House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 3 Consolidation

Outline of chapter

3.1 Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to modify the consolidation tax cost setting and rights to future income rules so that the tax outcomes for consolidated groups are more consistent with the tax outcomes that arise when assets are acquired outside the consolidation regime.

Context of amendments

3.2 The consolidation regime aims to reduce tax compliance costs and improve the integrity of the income tax system by allowing a group of corporate entities the choice to lodge a single income tax return if, broadly, they are all wholly owned by an Australian resident company. The head company lodges the income tax return for the group, while the subsidiaries lose their individual income tax identities.

3.3 When a company acquires an asset, the cost of the asset can be recognised in different ways under the income tax law. When and how the cost is used will depend on the nature of the asset and the circumstances in which it is acquired. For example:

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in the case of a depreciating asset, the tax cost is deducted over the life of the asset;

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in the case of a capital gains tax (CGT) asset, the tax cost is recognised when the asset is sold (or when another CGT event happens to the asset);

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in the case of some other assets, the tax cost may be recognised when the asset is acquired, as income is derived from the asset, or when the asset is sold (depending on circumstances).

3.4 When a consolidated group acquires a company, the shares in the acquired company cease to be recognised for taxation purposes and the company's assets effectively become assets of the head company.

3.5 The tax costs of those assets are reset at an amount that reflects their respective share of the group's cost of acquiring the joining company (based on the relative market values of those assets). However, some specified assets (such as cash) retain their original tax cost.

3.6 A specific provision in the income tax law (section 701-55 of the ITAA 1997) deals with how the reset tax cost for an asset is used when applying other provisions of the income tax law to that asset. If a provision in the income tax law that is not specifically mentioned in that provision applies to the asset, the residual tax cost setting rule (subsection 701-55(6)) applies to specify the use of the reset tax cost.

3.7 Amendments to the consolidation regime made by the Tax Laws Amendment (2010 Measures No. 1) Act 2010 broadened the scope of the residual tax cost setting rule and introduced the rights to future income rule (subsection 701-55(5C)). Those amendments sought to remove uncertainty in the law by clarifying that, for some assets, the reset tax cost of the asset (rather than its original tax cost) is used when a taxing point later arises for the asset. They also clarified the tax outcomes for assets that are rights to future income (such as an entitlement to unbilled income). The amendments applied from 1 July 2002 as they were thought to be merely returning the regime to its originally stated intent.

3.8 Shortly after passage of those amendments, it became clear that the new rules, combined with Taxation Ruling TR 2004/13 on the meaning of an asset for consolidation purposes and a change to Australian Accounting Standard AASB 138 on intangible assets, could result in the recognition of the tax costs of some assets being brought forward in an unanticipated way.

3.9 For example, issues arose about whether a joining entity's original goodwill asset (which is a CGT asset) could be broken into a range of intangible assets (which have no actual tax cost and are not usually recognised for tax purposes), and whether some depreciating assets and some CGT assets could be reclassified as rights to future income or revenue assets. To the extent that these assets could be successfully identified and reclassified, tax recognition for the reset tax costs would be brought forward. In this way unintended windfalls could arise for some taxpayers.

3.10 Consequently, on 30 March 2011, the then Assistant Treasurer asked the Board of Taxation to examine the operation of the residual tax cost setting and rights to future income rules (see the then Assistant Treasurer's Media Release No. 045 of 30 March 2011).

3.11 The Board of Taxation concluded that the scope of the rules, as enacted, appeared to be broader than was originally intended at the time of their announcement in 2005. These rules, combined with the effect of other long standing elements of the consolidation regime, could allow consolidated groups to access deductions that are not available to taxpayers outside the consolidation regime. Consequently, the revenue impact of the rules was likely to be significantly larger than expected.

3.12 These amendments respond to the need to protect a significant amount of revenue that would otherwise be at risk, and to make the tax outcomes for consolidated groups more consistent with those for entities outside consolidation.

Summary of new law

3.13 Schedule 3 to this Bill amends the consolidation provisions in the income tax law to modify the consolidation tax cost setting and rights to future income rules and to make the tax outcomes for consolidated groups more consistent with the tax outcomes that arise when assets are acquired outside the consolidation regime.

3.14 The changes affecting a corporate acquisition will depend on the time when the acquisition took place. That is, different changes apply to acquisitions that took place before 12 May 2010 (when the law was passed by both Houses of Parliament), after 30 March 2011 (when the Board of Taxation was asked to review the rules) and the intervening period.

3.15 As the 2010 amendments operated with effect back to 2002, some of the further changes (the pre-rules) also need to operate with effect from that date. These changes prevent the retrospective operation of unintended effects of, and perceived weaknesses in, the law. In particular, the pre-rules, which apply broadly to the period before 12 May 2010, will restore the tax cost setting rules that operated prior to the 2010 amendments (the original tax cost setting rules), with modifications to:

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limit deductions for rights to future income to unbilled income assets;

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ensure that a deduction is allowed for the reset tax costs for consumable stores; and

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treat certain assets as goodwill.

3.16 The changes for the intervening period (the interim rules) will protect taxpayers who acted on the basis of the current law before the Board of Taxation review was announced. These rules, which apply broadly to the period between 12 May 2010 and 30 March 2011, will restore the current 2010 residual tax cost setting and rights to future income rules, with modifications to:

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treat certain assets as goodwill;

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ensure that no value is attributed to certain contractual rights to future income; and

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ensure that the reset tax costs for consumable stores are deductible.

