House of Representatives

Explanatory Memorandum

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

Chapter 2 - Consolidation: providing greater flexibility

Outline of chapter

2.1 Schedule 2 to this bill contains the following modifications to the consolidation regime:

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membership rules for corporate unit trusts and public trading trusts, multiple entry consolidated (MEC) groups, and interposed head companies;

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cost setting for assets that the head company does not hold under the single entity rule;

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leaving rules for partners and partnerships;

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deferred acquisition payments;

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application of transitional cost setting provisions to MEC groups;

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continuity of ownership test (COT) concession for foreign losses;

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interactions with international tax rules;

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consolidation liability rules;

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calculation of capital gains tax (CGT) cost base assumed CGT event;

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interaction with the Financial Corporations (Transfer of Assets and Liabilities) Act 1993; and

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privatised assets.

2.2 All references to legislative provisions in this chapter are references to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

2.3 Unless otherwise stated, reference in the chapter to a consolidated group should be read as including a MEC group.

Context of amendments

2.4 With the introduction of the consolidation regime, a number of modifications are being made to provide greater flexibility, further clarify certain aspects of the consolidation regime and to ensure that the regime interacts appropriately with other aspects of the income tax law.

Summary of new law

Corporate unit trusts and public trading trusts can be treated like head companies of consolidated groups

2.5 Part 2 of Schedule 2 to this bill allows corporate unit trusts (CUTs) and public trading trusts (PTTs) that are subject to Divisions 6B and 6C of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) to make an election to be treated like a head company of a consolidated group. In doing so they will also be treated like a company for income tax and related purposes. This will allow wholly-owned subsidiaries of such a trust to also be treated like subsidiary members of the consolidated group.

2.6 Once a CUT or PTT has made this election it will continue to be treated like a company for income tax and related purposes for the rest of its existence, even if the group it heads deconsolidates or it fails the definitional requirements of a CUT or a PTT that are found in Divisions 6B and 6C of Part III of the ITAA 1936 respectively.

Multiple entry consolidated groups and interposed head companies

2.7 The amendments made by Part 3 of Schedule 2 to this bill will:

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align the period in which a choice is made to continue as a consolidated group, under section 124-380 (exchange of shares in one company for shares in another company), with the notification period for events affecting consolidated groups under section 703-60;

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ensure that changes to the membership of a consolidated group which occur more than 28 days before formation of the group are notified by the head company of the group rather than the company that made the choice to consolidate, where they are different because of the existence of an interposed company; and

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ensure that the CGT roll-over relief available under Subdivision 126-B applies only to members of consolidated groups or to companies that are not members of consolidatable groups.

Cost setting for assets that the head company does not hold under the single entity rule

2.8 Part 4 of Schedule 2 to this bill amends the consolidation cost setting rules to ensure that the assets of a joining entity that do not become assets of the head company under the single entity rule have their tax cost reset when the entity joins the consolidated group. Intra-group assets, such as a loan from one group entity to another, are the main example of assets that do not become assets of the head company when the entities become members of a consolidated group.

Cost setting rules for partners and partnerships leaving a consolidated group

2.9 Part 5 of Schedule 2 to this bill provides special rules for determining the income tax consequences that arise where a partner or a partnership leaves a consolidated group. A minor amendment is also made to ensure that a partner's share of the overall foreign losses of a partnership are included when calculating the partner's allocable cost amount on entry.

Treatment of deferred acquisition payments

2.10 Part 6 of Schedule 2 to this bill ensures that, when an entity makes a deferred acquisition payment after the joining time (or becomes required to make such a payment), the allocable cost amount of the joining entity will be required to be recalculated to include the amount of the deferred acquisition payment.

Application of transitional provisions cost setting rules to multiple entry consolidated groups

2.11 Part 7 of Schedule 2 to this bill amends the transitional provisions relating to the cost setting rules to ensure that those provisions apply appropriately to MEC groups. This is achieved by ensuring that the following can be transitional entities:

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all subsidiary members of a MEC group, other than non-head company eligible tier-1 companies and transitional foreign held subsidiaries; and

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eligible tier-1 companies of a potential MEC group that are 'rolled down' to become subsidiaries of another eligible tier-1 company and remain wholly-owned subsidiary members at all times.

Foreign losses and the continuity of ownership test concession

2.12 Part 8 of Schedule 2 to this bill changes the recoupment tests applied to foreign losses incurred by companies from those contained in the ITAA 1936 to those in the ITAA 1997. This change ensures that foreign losses are eligible for the '3-year continuity of ownership test concession' (the 3-year COT concession) that allows certain losses to be used over three years instead of under the 'available fraction' method.

Trading stock election in relation to foreign investment fund interests

2.13 Part 9 of Schedule 2 to this bill inserts new rules to ensure that the entry history rule in Part 3-90 does not adversely affect the head company's ability to make elections in relation to a foreign investment fund (FIF) trading stock interest that it has when an entity joins a group. They also ensure the exit history rule in Part 3-90 does not adversely affect the leaving entity's ability to make elections in relation to trading stock interests in FIFs that it has upon leaving the group. However, the new rules do not affect the decisions that the head company has made in relation to its own trading stock interests in FIFs.

Foreign dividend accounts and consolidation

2.14 Part 9 of Schedule 2 to this bill ensures a provisional head company of a MEC group to credit the foreign dividend account (FDA) with the amount of an assessable non-portfolio dividend that is paid to a subsidiary member of the group and on which foreign tax was paid. The provisional head company is taken to have paid the foreign tax actually paid by the subsidiary member.

2.15 Part 9 of Schedule 2 to this bill also inserts a provision to ensure that the calculation of a FDA debit in relation to an Australian taxable dividend takes account of non-portfolio dividends paid throughout the income year to the members of a consolidated group. This is relevant for a head company of a MEC group that was not the provisional head company during the year.

2.16 The new rules also ensure a FDA surplus cannot be transferred by a company to a related company that is a member of a consolidated group where the paying company is not a member of the group.

Foreign tax credits and consolidation

2.17 Part 9 of Schedule 2 to this bill:

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provides that where entities with excess foreign tax credits join a consolidated group at the start of the head company's income year, the head company will be able to use those credits at the end of that income year;

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ensures the head company will be able to use excess foreign tax credits from a joining entity's non-membership period where the entity joins a consolidated group before or at the start of the head company's income year and that income year starts after the corresponding income year of the joining entity; and

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inserts a rule which explicitly implements the policy that once an entity joins a consolidated group any foreign tax credits it has whether from a non-membership period or from prior years will only be available to the head company of that group.

Collection and recovery rules

2.18 Part 10 of Schedule 2 to this bill provides greater flexibility to the consolidation collection and liability rules contained in Division 721. In particular, the amendments:

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modify the clear exit rule and the pay as you go (PAYG) instalment liability rules;

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clarify that a group liability can be subject to only one tax sharing agreement; and

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update references to the franking tax-related liabilities.

Calculation of cost base and reduced cost base - assumed capital gains tax event

2.19 Part 11 of Schedule 2 to this bill ensures that, whenever it is necessary for an entity to calculate the cost base or reduced cost base of a CGT asset, and a CGT event has not occurred in relation to that asset, the entity will be required to assume that a CGT event has occurred in relation to that asset.

Interaction with the Financial Corporations (Transfer of Assets and Liabilities) Act 1993

2.20 Part 12 of Schedule 2 to this bill amends the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 to ensure that the income tax relief provided by that Act applies appropriately to financial corporations that are members of consolidated groups.

2.21 The amendment ensures that upon the transfer of an asset or liability by a subsidiary member of a consolidated group, the group's head company is eligible for any tax relief that would have, but for consolidation, been available to the subsidiary under the Financial Corporations (Transfer of Assets and Liabilities) Act 1993.

Tax cost setting for privatised assets

2.22 Part 13 of Schedule 2 to this bill amends the consolidation regime to ensure that where a tax exempt entity (or previously privatised entity) becomes a member of a consolidated group, the tax cost for depreciating assets of the entity is appropriately capped. The amendments also apply, in appropriate circumstances, to assets acquired from a tax exempt entity by an entity that becomes a member of a consolidated group. The amendments ensure that the consolidation cost setting rules which reset the tax cost for assets that an entity brings into a consolidated group do not override the special rules which apply to privatised entities.

Comparison of key features of new law and current law

Detailed explanation of new law

Corporate unit trusts and public trading trusts can be treated like head companies of consolidated groups

2.23 Part 2 of Schedule 2 to this bill amends the consolidation membership rules to allow a corporate unit trust (CUT) or a public trading trust (PTT) that is subject to Division 6B or 6C of Part III of the ITAA 1936 to make an election to be treated like a head company of a consolidated group. But in doing so they are, in effect, also making an irrevocable election to be treated like a company for income tax and related purposes.

2.24 This income tax treatment may affect other entities as well, including members of the trust and entities in which the trustee holds membership interests. For example, it will allow wholly-owned subsidiaries of such a trust to be treated like subsidiary members of the consolidated group. [Schedule 2, Part 2, item 2, section 713-120]

Background

2.25 This measure was announced in Minister for Revenue and Assistant Treasurer's Press Release No. C19/03 of 27 March 2003. In brief, certain CUTs and PTTs that elect to be taxed the same as companies can head consolidated groups. This is in keeping with an underlying principle of consolidation that entities that are taxed like companies should be able to head consolidated groups. Once a trust chooses to head a consolidated group it will continue to be taxed like a company even if the group it heads deconsolidates. Trusts that either cannot, or choose not to, head consolidated groups will continue to be taxed as the law currently stands.

2.26 The consolidation membership rules set out the circumstances in which an entity can head a consolidated group. One of these conditions is that the entity must have some or all of its taxable income taxed at a rate that is or equals the general company tax rate. CUTs and PTTs do not satisfy this condition because even though they are treated as a company for some purposes of the income tax law and are taxed at the company rate, they are not taken to be a company. Their tax treatment is not identical to that of ordinary resident companies (e.g. they use the trust loss provisions and are eligible to obtain the 50% CGT discount that a company cannot). Consequently, they have been precluded from heading consolidated groups.

How a trust can be treated like a head company of a consolidated group

2.27 A trust can make a choice to consolidate a consolidatable group as if the trust was a company if it:

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is a CUT (as defined in Division 6B of Part III of the ITAA 1936) or a PTT (as defined in Division 6C of Part III of the ITAA 1936) for the income year. Trusts that are not taxed under these Divisions are not able to make the election to be treated like a head company of a consolidated group;

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elects to be treated like a head company of a consolidated group (and as a consequence will be treated forever more like a company for income tax purposes);

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is an Australian resident (but not a prescribed dual resident);

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has at least one wholly-owned subsidiary;

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is not a subsidiary member of a consolidatable or consolidated group;

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is not an entity that is specifically precluded from being a member of a consolidatable or consolidated group; and

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makes a choice to consolidate under section 703-50.

[Schedule 2, Part 2, item 2, section 713-130]

2.28 Where a CUT or a PTT owns a number of wholly-owned subsidiaries and it decides that it does not wish to be treated like a head company of a consolidated group, it may be possible for the CUT or PTT's wholly-owned subsidiaries to form a consolidated group of which the CUT or PTT is not a member.

Example 2.1: Trust not heading a consolidated group

A trust that is subject to Division 6B of Part III of the ITAA 1936 decides it does not want to be treated like a head company of a consolidated group. However, the entities that are legally owned by the trustee (and by each other) are able to independently form a consolidated group, the members being companies A, B and C.

Beneficial ownership

2.29 In order to be allowed to choose to consolidate the trust must have at least one 'wholly-owned subsidiary'. However, a CUT or a PTT cannot have any wholly-owned subsidiaries because the definition of 'wholly-owned subsidiary' in subsection 703-30(1) cannot be satisfied. In brief, this subsection provides that an entity is a wholly-owned subsidiary of the holding entity (i.e. the CUT or the PTT) if all the membership interests in the subsidiary entity are beneficially owned by the CUT or the PTT. This condition cannot be satisfied because the unitholders of the CUT/PTT have a proprietary interest in the underlying assets of the CUT or the PTT. The trustee owns the assets legally but not beneficially (see Charles v Federal Commissioner of Taxation (1954)
90 CLR 598 ). This issue has been resolved by assuming that the trust beneficially owns the membership interests in other entities that are legally owned by the trustees. [Schedule 2, Part 2, item 2, paragraph 713-130(a)]

The effect of a trust electing to consolidate

Date of effect

2.30 The amendment comes into effect from the commencement of the consolidation regime (i.e. 1 July 2002) [Schedule 2, Part 1, item 1]. However, the date of effect of making this choice is the first day of a CUT or PTT's income year [Schedule 2, Part 2, item 2, paragraph 713-130(b)]. This does not mean it must be the first income year in which an entity becomes a CUT or a PTT. It means the election does not have effect unless the day specified in the choice is the first day of a CUT or a PTT's income year. The reason for this is that it reduces compliance costs. If a trust could make an election that comes into effect half way through its income year (which it cannot) it would have to work out its income tax liability for that year using both the income tax law that applies to companies as well as either Division 6B or 6C of Part III of the ITAA 1936. By not having to use these two disparate systems in the one income tax year the tax laws are simpler and less complex.

Example 2.2: When a trust can head a consolidated group

A CUT whose income year ends on 31 January of each year chooses to consolidate the wholly-owned group as if it were a company. The earliest this trust can be treated like a head company of a consolidated group is 1 February 2003, this being the first day of its income year that starts after 1 July 2002.

Income tax treatment

2.31 From the date the election to consolidate the group comes into effect, a CUT or a PTT will remain a trust but will, for income tax related purposes only, be treated like a company (i.e. these trusts are not deemed to be companies for those purposes, they merely receive the same income tax treatment) [Schedule 2, Part 2, item 2, sections 713-125 and 713-130]. This treatment will continue even if the trust later fails the definitional requirements of a CUT or a PTT in Divisions 6B and 6C of Part III of the ITAA 1936 or if the group it heads later deconsolidates [Schedule 2, Part 2, item 2, paragraph 713-135(1)(b)].

2.32 In order for the income tax related law that applies to companies to also apply to the trust, it is necessary to assume that the trust is a company (the assumed company ). The assumed company has the same characteristics as the trust in question, for example the business being undertaken and its membership interests. [Schedule 2, Part 2, item 2, section 713-130]

2.33 This income tax treatment may affect other entities as well, including employees of the trust and the trustees. For example, it will allow entities that are legally wholly-owned by the trustee (or other entities in the group) to be treated like subsidiary members of the consolidated group. [Schedule 2, Part 2, item 2, subsections 713-125(1) and (3)]

2.34 Subsection 713-135(2) lists the law (called the applied law ) that applies to the trust or trustee (as appropriate) of a trust that has elected to consolidate and thereby also effectively elected to be treated like a company for income tax related purposes [Schedule 2, Part 2, item 2, subsection 713-135(1)]. The expression 'be treated as a company for income tax related purposes' is intended to reflect that the other legislation administered by the Commissioner will also apply to the trust as if it were a company. This includes:

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the ITAA 1936 (see the definition of 'this Act' in subsection 995-1(1) of the ITAA 1997);

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the ITAA 1997 (see the definition of 'this Act' in subsection 995-1(1) of the ITAA 1997);

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the International Tax Agreements Act 1953 (via paragraph 713-135(2)(e));

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the Income Tax (Transitional Provisions) Act 1997 (via paragraph 713-135(2)(e)); and

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the Taxation (Interest on Overpayments and Early Payments) Act 1983 (via paragraph 713-135(2)(e)).

