item 1, subsection 701D-10(5)]

4.16 A transitional foreign loss maker that is excluded from a consolidated group does, however, continue to be a wholly-owned subsidiary of the head company. This may be relevant for the purposes of the indirect value shifting rules in Division 727.

Making the choice for the transitional foreign loss maker provisions to apply

4.17 The head company must make the choice to exclude a transitional foreign loss maker by the end of the period allowed for a head company to elect to consolidate, or 30 days after Royal Assent, whichever is later. [Schedule 5, item 1, subsection 701D-15(3)]

4.18 A head company cannot elect to apply the transitional foreign loss maker provisions to an entity that has previously been excluded from a consolidated group under these rules - for example, where the transitional foreign loss maker is owned by an entity that exits to form a new consolidated group. [Schedule 5, item 1, subsection 701D-15(2)]

MEC groups

4.19 An entity is able to be excluded from a MEC group under the transitional foreign loss maker provisions if it meets the general eligibility conditions. The one difference is that all the membership interests in the entity must have been beneficially owned from 1 July 2002 by an entity that became an eligible tier-1 company of the group at the formation time, but not necessarily by the eligible tier-1 company that became the head company. [Schedule 5, item 4, section 719-10]