3.17 The prospective changes (the prospective rules) primarily implement the recommendations made by the Board of Taxation to improve the operation of the consolidation tax cost setting rules. These changes will increase certainty for taxpayers and make the tax outcomes for consolidated groups more consistent with the tax outcomes that arise when assets are acquired by entities outside the consolidation regime. In particular, the prospective rules, which apply broadly to the period after 30 March 2011, will:

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restrict the operation of the tax cost setting rules to CGT assets, revenue assets, depreciating assets, trading stock and Division 230 financial arrangements;

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apply a business acquisition approach to the residual tax cost setting rule;

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ensure that the reset tax costs for rights to future income that are work in progress (WIP) amount assets and consumable stores are deductible; and

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treat rights to future income, other than WIP amount assets, as retained cost base assets.

Comparison of key features of new law and current law

Detailed explanation of new law

3.18 The changes affecting a corporate acquisition will depend on the time when the acquisition took place. That is, different changes apply, with certain exceptions, to:

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acquisitions that took place before 12 May 2010 - in this case the pre-rules apply;

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acquisitions that took place between 12 May 2010 and 30 March 2011 - in this case the interim rules apply; and

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acquisitions that took place on or after 31 March 2011 - in this case the prospective rules apply.

3.19 The pre-rules amend the operation of the current law.

3.20 The interim rules amend the operation of the current law as modified by the pre-rules.

3.21 The prospective rules amend the operation of the current law as modified by both the pre-rules and the interim rules.

The pre-rules

3.22 The pre-rules amend the operation of the current law for, broadly, the pre-12 May 2010 period. These amendments:

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restore the original residual tax cost setting rule;

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limit deductions for rights to future income to unbilled income assets;

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ensure that a deduction is allowed for the reset tax costs for consumable stores; and

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treat certain assets as goodwill.

3.23 The objective of the pre-rules is to prevent the retrospective operation of unintended effects of, and perceived weakness in, the 2010 amendments to the law. The pre-rules are necessary to protect a significant amount of revenue that would otherwise be at risk. However, consistent with the announcement for these changes, the pre-rules ensure that the reset tax cost for consumable stores and for unbilled income assets are deductible.

Original residual tax cost setting rule restored

3.24 When an entity joins a consolidated group, the tax costs of its assets are reset under the tax cost setting rules.

3.25 Section 701-55 specifies how the reset tax cost for an asset is used when applying other provisions of the income tax law to that asset. If a provision in the income tax law that is not specifically mentioned in section 701-55 applies to the asset, the residual tax cost setting rule (subsection 701-55(6)) applies to specify the use of the reset tax cost.

3.26 The 2010 amendments to the consolidation regime broadened the scope of the residual tax cost setting rule. The amendments applied from 1 July 2002 as they were thought to be merely returning the regime to its originally stated intent.

3.27 The 2010 amendments have had a broader impact than expected. Therefore, to prevent taxpayers from obtaining a windfall gain from those amendments in the pre-12 May 2010 period, the pre-rules modify the current law to restore the original residual tax cost setting rule. [Schedule 3, item 2, subsection 701-55(6) of the pre-rules]

3.28 The operation of the original residual tax cost setting rule is explained in paragraph 2.57 of the explanatory memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002. In essence, that paragraph states that, in setting the cost for tax purposes of an asset which is not a depreciating asset, trading stock, a CGT asset or an asset covered by another specific provision in section 701-55, the provisions of the income tax law apply as though the asset's cost is reset.

3.29 In addition, paragraph 5.20 of that explanatory memorandum, which relates to the operation of the tax cost setting rules, states that:

The set cost for an asset (the tax cost setting amount) will be the relevant 'cost' for all income tax purposes including for the purposes of the CGT, capital allowance and trading stock provisions.

3.30 Consequential amendments modify the heading to section 701-56 and remove subsections 701-56(1) and (2). [Schedule 3, items 3 and 4, heading to section 701-56]

Rights to future income deductions limited to unbilled income assets

3.31 The 2010 amendments to the consolidation regime introduced the rights to future income rules (subsection 701-55(5C) and sections 701-90, 716-405 and 716-410). Those rules allowed consolidated groups to deduct the reset tax cost for a right to future income asset over, broadly, the lesser of the period of the relevant contract or 10 years. The amendments applied from 1 July 2002.

3.32 The 2010 amendments have had a broader impact than expected and unintentionally gave consolidated groups an advantage over other taxpayers. Therefore, to prevent consolidated groups from obtaining a windfall gain from those amendments in the pre-12 May 2010 period, deductions for the reset tax cost for rights to future income will be limited to unbilled income assets. This is consistent with the announcement that led to the 2010 amendments.

3.33 That is, if an entity joins a consolidated group holding an unbilled income asset that is expected to be included in the head company's assessable income after the joining time, then the head company will be able to apply section 716-405 to deduct the reset tax cost for the asset. [Schedule 3, item 1, subsection 701-55(5C) of the pre-rules]

3.34 Under the pre-rules, a right to future income is a valuable right (including a contingent right) to receive an amount for the performance of work or services or the provision of goods if:

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the valuable right forms part of a contract or agreement;

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the market value of the valuable right (taking into account all the obligations and conditions relating to the right) is greater than nil; and

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the valuable right is neither a Division 230 financial arrangement nor part of a Division 230 financial arrangement.

[Schedule 3, items 6 and 13, subsection 701-63(5) of the pre-rules and the definition of ' right to future income' in subsection 995-1(1 )]

3.35 This definition of right to future income is substantially the same as the current definition in subsection 701-90(1). Therefore, a consequential amendment is made to remove section 701-90. [Schedule 3, item 7]

3.36 Under the pre-rules, an asset is a non-deductible right to future income if it is a right to future income that is not an unbilled income asset. [Schedule 3, items 6 and 12, subsection 701-63(3) of the pre-rules and the definition of ' non-deductible right to future income' in subsection 995-1(1 )]

3.37 An asset that is a right to future income is an unbilled income asset if:

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the asset is in respect of work (but not goods) that has been performed or partially performed by an entity for another entity where a recoverable debt has not yet arisen in respect of the work; or

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an asset that is in respect of goods (other than trading stock) or services that have been provided by an entity for another entity where a recoverable debt has not yet arisen in respect of the goods or services.