[Schedule 2, Part 2, item 2, subsection 713-135(2)]

2.35 Further, all references in the applied law to trusts or trustees will not apply to a trust (or any trustees) that has made the choice to consolidate and be treated like a company. That is so even where the trust is no longer treated like a head company for income tax related purposes. The exceptions to this are certain penalty provisions and section 254 of the ITAA 1936. [Schedule 2, Part 2, item 2, subsection 713-140(2)]

2.36 When applying the 'applied law' to a trust (or to a trustee as appropriate) that has commenced being treated like a head company of a consolidated group, where appropriate, it is necessary to treat the characteristics of a trust as having a company equivalent [Schedule 2, Part 2, item 2, subsection 713-135(1) and note 2 to subsection 713-135(1)]. The practical application of this is that where there is a reference in the 'applied law' to a share, for example, it is necessary to read this as being a unit in a trust. But in all cases this can only occur where it is appropriate to do so. This must be determined on a case by case basis.

Example 2.3: Script for script roll-over

Trust A is being treated like a head company of a consolidated group (and therefore is being treated like a company for income tax related purposes). It undertakes a scrip for scrip takeover of Company X. In order for section 124-780 to work, where the word 'share' is used it means 'a unit in the trust'. Likewise, the word 'company' means 'the trust' and the term 'voting shares' means 'trust voting interests'.

Given this, subparagraph 124-780(1)(a)(i) would read as follows: 'a shareholder of Company X (the original interest holder) exchanges a share in the company (i.e. Company X) for a share (i.e. a unit in Trust A) (the replacement interest) in another company (i.e. Trust A)'.

If, instead, Company X undertakes a scrip for scrip takeover of Trust A, the appropriate modifications would mean that subparagraph 124-780(2)(a)(i) would read as follows: 'a company (i.e. Company X) (the acquiring entity) that is not a member of a wholly-owned group becoming the owner of 80% or more of the voting shares (i.e. the trust voting interests) in the original entity (i.e. Trust A)'.

2.37 As mentioned above, the 'applied law' applies on and after the start of the day specified in the trust's choice to be treated like a head company of a consolidated group [Schedule 2, Part 2, item 2, paragraph 713-135(1)(b)]. From this date, such a trust will no longer be assessed for income tax under either Division 6B or 6C of Part III of the ITAA 1936. It will be subject to the income tax law that applies to companies [Schedule 2, Part 2, item 3, note to subsection 102L(1); item 4, note to subsection 102T(1)].

2.38 The 'applied law' also applies when it is relevant in relation to a time when the trust existed before the day it started being treated like a company for income tax purposes [Schedule 2, Part 2, item 2, paragraph 713-135(1)(c)]. This provision is needed so that if a trust needs to go back in time in order to work out its current income tax liability, it can go back in time and pretend, for that purpose only, it was being taxed like a company. This provision is not imposing any retrospective obligations on a trust. The ability to look back merely lets the entity go back in time, if need be, so that it can comply with its current income tax obligations.

Example 2.4: Treatment of prior periods

Trust A has elected to consolidate and is treated like a head company of a consolidated group from 1 July 2002. From this date onwards it will also be treated like a company for income tax purposes. To see if it can bring unused carry-forward losses into consolidation it needs to pass the company COT or the company same business test. In order to pass either of these tests Trust A needs to go back to a time when it was still being taxed under Division 6B of Part III of the ITAA 1936 (i.e. prior to 1 July 2002). Paragraph 713-135(1)(c) allows Trust A to go back to the relevant time and pretend it was, at that time, being taxed like a company (even though this is not so). This will allow it to see whether it can pass the COT or the same business test.

Modifications to the 'applied law'

2.39 Where appropriate, modifications to the 'applied law' may be required [Schedule 2, Part 2, item 2, paragraph 713-135(1)(a) and subsection 713-140(1)]. What is appropriate must be determined on a case by case basis. Subsection 713-140(2) provides a number of modifications to certain references in the 'applied law' so that they will apply appropriately to trusts that are being treated like companies for income tax purposes [Schedule 2, Part 2, item 2, subsection 713-140(2)]. For example, a reference in the 'applied law' to a body corporate includes a reference to a trust or trustee.

2.40 Another modification that may be required to the 'applied law', depending on the circumstances, is found in subsection 713-140(5) [Schedule 2, Part 2, item 2, subsection 713-140(5)]. Again, these modifications only apply when it is appropriate to apply them. These modifications are required because the 'applied law' refers to things that a trust may not be able to satisfy, given that it is a trust.

Example 2.5: Modifications

A trust that is subject to Division 6B of Part III of the ITAA 1936 issues units to its employees in 2000. A restriction has been placed on these units, namely that employees cannot sell them until 2004.

On 1 July 2003 the trust commences being treated like a head company of a consolidated group (and therefore like a company for income tax purposes).

Item 3 of subsection 713-140(5) ensures that the income tax treatment of these units in the hands of the employees is not affected by the trust being subject to the income tax law that applies to companies. Therefore, in relation to these units, because the employees were not subject to Division 13A of Part III of the ITAA 1936 before their employer changed its income tax treatment they will not be subject to it after this event.

However, once a CUT or a PTT's income tax treatment has changed so that it is being taxed like a company, any units or rights it subsequently issues to its employees will be subject to the 'applied law'. Therefore, where units are treated as a share for income tax purposes and the conditions in Division 13A of Part III of the ITAA 1936 are satisfied, the employee will be subject to these provisions.

2.41 As mentioned above, references in the 'applied law' to trusts or trustees will not apply to a trust or trustee of a trust that has made the choice to consolidate and is treated like a head company of a consolidated group or where the trust is no longer being treated as a head company but is still being treated like a company for income tax and related purposes, the exceptions being certain penalty provisions and section 254 of the ITAA 1936. [Schedule 2, Part 2, item 2, subsection 713-135(3) and subsections 713-140(3) and (4)]

2.42 Subsection 713-135(3) provides that while an entity may be subject to the 'applied law' it does not make it liable for any criminal, civil or administrative penalty. This does not mean that where an entity breaches an obligation under the 'applied law' there will be no criminal, civil or administrative penalty imposed. It means that a trust or trustee will not be subject to penalties to which it would not otherwise have been subject. Therefore, the obligations in the 'applied law' that apply to companies will also apply to trusts and trustees of a trust that is being treated like a company. However, any penalty that might be imposed will be the penalty that is imposed for a trust or trustee (as appropriate) and not that of a company [Schedule 2, Part 2, item 2, subsection 713-140(3), note].

Example 2.6: Penalties

From 1 July 2003 a trust is being treated like a head company of a consolidated group. In 2005 it fails to lodge a tax return with the Commissioner. As a consequence, pursuant to subsection 286-75(1) of the Taxation Administration Act 1953 (TAA 1953) the penalty that will be imposed on the trust will be the penalty provisions that apply to trusts and not companies.

Consequences of failing the eligibility requirements

2.43 Once a CUT or a PTT has chosen to consolidate and is being treated like a head company of a consolidated group the income tax law and other 'applied laws' that apply to companies will continue to apply to it even if it fails to satisfy any of the definitional requirements of Division 6B or 6C of Part III of the ITAA 1936. Further, the trust will continue to be treated like a head company of a consolidated group. However, it is not treated as a head company if it fails the requirements of being a head company found in item 1 of subsection 703-15(2). For example, if a trust fails the Australian residency requirements (see subsection 6(1) of the ITAA 1936) it will be ineligible to continue to be treated like a head company of a consolidated group. This is so even if during the same period it satisfies the definition of resident unit trust in either section 102H or 102Q of the ITAA 1936. In such a case the trust will be taxed as if it were a non-resident company.

Resettlement of the trust

2.44 Where a trust is being treated like a company for income tax purposes (irrespective of whether it is still being treated like a head company of a consolidated group) and it undertakes activities that amount to a resettlement, a new trust will come into existence. The previous trust's election to be treated like a head company of a consolidated group will have no effect on the new trust. Consequently, the new trust will be taxed under the trust provisions that are appropriate for the characteristics of the new trust. If it wishes to be subject to the consolidation regime it will have to satisfy the appropriate conditions found in Subdivision 713-C.

Multiple entry consolidated groups and interposed head companies

Alignment of notification periods

2.45 Subdivision 124-G provides CGT roll-over relief where a taxpayer exchanges shares in one company (the original company) for shares in another company (the interposed company) as part of a company reorganisation.

2.46 Where the original company is the head company of a consolidated group immediately before the exchange of shares and immediately after the completion of the exchange, the interposed company is the head company of a consolidatable group consisting of itself and the members of the group immediately before the exchange of shares, the interposed company must choose whether the consolidated group is to continue in existence. Currently this choice must be made within two months of the exchange of shares.

2.47 This time period for notification conflicts with the notice requirements in section 703-60 for events affecting a consolidated group, which requires notification within 28 days of an event. For example, under section 703-60 the head company of a consolidated group must notify the Commissioner within 28 days of an entity becoming a member of the group.

2.48 Subsection 124-380(7) is amended to change the notification period to within 28 days of the completion of the exchange of shares [Schedule 2, Part 3, item 5, subsection 124-380(7)]. This aligns the notification period with the requirements of section 703-60.

Notification of event affecting a consolidated group

2.49 Under section 703-50 a company that is the head company of a group may make a choice to form a consolidated group on a specified day. The company must give notice of the choice to the Commissioner within the period starting on the day specified in the choice and ending on the day of lodgement of the income tax return for the year in which the specified day occurs.

2.50 Subsection 703-60(2) provides that where an event affecting a consolidated group happens more than 28 days before the choice to consolidate is provided to the Commissioner, the company making the choice must advise the Commissioner of the event at the same time. However, this poses problems when an interposed company becomes the head company of the group before the choice to consolidate is given to the Commissioner.

2.51 Subsection 703-60(2) is amended so that the head company of the consolidated group provides notice of the event to the Commissioner at the same time as the choice to consolidate is provided. [Schedule 2, Part 3, item 8, subsection 703-60(2)]

Capital gains tax roll-over relief

2.52 Broadly, Subdivision 126-B provides CGT roll-over relief for wholly-owned groups when assets are transferred between:

•

non-resident companies; or

•

a non-resident company and the head company of a consolidated group.

2.53 Subsection 126-50(6) is amended to ensure that if at the time of the trigger event, the originating company or the recipient company is an Australian resident, the company must not be a member of a consolidatable group at that time (see Diagram 2.1), but it may be a member of a consolidated group (see Diagram 2.2) or a MEC group at the time (see Diagram 2.3). [Schedule 2, Part 3, item 7, subsection 126-50(6)]

Diagram 2.1

GCT roll-over relief is not ) available for the transfer of a CGT asset between a member of a consolidatable group and the foreign resident top company.

Diagram 2.2

Diagram 2.3

Cost setting for assets that the head company does not hold under the single entity rule

2.54 Under the previous cost setting rules there was uncertainty as to whether certain assets that do not become assets of the head company under the single entity rule have their tax cost set. This is because it was arguable that only assets that become assets of the head company have their tax cost reset.

2.55 The most common example of assets that do not become assets of the head company under the single entity rule would be intra-group assets. Intra-group assets involve an asset of a joining entity that corresponds to a liability of either the head company or another subsidiary member of the group. A loan from one group member to another is an example of an intra-group asset.

2.56 Broadly, when working out the income tax liability for a head company, section 701-10 sets the tax cost of each asset of an entity at the asset's tax cost setting amount when the entity becomes a subsidiary member of a consolidated group. This process involves calculating an allocable cost amount for the entity which is then allocated to the assets of the entity to determine the tax cost for the assets.

2.57 Part 4 of Schedule 2 to this bill amends subsection 701-10(2) to ensure that assets which do not become assets of the head company have their tax cost set and that allocable cost amount is allocated to these assets. This ensures that the appropriate amount of allocable cost amount is allocated to the other assets of the entity. If an appropriate amount of the cost was not allocated to assets that do not become assets of the head company under the single entity rule then too much cost may be allocated to other assets which would distort the income tax outcomes for those assets. [Schedule 2, Part 4, item 11, subsection 701-10(2)]

2.58 The amendment ensures that assets of the joining entity, at the time it becomes a subsidiary member of the group, have their tax cost set - assuming that the single entity rule did not apply. The exclusion of the operation of the single entity rule ensures that intra-group assets and other assets that would be ignored as a consequence of the single entity rule have their tax cost reset.

2.59 As intra-group assets relating to synergistic goodwill have their tax cost set as a result of subsection 705-35(3) a note is added to the end of subsection 701-10(2) to refer to the operation of subsection 705-35(3). [Schedule 2, Part 4, item 11, note at the end of subsection 701-10(2)]

2.60 In addition, section 701-58 ensures that the tax cost which is set for assets that do not become assets of the head company under the single entity rule is not taken into account in applying the provisions mentioned in subsections 701-55(2) to (6) at the joining time. This ensures that the reset tax cost for assets that do not become assets of the head company under the single entity rule will not be used in working out any income tax consequences for the head company in relation to those assets. This is consistent with ignoring these assets as a consequence of the single entity rule. [Schedule 2, Part 4, item 13, section 701-58]

Overall foreign losses of a partnership

2.61 Foreign losses incurred by a partnership are quarantined in the partnership (unlike other partnership losses, which are distributed to the partners). There is currently no mechanism that enables these losses to be taken into account when calculating a partner's allocable cost amount on entry to a consolidated group, as these losses are not 'sorts of losses' within the meaning of subsection 701-1(4).

2.62 Amendments made by this bill will ensure that, where a partnership has unutilised foreign losses at the joining time and a partner in the partnership joins the consolidated group, the loss will be a 'sort of loss' for the purposes of subsection 701-1(4). As a result, the partner will have to include their share of the partnership foreign loss when calculating their allocable cost amount at the joining time, in particular when determining any adjustments required under sections 705-100 (about losses accruing to a joined group before the joining time) and 705-110 (about losses transferred to a head company at the joining time). [Schedule 2, Part 5, item 31, subsection 713-225(6A)]

Cost setting rules for partners and partnerships that leave a consolidated group

2.63 The modifications to the general cost setting rules for setting the tax cost for assets of a partner or a partnership that joins a consolidated group are contained in Subdivision 713-E. Under these rules, partnerships are not treated as a joining entity for the purposes of Division 705. Instead, where a partner joins a consolidated group (and not the partnership), an allocable cost amount is worked out for the partner in the usual manner (as modified by Subdivision 713-E) and a tax cost is set for the partner's individual interests in the assets of the partnership (called partnership cost setting interests). Where a partnership becomes a member of a consolidated group, the 'underlying' assets of the partnership have their tax cost reset by reference to the partnership cost pool (see sections 713-235 and 713-240). In this case, the partnership cost setting interests are then ignored.

2.64 The object of the amendments made by this bill to Subdivision 713-E is to allow a head company to determine the income tax consequences that arise where either a partner or a partnership leaves a consolidated group. A partnership may leave a group either as a result of the partner leaving or as a result of the head company of the group disposing of some or all of its partnership cost setting interests in the assets of the partnership.

Partnership was never part of the consolidated group - head company disposes of partnership cost setting interests

2.65 Where a partnership was never a member of a consolidated group (but the consolidated group held partnership cost setting interests in the partnership) no new rules are required for determining the income tax consequences of a disposal by the consolidated group of its partnership cost setting interests. The income tax consequences of this disposal will be determined under the existing CGT rules, as is the case outside of consolidation (see section 106-5).

Partnership leaves the consolidated group

2.66 Where a partnership ceases to be a subsidiary member of a consolidated group, the new rules in Subdivision 713-E will apply [Schedule 2, Part 5, item 32, subsection 713-250(1)]. In order to determine the income tax consequences of the partnership ceasing to be a subsidiary member, the head company will be required to apply the cost setting rules (in particular sections 701-15, 701-20, 701-45, 701-50 and Division 711), as modified by Subdivision 713-E [Schedule 2, Part 5, item 30, subsection 713-205(5); Part 5, item 32, subsection 713-250(2)]. The modified provisions operate:

•

as if the group's partnership cost setting interests were the group's only assets relating to the partnership; and

•

to set the tax cost of the group's partnership cost setting interests in the assets of the partnership (this will require the group to cease to recognise the underlying assets of the partnership and instead recognise partnership cost setting interests in the partnership) [Schedule 2, Part 5, item 30, subsection 713-205(4)].

2.67 In order to assist taxpayers, new notes have been inserted at the ends of subsection 701-15(3) and sections 701-20, 701-45, 701-50 and 701-60. These notes direct taxpayers to apply Subdivision 713-E when the leaving entity is a partnership. [Schedule 2, Part 5, items 20 to 27, subsection 701-15(3) and sections 701-20, 701-45, 701-50 and 701-60]

2.68 Further, the overview in section 713-200 has also been amended so that it now includes a reference to a partnership ceasing to be a member of a consolidated group as well as to the application of Division 711 in these circumstances. [Schedule 2, Part 5, items 28 and 29, section 713-200 and paragraph 713-200(b)]

2.69 A partnership can cease to be a subsidiary member of a consolidated group in one of two ways. Either the partner leaves the group (because the head company has disposed of its membership interests in the partner) or the head company disposes of some or all of its partnership cost setting interests in the partnership (including where only part of each interest is disposed of). In either case, the partnership will cease to be a 'wholly-owned subsidiary' and, as a consequence, will no longer be eligible to be a member of the group.

2.70 Regardless of how the partnership leaves the group, the special rules in Subdivision 713-E will apply to set the tax cost for the head company's partnership cost setting interests in the partnership [Schedule 2, Part 5, item 32, subsection 713-255(1)]. However, no tax cost setting amount is worked out for membership interests in the partnership [Schedule 2, Part 5, item 32, subsection 713-255(2)]. Further, no allocable cost amount is worked out for the partnership.

Single entity leaving

2.71 In the case where the partnership leaves as a result of the group disposing of some or all of its partnership cost setting interests in the partnership (including where only part of each interest is disposed of), the partnership is the only entity that leaves the group. Where this occurs, immediately before the partnership leaves, the head company must cease to recognise the underlying assets of the partnership and instead begin to recognise partnership cost setting interests in the partnership. As a consequence, the head company will be required to set the tax cost of each partnership cost setting interest held by a partner that is a member of the group just before the leaving time. [Schedule 2, Part 5, item 32, subsection 713-255(3)]

2.72 The tax cost setting amount of each partnership cost setting interest is determined by reference to the terminating value of the underlying partnership asset to which the partnership cost setting interest relates. Specifically, the tax cost setting amount will be equal to the partner's individual share of the terminating value of the underlying asset. [Schedule 2, Part 5, item 32, subsection 713-255(4)]

Example 2.7: Determining the head company's partnership cost setting interests just before a partnership leaves the consolidated group

If A Co sells all of its interests in the partnership, the partnership will cease to be a member of the consolidated group. Just before the partnership leaves, Head Co will cease to recognise the underlying assets of the partnership and instead begin to recognise partnership cost setting interests in the partnership. The tax cost of each partnership cost setting interest will equal the partner's individual share of the terminating value of the underlying asset of the partnership to which the partnership cost setting interest relates.

Assuming A Co and B Co were equal partners, Head Co will be taken to have two separate partnership cost setting interests in each underlying asset of the partnership (six partnership cost setting interests in total). The tax cost of each partnership cost setting interest will be equal to 50% of the terminating value of the underlying asset to which the interest relates. Therefore, Head Co will have:

•

two partnership cost setting interests in trading stock (each with a tax cost of $50);

•

two partnership cost setting interests in land (each with a tax cost of $100); and

•

two partnership cost setting interests in plant (each with a tax cost of $150).

2.73 Note that, for income tax purposes, when a partnership leaves a consolidated group, the head company will not be taken to have disposed of the underlying assets of the partnership. [Schedule 2, Part 5, item 32, note to subsection 713-255(4)]

2.74 Once the head company has set the tax cost of its partnership cost setting interests in the partnership, it can then determine whether it has made a capital gain or loss on disposal of those interests under the normal CGT rules.

2.75 An additional consequence of a partnership leaving a consolidated group is that the head company will need to set a tax cost for any intra-group assets, such as loans between the group and the partnership. These intra-group transactions would previously have been ignored under the single entity rule.

2.76 Where the leaving entity is not a partnership, sections 701-20 will set the tax cost for head company core purposes of an asset consisting of a liability owed by the leaving entity to the group. Additionally, section 701-45 will set the tax cost, for entity core purposes, of an asset consisting of a liability owed by the group to the leaving entity. Similar rules are required where the leaving entity is a partnership to take into account the unique nature of partnerships. Consequently, section 713-260 will apply where:

•

a partnership ceases to be a member of the consolidated group;

•

an asset becomes an asset of the head company because the single entity rule ceases to apply; and

•

the asset consists of :

•

a partner's interest in a liability owed by the group to the partnership; or

•

a partner's share of a liability owed by the partnership to the group.

[Schedule 2, Part 5, item 32, subsection 713-260(1)]

2.77 Under section 713-260 these intra-group assets will have a tax cost equal to the market value of the asset at the leaving time. [Schedule 2, Part 5, item 32, subsection 713-260(2)]

2.78 Where section 701-20 or 701-45 operate to set the tax cost of these types of assets then section 713-260 will not have application.

Example 2.8: Setting the tax cost of assets consisting of intra-group liabilities

Assume Head Co has lent the Partnership $100 (Loan 1) and the Partnership has lent Head Co $100 (Loan 2). As a result of A Co disposing of some of its partnership cost setting interests in the partnership, the Partnership will cease to be a member of the consolidated group.

Under the single entity rule, the loans to and from the Partnership would not have a tax cost as they would have been ignored for income tax purposes. However, when the Partnership leaves the group, the rules in section 713-260 will enable Head Co to set the tax cost of both of these intra-group assets.

The tax cost setting amount of the asset consisting of Loan 1 (which is a receivable in the hands of Head Co) will be equal to the sum of the market values of each partner's individual share of the liability of the Partnership (see subparagraph 713-260(1)(c)(ii)). Assuming A Co and B Co were equal partners; each partner will have a 50% share of the $100 liability of the Partnership. Accordingly, Head Co's tax cost for Loan 1 will be $100, being the sum of the market value of A Co and B Co's share of the Partnership liability (assuming the original loan amount equals market value).

As with Loan 1, the tax cost of Loan 2 to Head Co will be equal to the sum of the market values of each partner's interest in the asset of the Partnership. Accordingly, the tax cost will be $100, being the sum of A Co and B Co's individual interests in the asset of the Partnership.

Multiple entities leaving

2.79 Where two or more entities leave a consolidated group at the same time and one of the leaving entities is a partnership, the multiple exit rules in Division 711 apply, as modified by Subdivision 713-E. Modifications to the multiple exit rules are required because Division 711 relies on the concept of membership interests, which are ignored where the entity concerned is a partnership. Special rules are also required to adjust a partner's allocable cost amount so that it includes the partner's share of a partnership's liabilities and future deductions and to ensure that intra-group assets, which were previously ignored under the single entity rule, are appropriately included when calculating a leaving partner's allocable cost amount.

2.80 Examples of when the modified rules in Division 711 would apply include where a partnership leaves a consolidated group as a result of a partner leaving or, if a partnership holds membership interests in a lower tier subsidiary and the partnership leaves because the group disposes of some or all of its partnership cost setting interests in the partnership. In both circumstances, more than one entity is leaving the consolidated group at the same time and one of the leaving entities is a partnership.

2.81 As is the case in a 'normal' multiple exit case under section 711-55, the modified exit rules operate such that a tax cost is set for membership interests or partnership cost setting interests (where the leaving entity is a partnership) in the lowest subsidiary member before a tax cost is set for any higher tiered subsidiaries (i.e. a 'bottom-up' approach is adopted). [Schedule 2, Part 5, item 32, subsection 713-255(5)]

2.82 In order for the multiple exit rules to work appropriately where a partnership is one of the leaving entities, section 711-55 is modified such that:

•

a reference in that section (except in paragraph 711-55(3)(a)) to membership interests, or to the tax cost setting amount of such interests, is taken to be a reference to a partnership cost setting interest in the partnership, or to the tax cost setting amount of such interests; and

•

the head company is required to set the tax cost of its partnership cost setting interests in the partnership by applying subsection 713-255(4).

[Schedule 2, Part 5, item 32, subsection 713-255(5)]

Example 2.9: Multiple exit case - establishing the tax cost of membership interests and partnership cost setting interests when a partner and a partnership leave a consolidated group

Assume Head Co disposes of all of its membership interests in A Co, both A Co and the Partnership will exit the group. As two or more entities are leaving and one of the leaving entities is a partnership, the modified rules in Division 711 will apply to set the tax cost of Head Co's partnership cost setting interests in the partnership.

The tax cost of each of Head Co's partnership cost setting interests will be equal to each partner's individual share of the terminating value of the underlying asset to which the partnership cost setting interest relates (see paragraph 713-255(5)(b) and subsection 713-255(4)).

Head Co will then determine the tax cost of membership interests in A Co in the usual manner (i.e. by reference to the assets A Co takes with it when it leaves the group), which will include its partnership cost setting interests in the partnership. Head Co may also retain some partnership cost setting interests in the partnership after A Co leaves.

Example 2.10: Multiple exit case - establishing the tax cost of partnership cost setting interests and membership interests when a partnership and a lower tier subsidiary member leave a consolidated group

If Head Co disposes of any of its partnership cost setting interests in the partnership, both the Partnership and C Co (which is wholly-owned by the partnership) will leave the consolidated group. In accordance with the ordering rules in Division 711, a tax cost must first be set for the membership interests in C Co before a tax cost is set for the partnership cost setting interests in the partnership.

The tax cost of membership interests in C Co are worked out in the usual way, however, the modified rules in Subdivision 713-E apply to work out the tax cost of the partnership cost setting interests in the partnership (see subsections 713-255(1), (4) and (5)).

The tax cost of each of Head Co's partnership cost setting interests in the partnership will be equal to each partner's share of the terminating value of the underlying asset to which the partnership cost setting interest relates. One of the underlying assets of the partnership will be the partnership's membership interests in C Co (whose tax cost is set under Division 711).

Adjustments to leaving partner's allocable cost amount

2.83 As mentioned above, where a partner leaves a consolidated group, special rules are required in order to ensure that the leaving partner's allocable cost amount includes the partner's share of certain partnership attributes. Accordingly, section 713-265 requires that, where a partner leaves a consolidated group, it must adjust its allocable cost amount to include:

•

its share of partnership deductions to which the partnership becomes entitled;

•

its share of liabilities that the partnership owes to the old group; and

•

its share of liabilities owed to the partnership by the old group (which represent assets of the partnership).

2.84 The adjustments to the leaving partner's allocable cost amount are achieved by modifying the way in which sections 711-35, 711-40 and 711-45 operate.

Modification to step 2 in working out a leaving partner's allocable cost amount

2.85 Section 711-35 is modified so that it operates as if a deduction to which the partnership becomes entitled were a deduction to which the partner becomes entitled (to the extent of the partner's individual share of the deduction) and is the same kind of deduction as the partnership deduction [Schedule 2, Part 5, item 32, subsection 713-265(2)]. This adjustment ensures that the value of the partnership deduction is reflected in the allocable cost amount of the partner as the deduction will eventually flow to the partner (via an adjustment to its partnership distributions).

Modifications to step 3 in working out a leaving partner's allocable cost amount

2.86 The purposes of section 711-40 is to ensure that where members of the old group have liabilities consisting of amounts owing to the leaving entity, the leaving entity is able to include these amounts when calculating its allocable cost amount (as they are assets of the leaving entity). Under the single entity rule, these intra-group assets and liabilities would not have been recognised.

2.87 As no allocable cost amount is worked out for a leaving entity that is a partnership, without modification, section 711-40 will not apply. This would result in a partner not being able to include its share of partnership assets that consist of liabilities owed by members of the group to the partnership in its allocable cost amount. Accordingly, section 711-40 has been modified to treat such assets as being assets of the partner, and not the partnership, to the extent of the partner's individual share. In other words, the liability is treated as if it is owed to the partner and not the partnership, to the extent of the partner's share of the liability. [Schedule 2, Part 5, item 32, subsection 713-265(3)]

Modifications to step 4 in working out the leaving partner's allocable cost amount

2.88 Section 711-45 operates to reduce a leaving entity's allocable cost amount by the amount of liabilities owed by the leaving entity to the group. As no allocable cost amount is worked out for a partnership, any liabilities of the partnership that are recognised in its statement of financial position which are not liabilities of the partner will not be included in working out a partner's allocable cost amount. This would result in these liabilities never being included in the leaving partner's allocable cost amount, even though they are effectively liabilities of the partner.

2.89 Section 711-45 has been modified so that where a partnership liability is recognised in the partnership's statement of financial position and for that reason is not also included in the partner's statement of financial position, it is treated as if it was a liability of the partner and not the partnership to the extent of the partner's share of the partnership liability. This will allow the partner's share of the partnership liability to be included in step 4 when working out the leaving partner's allocable cost amount. [Schedule 2, Part 5, item 32, subsection 713-265(4)]

Partnership leaves the group - certain partnership cost setting interests treated as having been acquired before 20 September 1985

2.90 Where an entity that is not a partnership joins a consolidated group, the pre-CGT status of its membership interests are preserved by 'tagging' its underlying assets with a pre-CGT factor at the joining time. Where the joining entity is a partner in a partnership, one of its assets will include its partnership cost setting interests in the partnership. Therefore, if any of the membership interests in a partner are pre-CGT, each of its assets, including its partnership cost setting interests (where applicable), will receive a pre-CGT factor at the joining time. This allows the pre-CGT status of membership interests in a joining entity that is not a partnership to be preserved by being 'stored' in the cost of the assets of the joining entity.

2.91 If a partnership also joins the consolidated group (either at the same time as the partner or at a later time), any pre-CGT factor that was attached to the partnership cost setting interests of the partner(s) is effectively 'pushed down' onto the underlying assets of the partnership via section 713-245. This results in the underlying assets of the partnership receiving a pre-CGT factor at the time the partnership joins the consolidated group.

2.92 Where a partnership leaves a consolidated group and, in doing so, takes with it assets that have a pre-CGT factor, section 713-270 ensures that certain partnership cost setting interests are treated as having been acquired prior to 20 September 1985. This rule is akin to the rules contained in sections 711-65 and 711-70, which apply when the leaving entity is not a partnership.