[Schedule 3, items 6 and 14, subsection 701-63(5) of the pre-rules and the definition of ' unbilled income asset' in subsection 995-1(1 )]

3.38 That is, an asset held by a joining entity will be an unbilled income asset where:

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a joining entity has performed or partially performed work, or provided goods (other than trading stock) or services, for another entity before the joining time; and

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at the joining time, a recoverable debt has not yet arisen in respect of the work, goods or services.

3.39 If an entity joins a consolidated group holding an unbilled income asset and section 716-410 covers the asset, then section 716-405 will apply to allow a deduction for the reset tax cost for the asset. [Schedule 3, item 1, subsection 701-55(5C )]

3.40 Section 716-410 covers an asset if:

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the asset is a right to future income;

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the asset is held by an entity just before the time that it became a subsidiary member of a consolidated group;

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it is reasonable to expect that an amount attributable to the asset will be included in the assessable income of the entity or any other entity after the joining time; and

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the asset is not a financial arrangement that is covered by the taxation of financial arrangement provisions in Division 230 (disregarding the operation of section 230-455).

[Schedule 3, item 10, section 716-410]

3.41 Section 716-405 allows a deduction for the tax cost setting amount if:

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an entity becomes a subsidiary member of a consolidated group; and

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subsection 701-55(5C) applies in relation to the asset - that is, the asset is an unbilled income asset that is covered by section 716-410.

[Schedule 3, item 9, subsection 716-405(1) of the pre-rules]

3.42 The deduction will be available to the entity that is qualified for a deduction under subsection 716-405(5) for the unbilled income asset. In most cases this will be the head company of a consolidated group that holds the asset because of the single entity rule (subsection 701-1(1)). However, if an entity ceases to be a member of the consolidated group and takes the right to future income asset with it, the leaving entity will be entitled to the deduction. [Schedule 3, item 9, subsections 716-405(2) and (5) of the pre-rules]

3.43 If the head company expects that a recoverable debt will arise in respect of the work, goods or services in relation to the unbilled income asset within 12 months of the joining time, the head company will be able to deduct the unexpended tax cost setting amount for the unbilled income asset in the income year in which the joining time occurs. [Schedule 3, item 9, paragraph 716-405(2)(a) of the pre-rules]

3.44 If a recoverable debt in respect of the work, goods or services in relation to the unbilled income asset arises more than 12 months after the joining time, the entity that is qualified for a deduction will be able to deduct, in the income year in which the recoverable debt arises, the lesser of:

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the unexpended tax cost setting amount for the asset for the income year;

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the total of the recoverable debts.

[Schedule 3, item 9, paragraph 716-405(2)(b) of the pre-rules]

3.45 The unexpended tax cost setting amount for the unbilled income asset for an income year is the tax cost setting amount for the asset reduced by the amounts (if any) of all deductions under section 716-405 in respect of the asset for previous income years. [Schedule 3, item 9, paragraph 716-405(4)(a) of the pre-rules]

3.46 In addition, in determining the amount of a deduction for a right to future income asset for an income year for an entity that ceased to be a subsidiary member of the group in that income year, the tax cost setting amount is reduced by the amount (if any) that the head company of the group can deduct under section 716-405 in respect of the asset for that income year. [Schedule 3, item 9, paragraph 716-405(4)(b) of the pre-rules]

3.47 An amount that is deducted under section 716-405 for the tax cost setting amount for the unbilled income asset:

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cannot be deducted under any other provision in the income tax law;

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is not taken into account in determining the amount included in assessable income of the head company or an entity that has ceased to be a member of the group for any income year for the asset;

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is not taken into account in determining the amount of a deduction for the head company or an entity that has ceased to be a member of the group for any income year for the asset; and

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is not taken into account in working out any of the elements of the CGT cost base of the asset.

[Schedule 3, item 9, subsection 716-405(6) of the pre-rules]

3.48 Note that, to ensure consistency between the pre-rules and the interim rules, there is no subsection 716-405(3) in the pre-rules. This subsection is reinserted under the interim rules.

3.49 If a right to future income that is an unbilled income asset is held by an entity that is already owned by the group (that is, in a formation case), the asset will be a retained cost base asset, with a tax cost setting amount equal to the joining entity's terminating value for the asset. [Schedule 3, item 8, paragraph 705-25(5)(d) of the pre-rules]

Consumable stores are deductible

3.50 A primary objective of broadening the scope of the residual tax cost setting rule was to ensure that deductions could be claimed under the general deduction provision (section 8-1) for the reset tax costs of consumable stores.

3.51 Therefore, consistent with the announcement that led to the 2010 amendments, the general deduction provision will apply to allow a deduction for the reset tax cost for consumable stores.

3.52 Consequently, when an entity joins a consolidated group holding an asset that is consumable stores, for the purposes of applying the general deduction provision, the head company will be taken to have incurred an outgoing at the joining time in acquiring the asset for an amount equal to the reset tax cost for the asset. [Schedule 3, item 1, subsection 701-55(5D )]

Certain assets treated as goodwill

3.53 The pre-rules will treat certain assets as forming part of the goodwill asset of a business of a joining entity. The assets which are treated as part of the goodwill of a business may include:

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some assets which are already legal goodwill under general principles; and

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some assets which are not legal goodwill.