2.93 Section 713-270 applies when any of the assets of the partnership at the leaving time has a pre-CGT factor under section 713-245 [Schedule 2, Part 5, item 32, subsection 713-270(1)]. This section modifies the operation of sections 711-65 (the basic case) and 711-70 (multiple exit case) by:

•

deeming the pre-CGT factor to be one which was determined under section 705-125 (instead of being determined under section 713-245). This amendment is required because section 711-65 only applies to assets whose pre-CGT factor was determined under section 705-125; and

•

modifying the sections so that, a reference in those sections to membership interests, where the entity is a partnership, is taken to be a reference to partnership cost setting interests that relate to assets of the partnership.

[Schedule 2, Part 5, item 32, paragraphs 713-270(2)(a), (2)(b) and (3)(a)]

2.94 Where the pre-CGT factor of an underlying asset of the partnership is equal to one, the partnership cost setting interest that relates to that asset is treated as being acquired prior to 20 September 1985. [Schedule 2, Part 5, item 32, paragraph 713-270(2)(c)]

2.95 Where the pre-CGT factor of an underlying asset of the partnership is less than one, the partnership cost setting interest that relates to that asset (the actual interest) is split into two separate partnership cost setting interests. One of these partnership cost setting interests is treated as post-CGT and one is treated as being pre-CGT. The proportion of the actual interest that is treated as pre-CGT is equal to the pre-CGT factor of the actual interest. The pre-CGT factor of this partnership cost setting interest is deemed to be one. The remaining proportion of the actual interest is treated as post-CGT. [Schedule 2, Part 5, item 32, paragraph 713-270(2)(d)]

2.96 The reason for splitting the pre-CGT interests into two separate interests where the pre-CGT factor of the underlying asset of the partnership is less than one, is to remove the ability for taxpayers to choose which partnership cost setting interests are treated as pre-CGT and which are treated as post-CGT. If this requirement was not included and the pre-CGT factor of the underlying assets were, say 0.5, a taxpayer could effectively pick which 50% of its partnership cost setting interests it treats as pre-CGT and which 50% it treats as post-CGT. The provisions, therefore, ensure that taxpayers cannot manipulate the tax treatment of their partnership cost setting interests.

Example 2.11: Certain partnership cost setting interests treated as having been acquired before 20 September 1985 - single exit case

When A Co disposes of its partnership cost setting interests in the Partnership, the Partnership will leave the consolidated group. Immediately before the Partnership leaves the group, Head Co will cease to recognise the underlying assets of the partnership and begin to recognise partnership cost setting interests in the partnership. Head Co will set the tax cost of its partnership cost setting interests in the partnership by reference to the terminating value of the underlying assets to which the partnership cost setting interest relates.

Because some of the underlying assets that are leaving the group with the Partnership have a pre-CGT factor, section 713-270 will apply to determine the number of partnership cost setting interests that are treated as being acquired prior to 20 September 1985.

Assuming A Co and B Co were equal partners, Head Co will have two partnership cost setting interests in the land of the partnership (held via A Co and B Co), each with a tax cost of $100 (being each partner's share of the terminating value of the land). As the pre-CGT factor of the land is one, both partnership cost setting interests in the land are treated as pre-CGT (see paragraph 713-270(2)(c)). The income tax consequences of disposing of A Co's interests is determined under the existing CGT rules.

Prior to applying paragraph 713-270(2)(d), Head Co will also have two partnership cost setting interests in both the equipment and plant of the partnership (four in total). As both of these assets have a pre-CGT factor of less than one (each has a pre-CGT factor of 0.5), each of these partnership cost setting interests is split into two separate interests (see paragraph 713-270(2)(d)). This results in Head Co having four partnership cost setting interests in each of these partnership assets.

Pre-CGT status of partnership cost setting interests in equipment

Prior to applying paragraph 713-270(2)(d), the tax cost of each partnership cost setting interest in the equipment of the partnership will be $50 (assuming A Co and B Co are equal partners), being equal to each partner's share of the terminating value of the equipment (see subsection 713-255(4)).

Paragraph 713-270(2)(d) results in each of the actual interests being split into two separate interests, one being pre-CGT and one being post-CGT. Accordingly, two of the partnership cost setting interests in the equipment will be treated as pre-CGT assets and two will be treated as post-CGT assets. Those interests that are pre-CGT will have a pre-CGT factor of one for the purposes of paragraph 713-270(2)(c) (see subparagraph 713-270(2)(d)(i)).

The pre-CGT interests will consist of the fraction of the actual interest that equals the pre-CGT factor. In other words, the pre-CGT interests will equal half of the actual interest as the pre-CGT factor is 0.5. This results in the tax cost of each pre-CGT partnership cost setting interest being equal to $25 (0.50 * $50). The remaining two post-CGT partnership cost setting interests will also have a tax cost of $25 (being the remainder of the actual interest).

Pre-CGT status of partnership cost setting interests in plant

Applying the same rules to the partnership cost setting interests in the plant, Head Co will have four partnership cost setting interests in total, two of which will be treated as pre-CGT and two of which will be treated as post-CGT. Each partnership cost setting interest will have a tax cost of $12.50 (50% * $50 * 0.5). The two pre-CGT interests will have a pre-CGT factor of one.

2.97 Where a partnership leaves a consolidated group and another entity leaves at the same time (i.e. a multiple exit case), special rules modify the application of section 711-70 if any assets of the partnership have a pre-CGT factor. [Schedule 2, Part 5, item 32, subsections 713-270(1) and (3)]

2.98 Subsection 713-270(3) modifies the multiple exit case rules so that where a leaving entity is a partnership:

•

a reference in section 711-70 to membership interests is replaced by a reference to partnership cost setting interests; and

•

the requirement in subsection 711-70(4) to apply subsections 711-65(3) to (6) is replaced by a requirement to apply subsection 713-270(2).

2.99 The normal 'ordering' rules apply so that the allocable cost amount in the lowest tiered entity must first be worked out before the allocable cost amount of any higher tiered entities is worked out.

Example 2.12: Certain partnership cost setting interests treated as having been acquired before 20 September 1985 - multiple exit case

Assuming Head Co disposes of some of its partnership cost setting interests in the Partnership (via A Co), both the Partnership and C Co will cease to be members of the consolidated group. As this is a multiple exit case and the Partnership holds some assets that have a pre-CGT factor, subsection 713-270(3) will apply. Assume for the purposes of this example that A Co and B Co are equal partners.

Section 711-70 (unmodified) requires that the cost base of membership interests in C Co be worked out before the cost base of any partnership cost setting interests are worked out. The cost base of membership interests in C Co will be worked out in the usual manner under Division 711. Assuming the old group's allocable cost amount for C Co is $600, the cost base of each membership interest is $5 ($600/120 shares = $5). As the pre-CGT proportion is 50%, 60 of the 120 shares in C Co will be treated as pre-CGT, with each of these shares having a pre-CGT factor of one (see section 711-70). The remaining 60 shares in C Co will be treated as post-CGT. These shares have no pre-CGT factor.

Tax cost setting amount for partnership cost setting interests

The tax cost setting amount of partnership cost setting interests in the underlying assets of the partnership will be determined under section 713-255(4). As some of the underlying assets of the partnership have a pre-CGT factor, regard must also be had to the rules in section 713-270.

Similar to Example 2.11, the old group will have four partnership cost setting interests in equipment and four partnership cost setting interests in plant. This is because the pre-CGT factors of each of these assets is less than one, resulting in each partnership cost setting interest being split into two separate interests (prior to applying paragraph 713-270(2)(d), the old group held two partnership cost setting interests in each asset, one via A Co and one via B Co).

Of the four partnership cost setting interests in equipment, two will be treated as pre-CGT and two will be treated as post-CGT. Those interests that are treated as pre-CGT will have a pre-CGT factor of one for the purposes of applying paragraph 713-270(2)(c). Each pre-CGT interest is comprised of the fraction of the actual interest that equals the pre-CGT factor. This results in the two pre-CGT interests each having a tax cost of $25 ($100 * 0.5 * 0.5). The remaining two interests will also have a tax cost of $25, being the remainder (see subparagraph 713-270(2)(d)(ii)).

Applying the same rules to plant, the two pre-CGT partnership cost setting interests will have a tax cost of $20 ($80 * 0.5 * 0.5) and a pre-CGT factor of one for the purposes of applying paragraph 713-270(2)(c). The two post-CGT partnership cost setting interests will also have a tax cost of $20, being the remainder.

As the pre-CGT factor of the 60 pre-CGT shares in C Co is one, each partnership cost setting interest in the pre-CGT shares will also be treated as pre-CGT. The post-CGT shares will have no pre-CGT factor. Therefore the partnership cost setting interests in these shares will be treated as post-CGT. The tax cost of the partnership cost setting interests in the post-CGT shares will be equal to the partner's share of the terminating value of the underlying asset. Each partner will have 30 partnership cost setting interests in the shares of C Co (one for each share). Consequently, as the terminating value of each underlying share is $5, the tax cost of each partnership cost setting interest in each share will also be $5. In total, the group will hold 60 post-CGT partnership cost setting interests (one for each post-CGT share) with a total tax cost of $300 ($5 * 60).

The old group will also hold 60 pre-CGT partnership cost setting interests in the pre-CGT shares of C Co (each partner will hold 30 interests each). As the pre-CGT factor of each of the pre-CGT shares in C Co is one, there is no need to split these interests into two separate interests. As with the post-CGT interests, the tax cost of each pre-CGT partnership cost setting interest in each share will be $5, being equal to the terminating value of the underlying share.

Treatment of deferred acquisition payments

2.100 Certain commercial arrangements for the acquisition of an entity may provide for the consideration to comprise the payment of a lump sum payment plus a right to one or more future payments (referred to as 'deferred acquisition payments'). These future payments are usually contingent upon certain events occurring at some later point in time, for example, the acquired entity achieving a specific profit forecast.

2.101 The amendments contained in Schedule 2 to this bill ensure that, for the purposes of working out a joining entity's allocable cost amount, if a head company makes a deferred acquisition payment (or becomes required to make such a payment) after the entity joins a consolidated group, it will be taken to have always been able to include the payment in the joining entity's allocable cost amount (in the step 1 calculation). [Schedule 2, Part 6, item 33, subsection 705-65(5B)]

2.102 This will mean that, when such a payment is made by the head company (or the head company becomes required to make such a payment), it will need to recalculate the joining entity's allocable cost amount as if the payment was included at the joining time. This is because the head company is taken to have always been able to take that payment into account. Consistent with the current CGT provisions, such payments may be in the form of money or property.

2.103 Currently a payment may not be taken into account at the joining time because, at the joining time, the payment was either not made or was not required to be made. As a result, the payment is not included in the cost base of membership interests in the joining entity at the joining time.

2.104 The joining entity's allocable cost amount will, as a result of the future event, need to be restated. However, until the payment is made, or required to be made, the original allocable cost amount calculation is correct (as a consequence of the correct application of the CGT rules at that time). Consequently, Subdivision 705-E (which is about adjustments for errors) and CGT event L6 (which provides for a capital gain or loss where an error is made) will not apply.

2.105 Where several deferred acquisition payments are made during one income year, it is expected that the allocable cost amount will only need to be recalculated at the end of that income year and not every time a payment is made. Where there are payments which are made over more than one income year, then it is expected that the allocable cost amount will have to be recalculated for each income year and amended income tax returns lodged (where appropriate) for any prior years.

2.106 If the payment is made, or required to be made, outside of the amendment period, only those returns which can be amended will be able to be adjusted to reflect the effects of restating the allocable cost amount. However, this outcome should be limited to the extent that the deferred acquisition payments do not extend past the amendment period.

Example 2.13: Recalculation of joining entity's allocable cost amount when deferred acquisition payment is made (or required to be made)

Assume Head Co acquires A Co on 29 June 2003 for $100 and that Head Co and A Co form a consolidated group on 1 July 2003. The cost base of membership interests in A Co at the joining time is $100.

Assume that as part of acquiring A Co, Head Co agrees to make an additional payment of $100 to the previous owner if A Co has an accounting profit of $150 or more for the year ended 30 June 2004.

Assume that for the year ended 30 June 2004, A Co has an accounting profit of $200. As a result, Head Co is required to pay the previous owner an additional $100. The additional $100 is part of the cost to Head Co of acquiring the membership interests in A Co. Therefore, as soon as Head Co becomes obligated to pay the additional $100, it must recalculate the allocable cost amount for A Co on the basis that it had always paid $200 for A Co. This will result in Head Co having to recalculate the tax cost of A Co's assets and may also result in Head Co having to lodge an amended income tax return for the year ended 30 June 2004.

Application of transitional cost setting rules to multiple entry consolidated groups

2.107 Division 701 of the Income Tax (Transitional (Provisions) Act 1997 provides for a modified application of the ITAA 1997 for certain consolidated groups (transitional groups) formed in the 2002-2003 and 2003-2004 financial years. Where a consolidated group is formed, with effect, before 1 July 2004, the head company may choose that assets of certain subsidiary members (transitional entities) retain their 'costs' for tax purposes. This choice enables existing groups to consolidate without valuing the assets of, or calculating allocable cost amounts for, subsidiary members. Transitional group and transitional entity are defined in section 701-1 of the Income Tax (Transitional Provisions) Act 1997.

Modified effect of section 701-1 of the Income Tax (Transitional Provisions) Act 1997 for multiple entry consolidated groups

2.108 Part 7 of Schedule 2 to this bill amends Subdivision 719-C of the Income Tax (Transitional Provisions) Act 1997 to modify the application of section 701-1 to MEC groups [Schedule 2, Part 7, item 34, section 719-161]. Where the consolidated group is a MEC group, section 719-161 modifies section 701-1 so that it applies as if the consolidated group mentioned in section 701-1 is a MEC group [Schedule 2, Part 7, item 34, subsection 719-161(1)].

2.109 The rules relating to groups formed after 1 July 2002 but before 1 July 2003 (subsection 701-1(2) of the Income Tax (Transitional Provisions) Act 1997 ) and to groups formed during the financial year starting on 1 July 2003 (subsection 701-1(3) of the Income Tax (Transitional Provisions) Act 1997 ) do not apply appropriately to MEC groups.

2.110 The problem arises with the definitions of 'transitional entity' in paragraphs 701-1(2)(b) and (3)(b), in that they do not apply to:

•

subsidiary entities of non-head company eligible tier-1 companies; and

•

transitional foreign-held indirect subsidiaries.

These subsidiary members of a MEC group cannot be transitional entities because they are not wholly-owned subsidiaries of the future head company.

2.111 It should be noted that neither a transitional foreign-held subsidiary nor an eligible tier-1 company that is not a head company of a MEC group are affected by Division 701-1 of the Income Tax (Transitional Provisions) Act 1997. This is because neither have the tax cost of their assets reset at joining time (see section 701C-30 of the Income Tax (Transitional Provisions) Act 1997 for transitional foreign-held subsidiaries and section 719-160 of the ITAA 1997 for eligible tier-1 companies).

Group formed after 1 July 2002 but before 1 July 2003

2.112 Where a MEC group comes into existence after 1 July 2002 but before 1 July 2003, the group is a transitional group if at least one entity that became a subsidiary member of the group (on the day the group came into existence) is a transitional entity.

2.113 An entity is a transitional entity if:

•

the entity was a wholly-owned subsidiary of any entity that became a member of the group, and that was an eligible tier-1 company, at the time the MEC group came into existence, and had not been a wholly-owned subsidiary at any time after 1 July 2002 and before the day the MEC group came into existence; or

•

the entity was a wholly-owned subsidiary of any entity that became a member of the group, and that was an eligible tier-1 company, at the time the MEC group came into existence, and had remained a wholly-owned subsidiary from the earliest time after 1 July 2002 until the group came into existence.