3.54 That is, under the pre-rules, for the purposes of applying the consolidation provisions in Part 3-90 to an entity that becomes a subsidiary member of a consolidated group:

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the goodwill of a business of the joining entity is treated as a single asset;

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an asset of that business that is an asset forming part of goodwill is treated as being part of that single asset; and

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as a result, an asset forming part of goodwill is not treated as a separate asset.

[Schedule 3, item 6, subsections 701-63(1) and (2) of the pre-rules]

3.55 If the joining entity has not allocated allocable cost amount to a goodwill asset, the tax cost setting amounts for the assets treated as forming part of goodwill will effectively be the tax cost setting amount for the goodwill asset of each relevant business of the joining entity.

3.56 Some provisions in Part 3-90 specify the treatment of goodwill in specific circumstances. For example, subsections 705-35(3) and 711-25(2) specify the treatment of synergistic goodwill. The specific operation of those provisions will not be affected by section 701-63.

3.57 In addition, a goodwill asset of a joining entity that is a life insurance company or a general insurance company that demutualised before the joining time is treated as a retained cost base asset (paragraph 713-515(1)(c) and section 713-705). Specific provisions to clarify the interaction between those provisions and section 701-63 will be introduced in a later bill.

3.58 A goodwill asset is a CGT asset. Taxation Ruling TR 1999/16 outlines how the CGT provisions apply to goodwill assets. Applying that ruling, the tax costs allocated to these assets will be recognised only when, broadly:

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a subsidiary member leaves the group taking the goodwill asset with it;

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the goodwill asset is sold; or

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the goodwill asset ceases to exist.

3.59 Paragraph 14 of the Taxation Ruling states that:

Goodwill is not a series of CGT assets that inhere in other identifiable assets of a business. Goodwill, being a composite thing, attaches to the whole of the business. It does not attach separately to each identifiable asset of the business. Nor is there an element of goodwill in each identifiable asset of a business.

3.60 Consequently, the tax costs for assets that are treated as goodwill will not be recognised at the joining time or when, for example, a CGT event happens to the asset.

3.61 The Taxation Ruling also states that the goodwill of a business is a single CGT asset (paragraph 16). However, the Taxation Ruling also discusses the issue as to whether there is a disposal of goodwill on a disposal of one of several businesses or on the disposal of something less than a business (paragraphs 70 to 79).

'If a business owner is carrying on more than one business, each business has its own separate goodwill and each business may be disposed of along with the goodwill attaching to it.' (Paragraph 73 of Taxation Ruling TR 1999/16)

'If a business owner is carrying on one business and disposes of some part of that business, it is a question of fact as to whether the owner has disposed of a discrete business that a purchaser could conduct or has merely disposed of a business asset or a collection of business assets. ...If a business owner disposes of part of their business, an important consideration is whether the effect of the transaction is to put the purchaser in possession of a going concern the activities of which the purchaser could carry on without interruption.' (Paragraph 74 of Taxation Ruling TR 1999/16)

3.62 Under the pre-rules, an asset is treated as forming part of the goodwill asset if:

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the asset is an intangible asset, the value of which is attributable to the expected future profits from life insurance policies or general insurance policies;

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the asset is a customer relationship asset, know how or another accounting intangible asset that is not a CGT asset, a revenue asset, a depreciating asset, trading stock, a Division 230 financial arrangement, goodwill or an asset that is excluded from the tax cost setting rules because of subsection 705-30(2); or

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the asset is a non-deductible right to future income.

[Schedule 3, items 6 and 11, subsection 701-63(3) of the pre-rules and the definition of ' asset forming part of goodwill' in subsection 995-1(1 )]

3.63 An asset that is an intangible asset, the value of which is attributable to the expected future profits from life insurance policies or general insurance policies for both existing and anticipated policy holders may or may not form part of legal goodwill. Paragraph 701-63(3)(a) ensures that an asset whose value is attributable to expected future profits from both existing and anticipated policies (however those expected future profits are classified for actuarial, accounting or other purposes) is treated as an asset forming part of the goodwill of a business of the joining entity.

3.64 The value of an insurance business may also reflect anticipated benefits from the future recoupment of past acquisition costs. Acquisition costs broadly represent expenses involved in obtaining new customers and establishing their policies. In some cases, the anticipated future revenues of a life insurance business seen as recouping acquisition costs exceed anticipated future outgoings, resulting in an overall debit balance liability for a policy or group of policies. Thus, these debit balances represent expected future profits from life insurance policies (even though those profits offsetting corresponding acquisition costs). Paragraph 701-63(3)(a) also ensures that these expected future profits are treated as an asset forming part of the goodwill of a business of the joining entity.

3.65 Paragraph 701-63(3)(b) specifies that a customer relationship asset, know how or another accounting intangible asset that is not otherwise recognised for tax purposes is treated as an asset forming part of the goodwill of the business of the joining entity asset. Examples of other accounting intangible assets include:

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customer related intangible assets - such as customer lists, order or production backlogs, and customer relationships;

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marketing related intangible assets - such as unregistered trademarks and trade names; and

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technology based intangible assets - such as information databases and trade secrets (such as secret formulas, processes or recipes).

Part 2 - Interim rules

3.66 The interim rules amend the operation of the current law as modified by the pre-rules. These rules apply to, broadly, the period between 12 May 2010 and 30 March 2011. These amendments restore the current rights to future income and residual tax cost setting rules. However, modifications are made to:

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treat certain assets as goodwill;

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ensure that no value is attributed to certain contractual rights to future income; and

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ensure that the reset tax costs for consumable stores are deductible.