[Schedule 2, Part 7, item 34, subsection 719-161(2)]

Group formed during financial year starting on 1 July 2003

2.114 Where a MEC group comes into existence during the financial year starting on 1 July 2003, the group is a transitional group if at least one entity that became a subsidiary member of the group (on the day the group came into existence) is a transitional entity.

2.115 An entity is a transitional entity if:

•

just before 1 July 2003, it was a wholly-owned subsidiary of any entity that became a member of the group, and that was an eligible tier-1 company, at the time the MEC group came into existence; or

•

it remained a wholly-owned subsidiary of any entity that became a member of the group, and that was an eligible tier-1 company, at the time the MEC group came into existence from the earliest time after 1 July 2002 until the group came into existence.

[Schedule 2, Part 7, item 34, subsection 719-161(2)]

Rolldowns

2.116 If an entity is an eligible tier-1 company of a potential MEC group at 30 June 2003 and its shares are transferred to another eligible tier-1 company during the year commencing 1 July 2003 and before the group consolidates (i.e. it becomes a subsidiary of the other eligible tier-1 company), it cannot be a transitional entity under subsection 701-1(3) of the Income Tax (Transitional Provisions) Act 1997. In this situation, the 'new' subsidiary member of the MEC group should be able to be a transitional entity so long as it remains a wholly-owned subsidiary of the future head company.

2.117 Amendment is therefore made so that an entity is a transitional entity, for the purposes of paragraph 701-1(3)(b) if:

•

the entity and another entity were members of a potential MEC group and were eligible tier-1 companies from just before 1 July 2003 until just before a time (the rolldown time), prior to the MEC group coming into existence (see Diagram 2.4);

Diagram 2.4

•

at the rolldown time, the entity became a wholly-owned subsidiary of the other entity (see Diagram 2.5);

Diagram 2.5

•

the entity remained a wholly-owned subsidiary of the other entity from the rolldown time until the MEC group came into existence;

•

the other entity remained a member of the potential MEC group as an eligible tier-1 company from just before 1 July 2003 until the MEC group came into existence; and

•

the other entity was an eligible tier-1 company and a member of the MEC group when it came into existence.

[Schedule 2, Part 7, item 34, subsection 719-161(3)]

Foreign losses and the Continuity of Ownership Test concession

2.118 The consolidation legislation provides a '3-year COT concession' for certain company losses. This concession allows company losses that satisfy certain conditions to be utilised by the head entity over three years instead of under the 'available fraction' method. One of the conditions for access to this concession is that the company that actually made the loss met the conditions in section 165-12 in respect of the loss. The condition in section 165-12 is the COT. The new law changes the recoupment tests a company with a foreign loss must satisfy to be able to deduct the losses (section 160AFD of the ITAA 1936) from those in the ITAA 1936 to those in the ITAA 1997.

2.119 Paragraph 160AFD(6)(b) of the ITAA 1936 provides that overall foreign losses incurred by a company are deductible only if they satisfy the specified tests in the ITAA 1936. Companies are entitled to deductions for tax losses if the company satisfies the continuity of ownership test or the same business test (Subdivision 165-A). However, the deduction may be denied if income has been injected into a company because of an available tax loss (section 175-10) or an available tax loss has provided a tax benefit to someone else (section 175-15).

2.120 Paragraph 160AFD(6)(b) of the ITAA 1936 has been rewritten to align the treatment of foreign losses in the income tax law with those of other losses. Previous references to the tests in the ITAA 1936 have been replaced by references to the equivalent provisions in the ITAA 1997. The effect of aligning the treatment of foreign losses in the income tax law with that of other losses is that foreign losses are eligible for the '3-year COT concession' contained in section 707-350 of the Income Tax (Transitional Provisions) Act 1997. [Schedule 2, Part 8, item 35, paragraph 160AFD(6)(b)]

2.121 In applying the recoupment tests for tax losses and net capital losses, the loss year is taken to start at the time the loss was transferred to the head company (subsection 707-205(1)). This ensures that things that happened to the head company before the loss was transferred to it (and which may have already been taken into account in testing the loss for transfer) are not taken into account again. However, the consolidation changes in ownership of a loss company may continue to count in determining whether the continuity of ownership test is passed post-consolidation (section 707-210).

2.122 As these recoupment tests now apply to foreign losses, this rule has been expanded to apply to a loss of any sort which includes an overall foreign loss in respect of any or the four classes of assessable foreign income. The four classes of assessable foreign income are:

•

passive income;

•

offshore banking income;

•

lump sum payments from eligible non-resident non-complying superannuation funds; and

•

other income.

[Schedule 2, Part 8, item 36, subsection 707-205(1)]

Trading stock election in relation to foreign investment fund interests

2.123 There are special rules for valuing interests in FIFs that are trading stock (section 70-70). Generally, trading stock FIF interests are valued at cost unless an election is made to value the FIF interests at market value. The election must be made before the lodgement of the tax return for the first income year in which a notional accounting period of a FIF ends (subsection 70-70(3)). Trading stock interests in FIFs that are valued at market value are excluded from attributable income calculations under Part XI of the ITAA 1936.

2.124 All interests in FIFs that are trading stock must be valued at market value if the election is made. The election also applies to all future trading stock interests in FIFs. If the election is not made, the entity with the interests in the FIFs may have to include FIF income in its assessable income, under Part XI.

2.125 Where entities with interests in FIFs become subsidiary members of a consolidated group, a head company has those interests in FIFs under the single entity rule (section 701-1). The head company must determine whether those FIF interests are trading stock. If the FIF interests are trading stock, the rules allow the head company to make a decision as to whether it would value those interests at market value. The head company can only make a new choice if it has not previously held interests in FIFs as trading stock. [Schedule 2, Part 9, item 42, section 717-292]

2.126 Without the rules, the ordinary application of the entry history rule (section 701-5) in these circumstances would mean the head company was prevented from making the election to value the trading stock FIF interests at market value. This would happen because the head company would be considered to have held a trading stock FIF interest for which a notional accounting period had ended in a previous income year (if that was in fact the case for the subsidiary member).

2.127 The rules essentially prevent the entry history rule from treating the head company as holding the trading stock FIF interests from the time that the subsidiary member held those interests. This means the head company will have to make the market value election in the time required by subsection 70-70(3) as if the head company had just acquired the FIF interests. The head company will only be able to make this election if it had not previously held trading stock FIF interests. The new rules also prevent the head company from being bound by any earlier decisions made by subsidiary members as to how their trading stock FIF interests were valued. [Schedule 2, Part 9, item 41, section 717-285]

2.128 The head company will not be given a chance to change its own decision in relation to the valuation method used for trading stock FIF interests if it had previously held such interests before an entity became a subsidiary member. Any previous decision will apply equally to any new trading stock FIF interests the head company now holds via the subsidiary member.

2.129 As discussed above in relation to the entry history rule, the ordinary application of the exit history rule (section 701-40), may similarly affect the ability of an entity that leaves the group with FIF interests to make a different decision to that of the head company.

2.130 The amendments will allow an entity that leaves a group with FIF interests to make a decision about the valuation method it will use for FIF interests that are trading stock despite the decision made by the head company [Schedule 2, Part 9, item 49, section 717-320]. The leaving entity will not be bound by the decision made by the head company [Schedule 2, Part 9, item 46, section 717-310].

2.131 Where an entity has trading stock FIF interests that it chooses to value at market value, that entity will be bound by that decision whether or not it joins a consolidated group and later leaves the group. Further, if the entity had not made the election then the fact that it joined a consolidated group would not enable it to change that decision after it left the group. Joining and leaving a consolidated group cannot be used as a way of reversing an earlier decision made under subsection 70-70(2).

Example 2.14

Assume that:

•

A Co is the head company of a consolidated group.

•

A Co does not hold any FIF interests as trading stock at 30 June 2005, the end of its income year. It has also not previously held FIF interests as trading stock.

•

B Co joins the group on 1 July 2005. B Co has FIF interests that are trading stock. B Co has made the election to value the FIF interests at market value. The FIF notional accounting periods end on 30 June.

•

C Co joins the group on 1 January 2007. C Co has FIF interests that are trading stock. C Co has not made the election to value the FIF interests at market value. The FIF notional accounting periods end on 30 June.

•

C Co leaves the group on 1 July 2007 with FIF interests that are trading stock.

When B Co joins the consolidated group, A Co must determine whether or not the FIF interests are trading stock. If the interests are trading stock then A Co can decide whether to value the interests at cost or market value before lodgement of its 2005-2006 tax return. If A Co chooses to value the FIF interests at market value then when C Co joins the group, A Co must decide whether or not C Co's FIF interests are trading stock. If the interests are trading stock then A Co would have to value those interests at market value.

When C Co leaves the group with its FIF interests it will not be able to elect to value the trading stock FIF interests at market value.

If B Co leaves the group with interests in FIFs, it will have to value all trading stock FIF interests at market value.

Foreign dividend accounts and consolidation

2.132 The current FDA measure in Subdivision B of Division 11A of Part III of the ITAA 1936 was introduced to enable certain foreign source dividends paid to a resident company to be paid to non-resident shareholders free from dividend withholding tax to the extent that Australian company tax is not paid on the foreign dividends. The exemption from dividend withholding tax is provided where a resident company pays an unfranked dividend from the FDA. Broadly, the FDA is credited with foreign non-portfolio dividends and is debited with expenses, including Australian tax, that relate to those dividends. It is also debited with any dividends paid to foreign shareholders on which dividend withholding tax is not paid.

2.133 Current rules ensure the head company of a consolidated group or a provisional head company of a MEC group operate a single FDA. With the introduction of those rules, the grouping rules that were contained in the FDA provisions were phased out.

Provisional head company taken to have paid foreign tax

2.134 Under the operation of the current FDA rules, a credit arises in a FDA when an Australian resident company receives a foreign non-portfolio dividend that is either exempt under section 23AJ of the ITAA 1936 or foreign tax has been paid in relation to the dividend. The credit arises at the time the foreign dividend is received.

2.135 Section 717-10 deems a head company of a consolidated group to have paid the foreign tax that is actually paid by a subsidiary member. Section 719-2 ensures that section 717-10 also operates for a head company of a MEC group. However, section 719-2 does not cause section 717-10 to operate for a provisional head company of a MEC group.

2.136 Where a non-portfolio dividend is included in the assessable income of the head company of the MEC group, the new rules ensure the provisional head company is able to credit the FDA at the time the dividend is received where foreign tax was paid in relation to that dividend.

2.137 To achieve this, the provisional head company of the MEC group will be deemed to have paid any foreign tax actually paid by subsidiary members. [Schedule 2, Part 9, item 50, section 719-903]

Foreign dividend account debit

2.138 The amendments ensure the correct amount of a FDA debit is calculated for a head company of a MEC group where members of a consolidated group have received a non-portfolio dividend for which Australian tax will be paid by the head company. A debit is required for two reasons. First, one is needed to reflect the fact that because of the payment of tax there are fewer profits to distribute. Secondly, a debit is required to avoid an exemption from dividend withholding tax being available under both the FDA provisions and the imputation system. [Schedule 2, Part 9, item 50, subsection 719-903(5)]

Application of the removal of the grouping rules

2.139 Currently, it is not clear whether the FDA grouping rules apply in the situation where some members of a wholly-owned group consolidate but other members do not. This is particularly relevant to potential MEC groups but also applies to foreign loss companies that remain outside a consolidated group.

2.140 The rules will prevent transfers of FDA surpluses where the old FDA grouping rules apply to entities that are not part of a consolidated group and those entities pay a dividend to a related company that is a member of a consolidated group. The rules prevent a credit to the FDA arising for a head company of a consolidated group or a provisional head company of a MEC group when a company outside the group pays a dividend to a related company that is a member of the group. [Schedule 2, Part 9, item 51, subitem 12(5) of Schedule 9 of the New Business Tax System (Consolidation and Other Measures) Act 2003]

2.141 The payment of dividends by members of a consolidated group to related companies is governed by the current FDA rules which no longer allow the transfer of FDA surpluses to related companies by companies that are members of a consolidated group.

2.142 The new rules do not prevent FDA surpluses from being transferred between related companies, within certain transitional periods, where both companies are not members of a consolidated group.

Example 2.15

A Co and B Co are companies wholly-owned by a foreign parent, F Co A Co wholly-owns C Co and D Co. B Co owns 80% of E Co and D Co owns the remaining 20%.

A Co, B Co, C Co, D Co and E Co are all related companies that are eligible to form a MEC group, or A Co can form a consolidated group with C Co and D Co as subsidiary members.

On 1 July 2002 A Co, C Co and D Co form a consolidated group. E Co does not qualify as a subsidiary member of A Co's consolidated group because A Co only holds 20% interest in E Co and not 100%.

E Co pays a dividend to its shareholders on 1 September 2002. E Co is able to pay a dividend to D Co but the dividend will not give rise to a FDA credit for A Co (or D Co as it is a subsidiary member).

The dividend paid to B Co would give rise to a FDA credit if E Co had a FDA surplus at the time it paid the dividend with a FDA declaration percentage.

Foreign tax credits and consolidation

2.143 The following minor amendments to the foreign tax credit provisions in the consolidation rules ensure the provisions operate as intended.

Consolidation foreign tax credit provisions

Head company using transferred excess foreign tax credits

2.144 Section 717-15 deals with the transfer of excess foreign tax credits from entities that become subsidiary members of a consolidated group to the head company of the group. This provision also enables the head company to appropriately use those excess credits.

2.145 Currently, section 717-15 allows the head company to use excess foreign tax credits at the end of its income year from subsidiary members that joined the group before the beginning of that income year.

2.146 A minor amendment to subparagraph 717-15(1)(b)(i) ensures that the head company of a consolidated group can use excess foreign tax credits of subsidiary members at the end of its income year where those entities became subsidiary members at or before the start of the head company's income year. [Schedule 2, Part 9, item 52, subparagraph 717-15(1)(b)(i)]

Head company with a different year of income to a joining entity with excess foreign tax credits

2.147 Section 717-15 operates for entities with ordinary income years. It also generally operates appropriately for entities with a substituted accounting period. However, where the head company has a later balancing date for an income year to that of the joining entity, any excess foreign tax credits that the joining entity has for part of an income year ending at the time it joins the group (a non-membership period) may not be able to be used by the head company at an appropriate time. (See the diagram in Example 2.16.)

Example 2.16

JE (a joining entity) has an early balancing substituted accounting period (SAP). It joins a group before the beginning of the head company's (HC) income year. HC does not have a SAP.

Under the current operation of section 717-15, HC would not be able to use any excess foreign tax credits that JE may have in relation to the non-membership period (NMP) ending at the joining time until the end of the 2006-2007 income year. It is unable to use the excess credits at the end of the 2005-2006 income year because the NMP excess credits do not relate to an earlier income year in that case, something required by section 717-15. However, the head company should be able to use the NMP excess foreign tax credits at the end of the 2005-2006 income year because the joining time was at or before the start of that income year. The new rules achieve this result.

If all the NMP excess foreign tax credits are not used HC will amalgamate those credits with any other excess foreign tax credits that may arise at the end of the 2005-2006 income year.

2.148 Section 717-22 ensures a joining entity's non-membership period will be treated as an earlier income year where the following conditions are met:

•

the head company and the joining entity have different balancing days for the same income year;

•

the entity joins the consolidated group at or before the first day of the income year of the head company and not on the first day of its own income year; and

•

the non-membership period for the joining entity relates to the same income year as the year of income of the head company that follows the joining time.