3.67 The objective of the interim rules is to protect taxpayers who acted on the basis of the 2010 law before the Board of Taxation Review was announced. The modifications address material uncertainties in the operation of the 2010 law, and ensure that the law operates as intended.

Current rights to future income and residual tax cost setting rules restored

3.68 The interim rules restore the current rights to future income and residual tax cost setting rules. That is, the rules restore the following provisions:

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subsections 701-55(5C) and (6);

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subsections 701-56(1) and (2);

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section 701-90 (noting that the definition of 'right to future income' in former subsection 701-90(1) has been relocated to subsection 701-63(5));

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paragraph 705-25(5)(d); and

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sections 716-405 and 716-410.

[Schedule 3, items 15 to 21, 23 and 24, subsections 701-55(5C) and (6), subsections 701-56(1) and (2), subsection 701-63(5), section 701-90, paragraph 705-25(5)(d) and sections 716-405 and 716-410 of the interim rules]

3.69 The operation of these rules is explained in detail in the explanatory memorandum, and the supplementary memorandum, to Tax Laws Amendment (2010 Measures No. 1) Bill 2010.

Certain assets treated as goodwill

3.70 The first modification to the current law that is made by the interim rules is to treat certain assets held by an entity that becomes a subsidiary member of a consolidated group as forming part of the goodwill asset of a business of the joining entity. The assets which are treated as part of the goodwill of a business may include:

•

some assets which are already legal goodwill under general principles; and

•

some assets which are not legal goodwill.

3.71 That is, under the interim rules, for the purposes of applying the consolidation provisions in Part 3-90 to an entity that becomes a subsidiary member of a consolidated group:

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the goodwill of a business of the joining entity is treated as a single asset;

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an asset of that business that is an asset forming part of goodwill is treated as being part of that single asset; and

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as a result, an asset forming part of goodwill is not treated as a separate asset.

[Schedule 3, item 19, subsections 701-63(1) and (2) of the interim rules]

3.72 If the joining entity has not allocated allocable cost amount to a goodwill asset, the tax cost setting amounts for the assets treated as forming part of goodwill will effectively be the tax cost setting amount for the goodwill asset of each relevant business of the joining entity.

3.73 The current taxation treatment of assets that are goodwill is broadly outlined in paragraphs 3.58 to 3.61.

3.74 Under the interim rules, an asset is treated as forming part of the goodwill asset if:

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the asset is a customer relationship asset, know how or another accounting intangible asset that is not a CGT asset, a revenue asset, a depreciating asset, trading stock, a Division 230 financial arrangement, goodwill or an asset that is excluded from the tax cost setting rules because of subsection 705-30(2); or

•

the asset is a non-deductible right to future income.

[Schedule 3, items 11 and 19, subsection 701-63(3) of the interim rules and the definition of ' asset forming part of goodwill' in subsection 995-1(1 )]

3.75 Under the interim rules, an asset is a non-deductible right to future income if it is a right to future income that arises under a contract or agreement entered into by the joining entity with another entity (the customer) to the extent that the value of the right:

•

is contingent on the renewal of the contract or agreement;

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is attributable to the period, if any, during which the customer can unilaterally cancel the contract or agreement without paying compensation or a penalty; or

•

if there is a period during which the customer can unilaterally cancel the contract or agreement but must pay compensation or a penalty, is attributable to that period but not to that compensation or penalty.

[Schedule 3, items 12 and 19, subsection 701-63(4) of the interim rules and the definition of ' non-deductible right to future income' in subsection 995-1(1 )]

3.76 A right to future income under a contract or agreement entered into by a joining entity with another entity (the customer) that is contingent on an expectation that the customer will renew the contract or agreement is uncertain. In this regard, the right is not an existing right to future income but is a mere expectation that cannot be attributed to those existing rights. Therefore, the right is a non-deductible right to future income that is treated as goodwill.

3.77 A right to future income under a contract or agreement entered into by a joining entity with the customer is uncertain if the customer can unilaterally cancel the contract or agreement at any time without paying compensation or a penalty. In this regard, the right is not an existing right to future income but is a mere expectation that cannot be attributed to those existing rights. Therefore, the right is a non-deductible right to future income that is treated as goodwill.

3.78 If the customer can unilaterally cancel the contract or agreement at any time but must pay compensation or a penalty, the value of the contract or agreement that is attributable to the compensation or a penalty, is not a non-deductible right to future income.

3.79 Ultimately it will be a question of fact as to whether a customer can unilaterally cancel a contract or agreement. If customer can cancel the contract or agreement only in circumstances that are beyond the customer's control, then the contract or agreement would not be a non-deductible right to future income. This could include, for example:

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a contract or agreement that can be cancelled by the customer only if there is a material breach of the terms of the contract by the consolidated group after the joining time; or

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a contract or agreement that can be cancelled by the customer only if the consolidated group is unable to fulfil its obligations under the contract or agreement due to forces (either natural or human) beyond its control - that is, the contract or agreement contains a force majeure clause.

3.80 Similarly, if a customer can unilaterally cancel a contract or agreement but only by paying compensation or a penalty that is punitive, it is likely that the contract or agreement would not be a non-deductible right to future income.

3.81 The question as to whether an entity can unilaterally cancel a contract or arrangement without paying compensation or a penalty can only be determined as a question of fact having regard to the circumstances of a particular case. However, the following examples illustrate the outcomes that could arise in some situations.

Example 3.1

Company A joins Head Co's consolidated group. Company A has entered into a contract with a customer to transport minerals from a mine site to a port. The customer is able to cancel the contract if Company A is unable to fulfil its obligations to transport minerals under the contract for a period of 12 months due to circumstances beyond Company A's control, such as a natural disaster which damages the infrastructure used to transport the minerals - that is, the contract or agreement contains a force majeure clause.