[Schedule 2, Part 9, item 56, section 717-22]

2.149 In these circumstances, the head company is able to use the excess foreign tax credits for the non-membership period at the end of the first income year that commences on or after the joining time (providing the other conditions for using excess foreign tax credits are met). [Schedule 2, Part 9, item 56, subsection 717-22(2), item 1 in the table]

2.150 Where the head company does not use all the excess foreign tax credits from such a non-membership period, those excess foreign tax credits are amalgamated with any excess foreign tax credits that the head company may have in relation to that first income year [Schedule 2, Part 9, item 56, subsection 717-22(2), item 2 in the table]. The head company can carry forward the excess foreign tax credits from both its income year and the non-membership period.

Excess foreign tax credits do not leave with a subsidiary member

2.151 Where an entity joins a consolidated group only the head company can use the excess foreign tax credits of that entity.

2.152 Where the entity subsequently leaves the consolidated group, it will not be able to use the excess foreign tax credits that it may have had prior to joining the group [Schedule 2, Part 9, item 56, section 717-28]. Under section 717-30, the entity will also not have excess foreign tax credits that relate to a period that it was a subsidiary member of a consolidated group.

2.153 These rules apply whether or not the entity becomes a member of another consolidated group or remains a separate entity.

Collection and recovery rules

2.154 Division 721 contains the consolidation collection and recovery rules for circumstances when the head company fails to meet its income tax-related liability. Broadly, where the head company fails to satisfy a group liability by the time that it becomes due and payable, each contributing member becomes jointly and severally liable for that liability. Contributing members can avoid joint and several liability if the group liability was covered by a valid tax sharing agreement that allocates the liability between the members of the group on a reasonable basis.

2.155 Part 10 of Schedule 2 to this bill provides greater flexibility and certainty to Division 721 by modifying the clear exit rule and the PAYG instalment liability rules, clarifying that a group liability can be subject to only one tax sharing agreement, and updating outdated legislative references.

Former contributing member to provide the tax sharing agreement to the Commissioner of Taxation in certain circumstances

2.156 Amendments made by this bill will expand the scope of subsection 721-25(3) to allow, in certain circumstances, a former contributing member which has complied with the clear exit provisions to provide the relevant tax sharing agreement to the Commissioner and thereby avoid joint and several liability for a group liability. [Schedule 2, Part 10, item 59, subsection 721-15(3A)]

2.157 The current effect of subsection 721-25(3) is that only the head company is allowed to provide the tax sharing agreement to the Commissioner when requested. If the head company fails to provide the tax sharing agreement to the Commissioner within 14 days of the request, the group liability is taken never to have been covered by a tax sharing agreement, and, consequently, the contributing members become jointly and severally liable for the group liability.

2.158 This result is inappropriate for an exited entity purporting to rely on the clear exit provisions. In these circumstances, without the tax sharing agreement, the exited entity cannot demonstrate to the Commissioner how the clear exit amount (a reasonable estimate of its share of the group liability based on the tax sharing agreement allocation) was calculated, and the Commissioner does not have the ability to consider whether this amount is reasonable.

2.159 This amendment will allow an exited entity to avoid joint and several liability for the group liability if the exited entity complies with the following conditions:

•

the group liability is taken never to have been covered by a tax sharing agreement due to the head company's failure to provide the tax sharing agreement to the Commissioner within 14 days, pursuant to subsection 721-25(3) [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(a)] ;

•

the Commissioner issued the contributing member written notice of the group liability [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(b)] ;

•

the contributing member, to the best of its knowledge, left the group clear of the group liability in accordance with section 721-35 [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(c)] ; and

•

the contributing member provides the tax sharing agreement to the Commissioner before its joint and several liability became due and payable [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(d)].

2.160 The first condition provides the basis for establishing that, under subsection 721-25(3), the group liability was taken never to have been covered by the tax sharing agreement, and, hence, the contributing members become jointly and severally liable for the debt. [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(a)]

2.161 The second condition provides that the Commissioner must issue the former contributing member written notice of the group liability under subsection 721-15(5) before the former contributing member is able to provide the tax sharing agreement to the Commissioner. The exited entity cannot provide the tax sharing agreement before such a request. This approach was taken because the exited entity may not be aware that its former head company has failed to provide the tax sharing agreement until it receives notice from the Commissioner to contribute to the group liability. In addition, this approach provides administration savings for the Australian Taxation Office. [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(b)]

2.162 Further, this provision of the tax sharing agreement by the exited member will only operate for that exited member; the remaining members (including any other exited entity that has not taken advantage of this amendment) will be jointly and severally liable for the group liability.

2.163 The third condition provides that the exited entity must have attempted to utilise the clear exit provisions in section 721-35. These provisions allow the exiting entity which is party to a tax sharing agreement to pay to the head company a reasonable estimate of its share of the group liability, based on the allocation in the tax sharing agreement. However, without this amendment, the exited entity will not be able to rely on the tax sharing agreement if the head company does not provide the tax sharing agreement to the Commissioner. [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(c)]

2.164 This amendment does not affect the other requirements for a clear exit in section 721-35, such as the requirement to exit the group before the head company's due time. The effect of this amendment is that if the Commissioner determines that the tax sharing agreement complies with these requirements, the exited entity's clear exit will not be precluded by virtue of the operation of subsection 721-25(3).

2.165 If the Commissioner were to determine that the tax sharing agreement was invalid, pursuant to subsection 721-15(1) the former contributing member will remain jointly and severally liable for the group liability.

2.166 The fourth condition requires the exited entity to provide the tax sharing agreement before its joint and several liability becomes due and payable. This will be 14 days after the Commissioner gives the member written notice of the liability. [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(d)]

2.167 For general interest charge (GIC), the joint and several liability becomes due and payable on the day the notice is given, but will then be extinguished if the contributing member gives the tax sharing agreement to the Commissioner within 14 days. For each day that the GIC liability remains unpaid, subsection 721-17(2) provides that the Commissioner is taken to issue a new notice for each subsequent day. This provision is ignored so that for GIC liability the taxpayer must provide the tax sharing agreement within 14 days after the initial notice is given.

2.168 The fourth condition will also operate for all of the group liabilities reasonably allocated by the tax sharing agreement, if, at a later stage, the Commissioners seeks to recover any of those liabilities from the exited entity. This is on the condition that the tax sharing agreement appropriately describes the exited entity's allocation of the new group liability (in addition to describing the original liability) and at that later date the tax sharing agreement contains all the information for the Commissioner to determine if the new liability is reasonably allocated. [Schedule 2, Part 10, item 59, paragraph 721-15(3A)(d)]

Head company liable for own quarterly pay as you go instalments before consolidated rate given

2.169 Amendments made by this bill will ensure that the quarterly PAYG instalment liability in item 30 in the table in subsection 721-10(2) does not include a head company's quarterly PAYG instalment liability relating to the period before the quarter in which the head company is given a consolidated PAYG instalment rate. [Schedule 2, Part 10, item 58, subsection 721-10(3)]

2.170 Without this amendment, the reference to a PAYG instalment liability in item 30 in could include a PAYG instalment liability of the head company for a quarter before the quarter in which the head company receives a consolidated PAYG instalment rate from the Commissioner. Under the consolidation liability rules, liability for this instalment would then fall to the contributing members in the event of the head company defaulting. Prior to the quarter in which the group receives a consolidated PAYG instalment rate, each entity in the group continues to be liable for its own quarterly PAYG instalment at its previously determined rate. Each member continuing to pay its own respective PAYG instalment in this period is analogous to each member meeting its share of the group's quarterly PAYG instalment liability.

2.171 Amendments made by this bill will prevent contributing members from being subjected to a quarterly PAYG instalment liability which is entirely attributable to the head company's own activities.

2.172 This change does not affect the head company becoming liable for meeting the PAYG instalments on behalf of the group from the quarter in which the Commissioner has determined the group's consolidated PAYG instalment rate.

2.173 This change is restricted to the quarters before the quarter in which the head company receives its consolidated PAYG instalment rate because of the effect of the following provisions:

•

section 45-705 of Schedule 1 to the TAA 1953, which ensures that the head company of a consolidated group, provisional head company of a MEC group or interposed head company will be liable for the group's quarterly PAYG instalment from the beginning of the quarter in which the consolidated PAYG rate is given; and

•

section 45-61 of Schedule 1 to the TAA 1953, which provides that the liability for the quarter's instalment is due on or before the 21st day of the month after the end of the instalment quarter. Accordingly, the subsidiary members will not have already contributed their PAYG instalments for the same quarter that the head company is given the consolidated rate.

2.174 If a head company is interposed in a quarter before the group is given a consolidated PAYG rate from the Commissioner, this amendment will operate to exclude the interposed head company's PAYG instalment liability from the group liability in item 30. Under section 45-740 of Schedule 1 to the TAA 1953, unlike other consolidation attributes, the PAYG instalment liability attributes of the original head company will not be treated as those of the interposed head company until the quarter in which the group is given a consolidated PAYG rate by the Commissioner.

2.175 The original head company remains liable for its PAYG instalment liability if a head company is interposed in a quarter before the quarter in which the group receives a consolidated PAYG rate. This is because the original head company's PAYG instalment liability is not considered part of the interposed head company's own PAYG instalment, and, hence, not a group liability, but instead is considered to be a liability of a subsidiary member.

Applying pay as you go instalment credits to income tax liability

2.176 Amendments made by this bill will allow a consolidated group to allocate a tax sharing agreement contribution amount for the group's income tax-related liability that is either the total amount or an amount equal to the total less the PAYG instalment credits available to the head company on assessment. [Schedule 2, Part 10, item 60, subsection 721-25(1A)]

2.177 The group's income tax-related liability is represented in item 25 in the table in subsection 721-10(2). This change provides that the requirement in paragraph 721-25(1)(c) (that the total amount be allocated) will be taken to be satisfied if an amount equal to the difference between the total liability and the PAYG instalment credits available to the head company on assessment is allocated instead of the total amount. This is the net amount the head company is required to pay to the Commissioner.

2.178 The change will not have the effect of treating an allocation of the total amount as unreasonable. If the group wishes instead to allocate the total amount, paragraph 721-25(1)(c) continues to allow the group to do so. The change provides an alternative way to satisfy this provision depending on the group's circumstances.

2.179 Paragraph 721-25(1A)(b) requires that PAYG instalment credits have arisen before, at or after the head company's due time. Section 45-30 of Schedule 1 of the TAA 1953 provides that the credits do not arise until the Commissioner makes an assessment of income tax. However, due to the self assessment system (pursuant to paragraph 166A(3)(d) of the ITAA 1936), the Commissioner is taken to have made an assessment on the day on which the return is lodged and this could occur at a time after the head company's due time. [Schedule 2, Part 10, item 60, paragraph 721-25(1A)(b)]

2.180 Under subsection 721-25(1), these agreements are required to be in place just before the head company's due time. It is acknowledged that the practical effect of this will be that groups will formulate their tax sharing agreements at a time before the assessment in contemplation of these credits arising on assessment. [Schedule 2, Part 10, item 60, paragraph 721-25(1A)(b)]

2.181 The relevant credits include the group's consolidation PAYG instalment credits (section 45-30 of Schedule 1 to the TAA 1953) and those that arise for a head company during a consolidation transitional year (section 45-865 of Schedule 1 to the TAA 1953).

2.182 A tax sharing agreement that purports to utilise this amendment needs to be in a form that deals appropriately with entries and exits of group members before the end of the relevant income year. This is because paragraph 721-25(1A)(c) requires an allocation for each of the tax sharing agreement contributing members in relation to the group liability. [Schedule 2, Part 10, item 60, paragraph 721-25(1A)(c)]

One tax sharing agreement

2.183 Amendments made by this bill also clarify the intended operation of the law relating to the number of tax sharing agreements that a group is allowed to utilise to allocate the group liability among contributing members. The object of the tax sharing agreement provisions is that there should be a reasonable allocation of a group liability among one or more group members in accordance with a single agreement. [Schedule 2, Part 10, item 60, subsection 721-25(1B)]

2.184 This does not mean that each individual group liability as described in the table in subsection 721-10(2) must be the subject of a separate tax sharing agreement. A group's tax sharing agreement can contemplate any number of group liabilities; however, a group cannot have two or more separate tax sharing agreements dealing with the same liability. Similarly, a group may have more than one tax sharing agreement provided the liabilities dealt with by one tax sharing agreement are not dealt with in any of the others. A tax sharing agreement that contemplates more than one group liability must be the only tax sharing agreement dealing with those liabilities.

2.185 Further, the tax sharing agreement can incorporate one or more contributing members. Only members of the group who contribute to the tax-related liability allocated by the tax sharing agreement need be included, as to include other members may be considered unreasonable.

Example 2.17

The WXYZ Group is a consolidated group consisting of the head company, W Co, and subsidiaries, X Co, Y Co, and Z Co. Apart from Z Co, the group is engaged in importing computer hardware from Taiwan and Vietnam. Z Co's sole function is to provide corporate services to the importing arms of the group.

When allocating the group's income tax-related liability (item 25 in the table in subsection 721-10(2)) in a tax sharing agreement, the group allocates the liability to X Co and Y Co as contributing members. The group considers it reasonable not to allocate any of this liability to Z Co as it is not engaged in any income generating function outside the group.

2.186 The effect of this change will be to void all of the tax sharing agreements that attempt to allocate the same group liability. If groups wish to replace an earlier tax sharing agreement with a later tax sharing agreement dealing with the same liability, they should ensure that the later tax sharing agreement completely voids the earlier allocation. If the later tax sharing agreement does not wholly replace the earlier allocation, it and the earlier allocation will be void.

Franking liabilities

2.187 The table in subsection 721-10(2) lists the tax-related liabilities of the head company and the periods to which the liabilities relate for the purposes of Division 721. The table includes items that refer to liabilities arising under the imputation system. These provisions have since been rewritten into the ITAA 1997, and, consequently, this bill updates the references to reflect the new provisions. [Schedule 2, Part 10, item 57, subsection 721-10(2), items 10, 15 and 20 in the table]

2.188 Item 20 refers to subsection 214-150(3) franking tax - amended assessments otherwise than because of deficit deferral. This concept did not previously exist in the ITAA 1936 and therefore reference to this liability has been introduced to reflect the new scope of that provision. [Schedule 2, Part 10, item 57, subsection 721-10(2), item 20 in the table]

2.189 Similarly, in the redrafted imputation rules the concept of deficit deferral tax, which was contemplated in previous item 20 in the table, no longer applies. However, a similar effect is achieved by subsection 214-150(4) with an application of franking deficit tax liability. This concept has been reflected in item 22. [Schedule 2, Part 10, item 57, subsection 721-10(2), item 22 in the table]

2.190 Further, the periods to which these liabilities relate have been amended so they are aligned with periods provided for in the liability provisions themselves.

2.191 The period for item 10 in the table will refer to the income year to which the franking tax relates, as opposed to the income year in which the franking tax becomes due and payable. The income year to which the franking tax relates is the income year before the income year in which the franking tax becomes due and payable. [Schedule 2, Part 10, item 57, subsection 721-10(2), item 10 in the table]

Calculation of cost base and reduced cost base - assumed capital gains tax event

2.192 Under some of the existing CGT provisions, in order to work out the cost base or reduced cost base of a CGT asset, a CGT event is required. For example, subsection 110-25(2) (which includes certain capital expenditure incurred to increase an asset's value in the asset's cost base) and subsection 110-37(1) (which excludes from the cost base certain deductible expenditure). This is in contrast to the generality of the cost base and reduced cost base provisions of Division 110 of the ITAA 1997, which make no reference to a CGT event.

2.193 The intention of Division 110 was that the cost base or reduced cost base of a CGT asset should be able to be worked out at any particular time, regardless of whether there is a CGT event or not at that time (i.e. it is a 'running balance'). Consequently, the amendments contained in Part 11 of Schedule 2 to this bill have been inserted to clarify the operation of Division 110.

2.194 This issue is of particular importance within the consolidation context, where, for certain purposes (e.g. where an entity joins a consolidated group), the group must determine the cost base or reduced cost base of its membership interests in a joining entity. In order to ensure that the correct cost base or reduced cost base is used, it is necessary for the group to assume that a CGT event occurs at the joining time. This is required so that any adjustments to the cost base or reduced cost base (e.g. indexation) can be taken into account at the joining time. As joining a consolidated group is not a CGT event, without the amendments contained in Part 11 of Schedule 2 to this bill, it may be argued that such adjustments would not occur. This is not the intended operation of Division 110 or Part 3-90.

2.195 The amendments to sections 110-25 and 110-55 ensure that:

•

if it is necessary to work out the cost base or reduced cost base of an asset at a particular time; and

•

a CGT event does not happen in relation to the asset at or just after that time then,

it is assumed that a CGT event has occurred in relation to the asset at or just after that time (but only for the purposes of working out the cost base or reduced cost base). [Schedule 2, Part 11, items 62 and 63, subsections 110-25(12) and 110-55(10)]

2.196 It is important to note that the amendments only assume a CGT event for the purposes of working out the cost base or reduced cost base of the asset. The amendments do not 'refresh' the acquisition time of the CGT asset, nor do they result in any of the elements of the cost base or reduced cost base becoming the first element (i.e. each element retains its character).

Interaction with the Financial Corporations (Transfer of Assets and Liabilities) Act 1993

2.197 The Financial Corporations (Transfer of Assets and Liabilities) Act 1993 ensures that foreign banks currently operating as an authorised bank subsidiary or money market corporation are not put at a disadvantage compared to new foreign bank entrants as a result of establishing branch banking operations in Australia.

2.198 Part 3 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 enables financial corporations to restructure their business at least cost. Part 3 achieves this by modifying certain provisions of the ITAA 1936 and the ITAA 1997.

2.199 When a consolidated group is formed, the group is treated as a single entity for income tax purposes. Broadly, this means on joining a consolidated group, the subsidiary members lose their income tax identities and are treated as parts of the head company of the consolidated group (rather than as separate entities) for the purposes of determining the head company's income tax liability. In addition a consolidated group inherits the history of the joining entity. This means, things that happened to an entity before it became a subsidiary member of the group are attributed to the head company of the group.

2.200 Furthermore, when an entity becomes a subsidiary member of a consolidated group the membership interests in the entity held by the group are ignored and the cost, for tax purposes, of the assets which become those of the head company is set in accordance with the cost setting rules. These rules recognise the cost of the assets as an amount reflecting the group's cost of acquiring the entity.

2.201 This bill amends Part 3 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 to modify its operation in relation to transfers of assets and liabilities from financial corporations that are subsidiary members of consolidated and MEC groups [Schedule 2, Part 12, item 65, subsection 14A(2)]. The object of section 14A is to ensure that, where appropriate, Part 3 applies consistently with the consolidation regime:

•

to affect the income tax position of the head company, rather than that of the subsidiary making the transfer; and

•

to determine the income tax position of the corporation receiving the transfer by reference to the income tax attributes of the head company.

[Schedule 2, Part 12, item 65, subsection 14A(1)]

2.202 This is achieved by modifying the provisions in Part 3 so that they apply consistently with the consolidation regime. Even though the head company of the group is not a financial corporation, the provisions will operate as if it were.

2.203 The provisions will apply to the head company in the same way as they would apply to the transferring corporation [Schedule 2, Part 12, item 65, subsection 14A(3)]. For example, subsection 15(1) determines the tax treatment of a transferring corporation for asset transfers. Broadly, it provides that when determining whether an amount is included in the assessable income of a transferring corporation as a result of an asset transfer, the transferring corporation is treated as if the transfer had not occurred. Where the transferring corporation is a subsidiary member of a consolidated or MEC group, subsection 15(1) is modified by subsection 14A(3) to apply to the head company - that is, when determining whether an amount is included in the assessable income of a head company, the head company is treated as if the transfer had not occurred.

2.204 The amendments in Part 3 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 will ensure that where the law affects the receiving corporation it does so on the basis of the consolidation rules applicable to the head company of the group. For example where an entity brought into a consolidated group has a cost base, that cost base will be reset by the head company's tax cost setting once that entity becomes a subsidiary member of a consolidated group. [Schedule 2, Part 12, item 65, subsection 14A(4)]

2.205 To avoid doubt section 20, section 23, or Division 8 (which are about transfers of net capital losses, tax losses, and interest withholding tax), will not be affected by Part 3 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993. This is because Subdivision 707-A of the ITAA 1997 prevents a subsidiary member of such a group from having such a loss to transfer to the receiving corporation. [Schedule 2, Part 12, item 65, subsection 14A(5)]

Tax cost setting for privatised assets

2.206 The amendments contained in Part 13 to Schedule 2 to this bill ensure an appropriate interaction between the consolidation regime and Division 58, former Division 58, Subdivisions 57-I and 57-J of Schedule 2D to the ITAA 1936 and section 61A of the ITAA 1936 (referred to as the privatised asset provisions). This is achieved by inserting special cost setting rules into the consolidation regime to appropriately cap the tax cost of depreciating assets of tax exempt or previously privatised entities that join a consolidated group.

2.207 Because tax exempt entities are not subject to balancing adjustment events, the absence of special rules (such as Division 58) would enable values to be shifted into depreciating assets and higher tax benefits to be claimed by the newly privatised business through greater tax depreciation deductions. The privatised asset rules generally apply where a tax exempt entity becomes to some extent a taxable entity or, in some cases, where assets are purchased in connection with a business by a taxable entity from an exempt entity.

2.208 Under the consolidation cost setting rules, where a consolidated group acquires a privatised entity (whether this is as a result of a past or prospective privatisation), the allocable cost amount for the privatised entity is based on the purchase price paid for the entity. This allocable cost amount will be allocated to the individual assets according to the consolidation regime's market valuation mechanism and it is possible that the value of depreciating assets could be increased above the 'capped' value required by the privatised asset provisions. When an entity leaves the consolidated group, the entity would also continue to depreciate the asset from the higher value.

2.209 The consolidation regime did not previously contain rules to ensure that the tax cost of depreciating assets are appropriately capped where a tax exempt asset or entity (or a previously privatised asset or entity) becomes held by a consolidated group. In the absence of these amendments, that insert a cap into the consolidation cost setting rules, Division 58 would be overridden and past (and prospective) privatised assets and entities would be treated in the same manner as taxable assets and entities.

2.210 These amendments prevent this adverse outcome by inserting into the consolidation regime a cap on the cost setting amount that the head company of a joined group can use for determining deductions for the decline in value of a depreciating asset in a similar way to how the privatised asset provisions limit deductions for privatised assets.

2.211 The amendments made by Part 13 of Schedule 2:

•

trigger the operation of Division 58 and Division 57 of Schedule 2D to the ITAA 1936 immediately before an entity joins a consolidated group where the joining results in the entity ceasing to be a tax exempt entity;

•

cap (by reducing) the tax cost setting amount for depreciating assets of a privatised or formerly privatised entity (including in appropriate circumstances where an asset joins another consolidated group and has not been held by a previous consolidated group for at least 24 months or where the groups are associates); and

•

adds back the reduction (by increasing the step 1 amount of working out the allocable cost amount) in the tax cost where the assets leave the consolidated group in an entity (including adding back an appropriate amount where the privatised asset was brought into the consolidated group by a 'chosen transitional entity').

Background to the privatised asset provisions

2.212 The income tax law contains a number of regimes (some now repealed but with transitional application) to provide appropriate rules for the transfer of assets from a non-taxable entity to a taxable entity.

2.213 The current version of Division 58 (which commenced on 1 July 2001) applies where a tax exempt entity becomes taxable to any extent (an 'entity sale') or where a taxable entity acquires depreciating assets from a tax exempt entity in connection with the acquisition of a business from the exempt entity (an 'asset sale'). The entity or asset sale must have occurred on or after 1 July 2001 including where the asset was acquired by the previously exempt entity or by the tax exempt vendor in an asset sale before that date.

2.214 The former version of Division 58 (which operated from 4 August 1997 to 30 June 2001) also applied to both entity and asset sales.

2.215 The former Division 58 replaced Subdivision 57-I and 57-J of Division 57 of Schedule 2D to the ITAA 1936 which applied to 'transition taxpayers' that became taxable on or after 3 July 1995. Under Division 57, Subdivision 57-I determined the deduction allowable to the transition taxpayer in respect of any period after the transition time for depreciation of a unit of property, if the property was owned by the taxpayer at the transition time. Subdivision 57-J modified the deduction rules to operate, for the income year in which the transition occurred and for later income years, as though the taxpayer's income had never been exempt from income tax.

2.216 Division 57 also ensures that only those gains and losses, expenditure and receipts, which relate to the period after the transition were relevant to determining the tax liability. Certain Subdivisions of Division 57 are still operative and apply to privatisations that occur after 3 July 1995.

2.217 Section 61A of the ITAA 1936 clarified the operation of the depreciation provisions in respect of tax exempt entities that became taxable at any time between 1 July 1998 and 2 July 1995. Section 61A ensured that the depreciable assets of tax exempt entities which became taxable were brought into the tax system, for the purposes of the depreciation provisions, at their notional written down values as if they had always been used wholly for the purposes of producing assessable income.

Division 58 continues to operate for asset sales into a consolidated group

2.218 The amendments do not cover situations where a privatisation occurs by way of an asset sale directly into a consolidated group. This is because Division 58 applies in these situations without the need for any amendment to the consolidation rules. Division 58 will operate to appropriately cap the tax cost for the depreciating assets that are acquired in connection with a business from a tax exempt entity.

When the privatised asset provisions are triggered

2.219 When an entity, ceases to be a tax exempt entity because it joins a consolidated group (and therefore has its activities subject to tax as a result of being treated as part of the head company of the consolidated group under the single entity rule), then it is necessary to ensure that Division 58 and Division 57 of Schedule 2D to the ITAA 1936 apply. To ensure that those Divisions operate in these circumstances section 715-900 provides that the transition time (being the time that the entity ceases to be tax exempt) is taken to have occurred immediately before the joining time. [Schedule 2, Part 13, item 74, subsection 715-900(1)]

2.220 Section 715-900 ensures that entities which are subject to the privatised asset provisions as a result of a simultaneous transition and joining time are treated in the same manner as entities that join a consolidated group in circumstances where there has been a delay between the transition and joining times.

2.221 The effect of triggering the operation of Division 58, in the simultaneous transition case, will ensure that Division 58 operates to limit the adjustable value for the depreciating assets of the entity just before it joins a consolidated group. This has the effect of providing the joining entity with a terminating value for the depreciating asset which has been subject to the capping under Division 58. [Schedule 2, Part 13, item 74, subsection 715-900(2)]

2.222 The joining entity will also, in these circumstances, have to apply Division 58 to determine the deductions for decline in value that would have been available to the joining entity. This operates to provide the joining entity with relevant 'history' in relation to such things as the choice of method of depreciation which will be relevant in applying the capital allowance provisions in relation to the asset for the head company as a consequence of subsection 701-55(2).

2.223 As mentioned above parts of Division 57 of Schedule 2D to the ITAA 1936 remain operative and do things other than limit the cost of depreciating assets. Therefore, section 715-900 triggers these provisions in addition to the Division 58 capping rules. [Schedule 2, Part 13, item 74, subsection 715-900(2)]

2.224 Broadly, Division 57 ensures that gains and losses, expenditure and receipts that relate to the period after the transition are appropriately taxed. For example, they determine what income is derived by the transition taxpayer at or after the transition time for services rendered by it, for goods provided by it or for any other things done by it before the transition time is treated as having been derived before the transition time.

Capping the tax cost setting amount of privatised assets

2.225 Section 705-47 ensures that where an entity that joins a consolidated group which holds a depreciating asset that has been subject to the privatised asset provisions (including as a consequence of the effect of section 715-900), the tax cost setting amount allocated to that asset is capped for depreciation purposes. The tax cost is capped by reference to the capped amount arising from the direct or indirect operation of the privatised asset provisions. For example, as a result of the operation of:

•

section 61A of the ITAA 1936 (which applied to tax exempt entities that became taxable between 1 July 1998 and 2 July 1995);

•

Subdivision 57-I or 57-J in Schedule 2D to the ITAA 1936 (which applied to tax exempt entities that became taxable between 3 July 1995 and 3 August 1997);

•

former Division 58 (which applied to tax exempt entities that became taxable and to asset sales in connection with a business from a tax exempt entity between 4 August 1997 and 30 June 2001); or

•

current Division 58 (which applies to tax exempt entities that became taxable and to asset sales in connection with a business from a tax exempt entity from 1 July 2001).

[Schedule 2, Part 13, item 67, subsection 705-47(1)]

2.226 The tax cost setting amounts allocated to privatised assets are capped to maintain two interrelated objectives of the privatised asset provisions by not re-allocating reduction amounts among other assets of the joining entity. The objectives are to ensure that there is no transfer of tax benefit to the tax exempt entity at the time of privatisation and that the purchasing company's capital allowance deductions are capped.

2.227 A depreciating asset that an entity brings into a consolidated group when it becomes a subsidiary member will have its tax cost capped, that is, reduced to the joining entity's terminating value for the asset (being the tax cost immediately prior to consolidation) where:

•

before the joining entity became a subsidiary member, the asset was held by an entity (not necessarily the same entity) that was tax exempt (i.e. an exempt Australian government agency or another entity whose income was exempt from tax);

•

the privatised asset provisions had directly or indirectly affected the amount that the joining entity could deduct for the asset; and

•

the tax cost setting amount (ignoring the operation of section 705-47) would have exceeded the joining entity's terminating value.

[Schedule 2, Part 13, item 67, subsection 705-47(2)]

2.228 Cost setting amounts are capped where either the privatised asset provisions are triggered by the joining entity entering the consolidated group (because of the operation of section 715-900) or where the privatised asset provisions had previously applied to the privatised asset of the joining entity. Triggering the privatised asset provisions where they had previously applied prevents inappropriate tax benefit transfers by way of an immediate on-sale of an exempt asset after the cost setting rules have removed the effects of the capping through resetting the tax cost for the assets.

2.229 An example of where entry to a consolidated group triggers the privatised asset provisions is where the entity was exempt prior to entering the group at which time it will have become taxable.

2.230 Examples of where the privatised asset provisions had previously applied to the asset of the joining entity include where:

•

the asset was held by an entity (that had its deductions affected by the privatised asset provisions) prior to the asset being acquired by the joining entity. Here the effect of the above mentioned deductions extends to the joining entity because of a previous application of subsection 705-47(2);

•

subsection 705-47(2) affected the joining entity's deductions for the asset because of the exit history rule. That is, the privatised asset provisions may have applied to cap the tax cost setting amount of the asset when it was purchased by a previous group and the asset then leaves that group when an entity leaves and joins another consolidated group;

•

a privatised asset held by an entity which joined a consolidated group and was treated as a chosen transitional entity (which do not have their asset's tax cost reset) leaves the consolidated group and joins another consolidated group; and

•

a privatised asset is sold to a group (by an asset sale) and then leaves that group in a leaving entity that joins a second group.