Company A's right to future income will not be a non-deductible right to future income because the customer is unable to unilaterally cancel the contract. That is, the customer can only cancel the contract in extraordinary and unexpected circumstances that are beyond its control.

Example 3.2

Company A joins Head Co's consolidated group. Company A has entered into an on-going funds management contract with a customer. The customer is unable to cancel the contract within the first two years. Once those two years have expired, the customer is able to cancel the contract at any time, but must give three months advance notice of its intention to cancel the contract.

Company A's right to future income is effectively non-cancellable for the first two years and three months of the contract. Therefore, to the extent that the value of the right to future income exceeds the value attributable to the non-cancellable period, the right will be a non-deductible right to future income that is treated as forming part of goodwill.

Example 3.3

Company A joins Head Co's consolidated group. Company A has entered into a contract to provide services to a customer. The customer is unable to cancel the contract within the first two years. Once those two years have expired, the customer is able to cancel the contract at any time, but must pay a fee to Company A on the termination of the contract.

Company A's right to future income is non-cancellable for the first two years of the contract. Therefore, to the extent that the value of the right to future income exceeds the value attributable to the non-cancellable period and the value of the fee payable on termination, the right will be a non-deductible right to future income that is treated as forming part of goodwill.

Example 3.4

Company A joins Head Co's consolidated group. Company A has entered into a telecommunications contract with a customer. The contract expires after two years. Once those two years have expired, Company A continues to provide telecommunications services to the customer until they choose to cancel the contract.

Company A's right to future income is non-cancellable for the first two years of the contract. Therefore, to the extent that the value of the right to future income exceeds the value attributable to the non-cancellable period, the right will be a non-deductible right to future income that is treated as forming part of goodwill.

No value is attributed to certain contractual rights to future income

3.82 A second modification to the current law that is made under the interim rules is to ensure that no value is attributed to certain rights to future income.

3.83 The modification applies where

•

the joining entity holds an asset;

•

under the terms of a contract or agreement, the joining entity holds a right to future income arising from the asset; and

•

the right to future income is not a non-deductible right to future income in relation to the joining entity.

[Schedule 3, item 22, subsection 705-56A(1 )]

3.84 In these circumstances, the amount of the reset tax cost for the right to future income will depend on whether or not the market value of the asset at the joining time (disregarding the right to future income) exceeds the sum of:

•

the market value of the asset at the joining time (having regard to the right to future income); and

•

the market value of the right to future income at that time.

[Schedule 3, item 22, subsection 705-56A(2 )]

3.85 If the sum of those amounts does exceed the market value of the asset at the joining time (disregarding the right to future income), then the market value of the right to future income is taken to be the amount of the excess for the purposes of working out the reset tax cost for the right to future income under section 705-35. [Schedule 3, item 22, subsection 705-56A(3 )]

3.86 If the sum of those amounts does not exceed the market value of the asset at the joining time (disregarding any encumbrances on the asset), then:

•

the right to future income is not taken into account under the tax cost setting rules; and

•

the right to future income's tax cost setting amount is taken to be nil.

[Schedule 3, item 22, subsection 705-56A(4 )]

Consumable stores are deductible

3.87 A third modification to the current law that is made under the interim rules is to retain the specific provision (inserted in the pre-rules) which ensures that the head company can apply the general deduction provision to deduct the reset tax costs for consumable stores is retained under the interim rules. [Schedule 3, item 1, subsection 701-55(5D )]

Part 3 - Prospective rules

3.88 The prospective rules amend the operation of the current law as modified by both the pre-rules and the interim rules. These rules apply to, broadly, the period after 30 March 2011. These amendments:

•

restrict the operation of the tax cost setting rules to CGT assets, revenue assets, depreciating assets, trading stock and Division 230 financial arrangements;

•

apply a business acquisition approach to the residual tax cost setting rule;

•

ensure that the reset tax costs for rights to future income that are WIP amount assets and consumable stores are deductible; and

•

treat rights to future income, other than WIP amount assets, as retained cost base assets.

3.89 The objective of the prospective rules is to increase certainty for taxpayers by making the tax outcomes for consolidated groups more consistent with the tax outcomes that arise when assets are acquired by entities outside the consolidation regime. In this regard:

•

by restricting the tax cost setting rules to CGT assets, revenue assets, depreciating assets, trading stock and Division 230 financial arrangements, those rules will not result in tax costs being allocated to assets that are not ordinarily recognised for taxation purposes - this will improve the integrity of the consolidation regime as consolidated groups will not seek to find ways to deduct the tax cost allocated to such assets;

•

by applying a business acquisition approach to the residual tax cost setting rule, assets acquired by a consolidated group as a result of acquiring an entity will generally be taken to be on capital account - this will ensure that the tax costs allocated to assets will be recognised only when a CGT event happens to the asset rather than giving rise to immediate revenue deductions;

•

by ensuring that the reset tax costs for rights to future income that are WIP amount assets and consumable stores are deductible, consolidated groups will have certainty that revenue deductions can be claimed for these assets; and

•

by treating rights to future income (other than WIP amount assets) as retained cost base assets, the consolidation tax cost setting rules will not result in substantial uplifts in the amount of the tax costs for these assets.

Restrict the tax cost setting rules to assets that are recognised for taxation purposes

3.90 Under the prospective rules, the consolidation provisions will apply to an asset only if the asset is one or more of the following:

•

a CGT asset;

•

a revenue asset;

•

a depreciating asset;

•

trading stock; or

•

a thing that is, or is part of, a Division 230 financial arrangement.

[Schedule 3, item 34, section 701-67]

3.91 In this regard, a CGT asset is defined in section 108-5 to mean:

•

any kind of property; or

•

a legal or equitable right that is not property.

3.92 Therefore, most revenue assets, depreciating assets, trading stock and Division 230 financial arrangements are CGT assets. However, mining, quarrying and prospecting information is an example of a depreciating asset that is not a CGT asset (see Taxation Ruling TR 98/3).

3.93 As a result, the tax cost setting rules will not result in tax costs being allocated to assets that are not ordinarily recognised for taxation purposes. This will improve the integrity of the consolidation regime as consolidated groups will not seek to find ways to deduct the tax cost allocated to such assets.

3.94 Examples of assets that may not be CGT assets, revenue assets, depreciating assets, trading stock or Division 230 financial arrangements include:

•

customer related intangible assets - such as customer lists, order or production backlogs, and customer relationships;

•

marketing related intangible assets - such as unregistered trademarks and trade names; and

•

technology based intangible assets - such as information databases and trade secrets (such as secret formulas, processes or recipes).

3.95 As the business capital expenditure provision (section 40-880) cannot apply to expenditure for CGT assets, revenue assets, depreciating assets, trading stock or Division 230 financial arrangements, a consequential amendment is made to remove the reference to the business capital expenditure provision in the list of provisions excluded from the scope of the residual tax cost setting rule. [Schedule 3, item 32, paragraph 701-56(3)(d )]

3.96 Under the current law, certain assets (excluded assets) are not allocated a tax cost setting amount. Excluded assets are not CGT assets, revenue assets, depreciating assets, trading stock or Division 230 financial arrangements. Therefore, consequential amendments are made to remove references to excluded assets from the tax cost setting provisions. [Schedule 3, items 27 and 37 to 41, sections 705-35 and 705-40 ]

Apply a business acquisition approach to the residual tax cost setting rule

3.97 Under the prospective rules, the residual tax cost setting rule in the current law (inserted by the interim rules) will be retained. [Schedule 3, item 16, subsection 701-55(6 )]

3.98 However, for the purpose of applying the residual tax cost setting rule to the assets of an entity that joins a consolidated group, the head company will be taken to have acquired all of the assets of the joining entity as part of acquiring the business of the joining entity as a going concern. [Schedule 3, items 29 to 31, subsections 701-56(1 ), ( 1A ), ( 1B) and (2) of the prospective rules]

3.99 As a result of applying a business acquisition approach to the residual tax cost setting rule, the head company will be treated as having acquired the assets of the joining entity as if they were acquired directly, as part of a business acquisition. The revenue or capital character of the assets will then be determined based on the character of the assets in the hands of the head company, rather than the joining entity.

3.100 A business is a going concern if it has not been stopped - that is, essentially any business which is not being wound up is a going concern. Therefore, a business which is a going concern has goodwill as a legal asset. By deeming the actual acquisition by the head company of the joining entity's membership interests to be the acquisition of the joining entity's assets as part of the acquisition of a business that is a going concern, and therefore a business that has goodwill, the acquisition of the assets by the head company is likely to be on capital account.

3.101 However, there may be some limited circumstances where the application of the business acquisition approach to a particular asset results in the asset being on revenue account. In that event, the residual tax cost setting rule (subsection 701-55(6)) will apply to allow the reset tax cost for the asset to be recognised.

WIP amount assets are deductible

3.102 Under the prospective rules, section 25-95 will apply to determine the whether the reset tax cost for rights to future income that are WIP amount assets is deductible.

3.103 In this regard, section 25-95 specifies the circumstances in which taxpayers can deduct work in progress amounts. Therefore, where an entity that joins a consolidated group holds a WIP amount asset, section 25-95 will apply as if the head company had paid a work in progress amount for the income year in which the joining time occurs equal to the reset tax cost for the asset. [Schedule 3, item 28, subsection 701-55(5C) of the prospective rules]

3.104 A WIP amount asset is an asset that is in respect of work (but not goods) that has been partially performed by a recipient mentioned in paragraph 25-95(3)(b) for a third party but not yet completed to a stage where a recoverable debt has arisen in respect of the completion of the work. [Schedule 3, items 33 and 48, subsection 701-63(6) of the prospective rules and the definition of ' WIP amount asset' in subsection 995-1(1 )]

3.105 The objective of restricting this deduction to the reset tax cost for rights to future income that are WIP amount assets is to ensure that consolidated groups do not get a deduction that is not available to entities that cannot, or choose not to, consolidate.

Consumable stores deductible

3.106 The modification inserted by the pre-rules to ensure that the head company can apply the general deduction provision to deduct the reset tax costs for consumable stores is retained under the prospective rules. [Schedule 3, item 1, subsection 701-55(5D )]

Rights to future income, other than WIP amount assets, are retained cost base assets

3.107 Under the prospective rules, a right to future income (other than a WIP amount asset) will be a retained cost base asset, with a tax cost setting amount equal to the joining entity's terminating value for the asset. [Schedule 3, item 36, paragraph 705-25(5)(d) of the prospective rules]

3.108 Under these rules, a right to future income is a valuable right (including a contingent right) to receive an amount if:

•

the valuable right forms part of a contract or agreement;

•

the market value of the valuable right (taking into account all the obligations and conditions relating to the right) is greater than nil;

•

the valuable right is neither a Division 230 financial arrangement nor part of a Division 230 financial arrangement; and

•

it is reasonable to expect that an amount attributable to the right will be included in the assessable income of any entity at a later time.