2.231 Primarily, Division 58 caps the cost allocated to privatised assets for depreciation purposes, thereby limiting the amount of deductions for the asset's decline in value and the amount of tax benefits that can be obtained by entities that purchase privatised assets. Under Division 58 entity sales and asset sales are treated consistently by providing a choice of how to work out the first element of cost of each individual depreciating asset based on the 'notional written down value' or the 'undeducted pre-existing audited book value'. Once a method is chosen it will determine 'the amount' that is used in calculating the joining entity's terminating value for the depreciating asset.

2.232 Where an entity leaves a consolidated group with a privatised asset that had its tax cost capped then it will continue to have its tax cost capped as a result of the exit history rule.

Situations in which the tax cost for depreciating assets are no longer capped

2.233 When the potential for tax benefit transfer no longer exists the capping of tax costs (achieved by either the privatised asset provisions or section 705-47) need not continue. The amendments included in this bill prevent the privatised asset provisions and section 705-47 applying indefinitely. In particular, they prevent a consolidated group that acquires an entity that was previously a member of another consolidated group from being subject to the capping rule in subsection 705-47(2) in certain circumstances.

2.234 Diagram 2.6 summarises whether the acquiring consolidated group will have its tax cost capped under these provisions when a privatised asset leaves a consolidated group and is acquired by another group.

Diagram 2.6: Tax cost setting outcomes where a privatised asset leaves a consolidated group and is acquired by another group

2.235 Where just before the joining time an entity, that becomes a member of a consolidated group (the joined group), was:

•

neither an exempt Australian government agency nor an entity whose income was exempt from tax; and

•

meets one of the two conditions set out below within the period between when the asset last stopped being an exempt asset and the joining time (this period is called the pre-joining taxable period);

•

the head company of the joined group will not have to reduce the tax cost setting amount to the capped amount.

[Schedule 2, Part 13, item 67, subsection 705-47(3)]

2.236 The first condition is where a balancing adjustment event that occurred for the asset resulted in an amount being included in the entity's assessable income or an amount being an allowable deduction for that asset. A balancing adjustment event in relation to a privatised asset ensures that the Division 58 objectives are met in that it ensures that tax benefit transfer does not occur. [Schedule 2, Part 13, item 67, subsection 705-47(4)]

2.237 The second condition is:

•

that for at least some of the pre-joining taxable period, the asset was held by the head company of a consolidated group (the earlier group) for a period (called the earlier group period) which:

•

started when the asset became held by the earlier group either because an entity joined the earlier group with the asset or because the head company of the group acquired the asset via an asset sale from a tax exempt entity; and

•

finished when an entity leaves the consolidated group with the asset or when the earlier group ceases to exist;

•

the head company of the earlier group, just before the end of the earlier group period, was not either an associate of the head company of the joined group just before the joining time or the same company as the head company of the joined group; and

•

the earlier group period was at least 24 months.

[Schedule 2, Part 13, item 67, subsection 705-47(5)]

2.238 The requirements in relation to testing whether the entities are associates and that the asset be held by the head company of a consolidated group for a period of at least 24 months are intended to provide integrity in ensuring that there is not a tax benefit transfer via an immediate on-sale of the privatised asset.

2.239 The 24-month period begins from the time the head company of a consolidated group acquires the asset (ignoring the inherited history rule). This is an integrity measure that requires the head company to hold the asset for a period of at least 24-months. Allowing the head company to include periods of time that subsidiary companies had held the asset (applying the inherited history rule) would undermine this test in certain cases.

2.240 Testing the relationship between the two consolidated groups requires determining whether the head company of the earlier group is an associate of the joined group just before the time it joins the joined group.

2.241 The subsidiaries of a MEC group that has a provisional head company are regarded as associates under subsection 318(2) of the ITAA 1936. This means that the privatised asset provisions would continue to apply if a privatised asset was transferred between MEC groups with a common top company.

Increase in step 1 amount when an entity leaves a consolidated group with an asset that had its tax cost capped

2.242 Where an asset, that has had its tax cost setting amount reduced either directly or indirectly under the privatised asset provisions, leaves a consolidated group the head company of the group may be entitled to increase its step 1 amount in working out the old group's allocable cost amount for the purpose of setting the tax cost for membership interests in the leaving entity. The amount of the increase depends on whether the asset's tax cost was limited by the operation of section 705-47 or because an asset that was subject to the privatised asset provisions was brought into a consolidated group with an entity that elected to be a chosen transitional entity and consequently retained the existing tax values for its assets.

Increase in step 1 amount where the tax cost was capped by section 705-47

2.243 Where the tax cost for a depreciating asset was reduced to the capped amount as a result of section 705-47 when an entity (whether or not it is the same entity as the leaving entity) joined the consolidated group and that asset leaves the group with the leaving entity then the amount of the reduction is added back in calculating the step 1 amount under subsection 711-25(3). The amount of the reduction in this case will be the difference between the tax cost that would have been allocated to the privatised asset but for section 705-47 and the tax cost that was set (after applying section 705-47). [Schedule 2, Part 13, item 72, subsection 711-25(3)]

2.244 Subsection 711-25(3) does not need to apply to asset sales under the former Division 58 because it ceased to apply from 1 July 2001 and assets sales to consolidated groups can only take place from 1 July 2002.

Increase in step 1 amount where the acquisition is by a consolidated group under an asset sale

2.245 Where an entity leaves a consolidated group and takes with it a depreciating asset for which the first element of its cost was set by reference to subsection 58-70(5) (because a member of the consolidated group acquired the asset in connection with a business from a tax exempt entity). That is, where subsection 58-5(4) applied and the amount of the cost is less than it would have been if the cost had not been reduced as a result of the operation of Division 58 (i.e. under item 11 of the table in subsection 40-180(2)) then the amount of the difference will be added to the step 1 amount. [Schedule 2, Part 13, item 72, subsection 711-25(4)]

Increase in step 1 amount where leaving entity takes asset brought into a group by a chosen transitional entity

2.246 There may also be an increase in the step 1 amount of the old group's allocable cost amount in the following two circumstances that involve a subsidiary member leaving a group with a depreciating asset that entered the group within a chosen transitional entity. [Schedule 2, Part 13, item 75, subsection 701-50(1) of the Income Tax (Transitional Provisions) Act 1997]

2.247 The first circumstance is where the chosen transitional entity itself was privatised (an entity sale situation covered by Division 58, the former Division 58, Division 57 of Schedule 2D to the ITAA 1936 or section 61A of the ITAA 1936). [Schedule 2, Part 13, item 75, subsection 701-50(2) of the Income Tax (Transitional Provisions) Act 1997]

2.248 In this circumstance, where section 61A of the ITAA 1936, Subdivision 57-I in Schedule 2D to the ITAA 1936 or former subsection 58-20(4) (i.e. where the notional written-down method is used) applied and the amount of the purchase price for the entity that is reasonably attributable to the asset exceeds the difference between:

•

the amount treated as the cost of the asset under the relevant privatised asset provisions; and

•

the total amount treated under the relevant provisions as being deductions for capital allowance of the asset assumed to have been allowed for the period before the transition time.

Then the excess is added back for the purpose of working out the head company's tax cost for the membership interests in the leaving entity. [Schedule 2, Part 13, item 75, subsection 701-50(3) of the Income Tax (Transitional Provisions) Act 1997]

2.249 In the circumstance, where former subsection 58-20(5) or Division 58 applied and the amount of the purchase price for the entity that is reasonably attributable to the asset exceeds the amount treated as being the cost or the first element of the cost of the asset under the relevant provision. Then the excess is added back for the purpose of working out the head company's tax cost for the membership interests in the leaving entity. [Schedule 2, Part 13, item 75, subsection 701-50(3) of the Income Tax (Transitional Provisions) Act 1997]

2.250 The second circumstance is where the chosen transitional entity's cost for the asset was limited because that entity or another entity acquired the asset in an asset sale covered by Division 58 or the former Division 58.

2.251 If either the former or current Division 58 applied to the asset sale and because of the acquisition the amount that could be deducted for the asset was reduced and the cost for the asset was less than what it would have been but for the operation of the privatised asset provisions (i.e. if former sections 58-160 and 58-220 and current subsection 58-70(5) had not applied) then the difference is added to the step 1 amount. [Schedule 2, Part 13, item 75, subsection 701-50(4) of the Income Tax (Transitional Provisions) Act 1997]

Where the reduction amount is not added back

2.252 In the case of a consolidated group joining another consolidated group, where the joined group acquires the head company (of the old group) that held the depreciating asset during the earlier holding period the reduction amount is not added back (because the cost for shares in the subsidiary member is not set in these circumstances) and the subsequent acquirer should be subject to the same tests that apply if a single entity were joining.

Retaining access to further deduction for certain balancing adjustments

2.253 In certain circumstances an entity that is subject to a balancing adjustment event that occurs for a depreciating asset may be entitled to a further deduction under subsection 40-285(3) of the Income Tax (Transitional Provisions) Act 1997. This can occur where former Division 58, section 61A of the ITAA 1936 or where the transition time under Division 57 of Schedule 2D to the ITAA 1936 occurred before 1 July 2001.

2.254 Section 701-55(2) sets out how the depreciating asset provisions apply in relation to the asset for the head company where an entity joins a consolidated group with a depreciating asset. In particular, paragraph 701-55(2)(a) provides that the depreciating asset provisions apply as though the asset were acquired at the joining time. The operation of this provision would result in the head company (and, if an entity left with the asset, that entity) not being entitled to a further deduction under subsection 40-285(3) of the Income Tax (Transitional Provisions) Act 1997.

2.255 Section 702-4 of the Income Tax (Transitional Provisions) Act 1997 ensures that where a balancing adjustment event occurs in relation to a depreciating asset that became, at some point, an asset of the head company of a consolidated group that subsection 40-285(3) of the Income Tax (Transitional Provisions) Act 1997 will continue to apply in appropriate circumstances. [Schedule 2, Part 13, item 76, subsection 702-4(1) of the Income Tax (Transitional Provisions) Act 1997]

2.256 An entity (including the head company of a consolidated group) will be entitled to a further deduction for a balancing adjustment event if the entity would have been entitled to the deduction if paragraph 701-55(2)(a) had not applied (i.e. the asset had not been deemed to have been acquired at a particular time) [Schedule 2, Part 13, item 76, subsection 702-4(2) of the Income Tax (Transitional Provisions) Act 1997]. However, the entity will not be entitled to the further deduction where the asset has had its tax cost reset as a result of joining a consolidated group (i.e. the tax cost for the asset is greater than its terminating value when it was brought into a consolidated group) [Schedule 2, Part 13, item 76, subsection 702-4(3) of the Income Tax (Transitional Provisions) Act 1997].

Application and transitional provisions

2.257 The majority of amendments made by Schedule 2 apply on and after 1 July 2002. This is the date of commencement of the consolidation regime.

2.258 The amendments are either beneficial to taxpayers or correct unintended outcomes. All of the amendments to address unintended outcomes are consistent with the original policy intent for the consolidation regime and therefore have the same commencement date as the consolidation regime.

2.259 The following amendments do not apply on and after 1 July 2002:

•

the amendment made to subsection 124-380(7) is to apply to choices made after the commencement of the item. This ensures that the changes to subsection 124-380(7) are not retrospective [Schedule 2, Part 3, item 5, subsection 124-380(7)] ;

•

the amendment to subparagraph 717-15(1)(b)(i) will apply from 1 July 2004. This amendment is required for wholly-owned groups that consolidate after the transitional period. Transitional rules already allow the head company to use excess foreign tax credits of subsidiary members at the end of the first consolidation year in certain circumstances [Schedule 2, Part 9, item 53, subparagraph 717-15(1)(b)(i)] ; and

•

the amendments to the provisions dealing with the calculation of 'cost base' and 'reduced cost base' apply to assessments for the 1998-1999 and later income years. This is consistent with the first application of the CGT provisions in the ITAA 1997:

•

the amendment clarifies the operation of the law and ensures that taxpayers can make relevant cost base and reduced cost base calculations. Although the need for the amendment was identified in the consolidations context, the amendment applies for CGT purposes more generally. It is not expected that the amendments will adversely affect taxpayers [Schedule 2, Part 11, item 64].

Consequential amendments

Cost setting for assets that the head company does not hold under the single entity rule

2.260 As a consequence of the change to subsection 701-10(2), an amendment to paragraph 104-510(1)(b) is made to allow assets that do not become assets of the head company to be included in the CGT event L3 calculation. This is achieved by restructuring paragraph 104-510(1)(b) to remove a reference to "assets of the head company". [Schedule 2, Part 4, item 10, paragraph 104-510(1)(b)]

2.261 Consequential amendments are also made for the following:

•

paragraphs 713-205(3)(a) and 719-160(3)(a) to remove references to "assets that an entity brings into the group". These references are replaced with a reference to "assets of an entity joining a group" [Schedule 2, Part 4, items 15 and 18, paragraphs 713-205(3)(a) and 719-160(3)(a)].

•

sections 717-275, 717-280 and 717-285 as a result of the provision that ensures the entry history rule does not affect when the head company may elect to value trading stock at market value [Schedule 2, Part 9, items 38 to 41, sections 717-275, 717-280 and 717-285]. Similarly, consequential amendments have been made to sections 717-300, 717-305 and 717-310 as a result of the provision that ensures the exit history rule does not affect when the leaving entity may elect to value trading stock at market value [Schedule 2, Part 9, items 43 to 48, sections 717-300, 717-305, and 717-310].

•

to repeal paragraph 717-15(2)(b) and the example in subsection 717-15(3) as a result of the insertion of section 717-28 [Schedule 2, Part 9, item 54, paragraph 717-15(2)(b); item 55, subsection 717-15(3)].

Multiple entry consolidated groups and interposed head companies

2.262 A consequential amendment is made to paragraph 701D-10(5)(a) of the Income Tax (Transitional Provisions) Act 1997 to update a reference to paragraph 126-50(6)(b) to subsection 126-50(6). [Schedule 2, Part 3, item 9, paragraph 701D-10(5)(a)]

Tax cost setting for privatised assets

2.263 As a consequence of inserting section 705-47, an amendment to subparagraph 705-55(b)(iii) is made to include section 705-47 in the order of application of sections 705-40, 705-45 and 705-50. The heading to section 705-55 is also amended to reflect this change. [Schedule 2, Part 13, items 68 and 69, heading to section 705-55, subparagraph 705-55(b)(iii)]

2.264 Consequential amendments are made to remove references to the "cost to the head company of assets that the entity brings into the group" in; item 1 in the table in section 701-60, note 1 to subsection 715-70(1), note 1 to subsection 715-225(1) and section 701-15 of the Income Tax (Transitional (Provisions) Act 1997. As a consequence of the changes to subsection 701-10(2) these references are replaced with a reference to the "cost to the head company of assets of joining entity". [Schedule 2, Part 4, items 14, 16, 17 and 19 ,table item 1 in section 701-60, note 1 to subsection 715-70(1), note 1 to subsection 715-225(1), section 701-15 of the Income Tax (Transitional Provisions) Act 1997]