[Schedule 3, item 13 and 33, subsection 701-63(5) of the prospective rules and the definition of ' right to future income' in subsection 995-1(1 )]

3.109 The definition of rights to future income under the prospective rules is broader than the definition in the pre-rules and the interim rules. That is, under the prospective rules, rights to future income are not restricted to rights to receive an amount for the performance of work or services or the provisions of goods. This will ensure that other contractual rights to future income (such as a right to income that arises under an insurance contract or a reinsurance contract) are treated as retained cost base assets.

Removal of interim rules

3.110 Under the prospective rules, specific provisions that applied under the interim rules will be removed. These are:

•

the rules to allow a deduction for rights to future income under the interim rules - that is, subsections 701-56(1) and (2) and sections 701-90, 716-405 and 716- 410; and

•

the rules to ensure that no value is attributed to certain rights to future income - that is, section 705-56A.

[Schedule 3, items 30, 31, 35, 42, and 43 to 47]

Application and transitional provisions

3.111 The changes affecting a corporate acquisition will depend on the time when the acquisition took place. That is, different changes apply, with certain exceptions, to:

•

acquisitions that took place before 12 May 2010 - in this case the pre-rules apply;

•

acquisitions that took place between 12 May 2010 and 30 March 2011 - in this case the interim rules apply; and

•

acquisitions that took place on or after 31 March 2011- in this case the prospective rules apply.

3.112 The changes are necessary to protect a significant amount of revenue that would otherwise be at risk, and to make the tax outcomes for consolidated groups more consistent with those for entities outside consolidation.

3.113 As the 2010 amendments operated with effect back to 2002, some of the further changes need to do so too. These changes (the pre-rules) prevent the retrospective operation of unintended effects of, and perceived weaknesses in, the law.

3.114 The interim rules protect taxpayers who acted on the basis of the current law before the Board of Taxation review of the operation of the residual tax cost setting and rights to future income rules was announced.

3.115 The prospective rules primarily implement the recommendations made by the Board of Taxation to improve the operation of the consolidation tax cost setting rules. These changes will increase certainty for taxpayers and make the tax outcomes for consolidated groups more consistent with the tax outcomes that arise when assets are acquired by entities outside the consolidation regime.

Application of the pre-rules

3.116 The pre-rules apply to the head company of a consolidated group or multiple entry consolidated group for an income year in respect of an entity that becomes a member of the group if:

•

the joining time was before 12 May 2010; or

•

the arrangement under which the joining entity joined the group commenced before 10 February 2010.

[Schedule 3, item 49 and subitems 50(1) and (2 )]

3.117 However, the pre-rules will not apply in respect of an income year if:

•

the interim rules apply for that income year;

•

the arrangement or transaction is covered by a notice of assessment for that income year which issued before 12 May 2010 that comes within the scope of subitem 50(5); or

•

the special rule in item 51 for an arrangement or transaction covered by a private ruling or written advice given by the Commissioner of Taxation (Commissioner) under an Annual Compliance Arrangement applies.

[Schedule 3, item 49, subitem 50(3), subitem 50(5) and item 51]

3.118 If an arrangement or transaction is covered by a notice of assessment for an income year which was served on the head company by the Commissioner before 12 May 2010, the original 2002 law will apply to the arrangement or transaction unless:

•

the head company requests an amendment to the assessment and the amendment relates to the application of subsection 701-55(6) of the original 2002 law in respect of the joining entity; or

•

the amendment of the assessment relates to an asset that is a customer relationship asset, know-how or another accounting intangible asset and would be inconsistent with the treatment of those assets under the pre-rules.

[Schedule 3, item 49 and subitems 50(5) and (6 )]

3.119 Therefore, where an assessment for an income year issued before 12 May 2010 based on the law that applied at that time (that is, the original 2002 law), the assessment will generally be unaffected by the changes made to the original 2002 law by the pre-rules.

3.120 If the head company has claimed a deduction in an income year for an unbilled income asset or consumable stores, the pre-rules will apply and the deduction will be allowed. Similarly, if a head company that is covered by the pre-rules makes a request for an amendment to a prior year income tax return to claim a deduction for an unbilled income asset or consumable stores, the pre-rules (rather than the original 2002 law) will apply so that the deduction will be allowed.

3.121 In addition, if a deduction for an asset that is a customer relationship asset, know-how or another accounting intangible asset was allowed under an assessment issued to the head company for an income year, the Commissioner can amend the assessment and apply the pre-rules to treat the asset as goodwill.

Application of the interim rules

3.122 The interim rules apply to the head company of a consolidated group or multiple entry consolidated group for an income year in respect of an entity that becomes a member of the group if:

•

the pre-rules would otherwise apply (because the joining time was before 12 May 2010 or the arrangement under which the joining entity joined the group commenced before 10 February 2010) but the head company's latest notice of assessment for the income year that relates to the application of the 2010 law in respect of the joining entity was served on the head company by the Commissioner between 12 May 2010 and 30 March 2011; or

•

the joining time was on or after 12 May 2010 and the arrangement under which the joining entity joined the group commenced between 10 February 2010 and 30 March 2011.

[Schedule 3, item 49, subitems 50(1) and (3), and item 52]

3.123 Therefore, if the joining time was before 12 May 2010 or the arrangement under which the joining entity joined the group commenced before 10 February 2010 (so that the pre-rules generally apply) and the joining entity holds, for example, a right to future income that is not unbilled income, then:

•

if the Commissioner has served a notice of assessment or amended assessment for an income year on the head company between 12 May 2010 and 30 March 2011 allowing a deduction for the claim, the interim rules will apply for that income year so that the deduction is allowed; and

•

the pre-rules will apply to the tail of claims for deduction in subsequent income years (and therefore a deduction may not be allowed in those subsequent income years).

3.124 However, if the joining time was on or after 12 May 2010 and the arrangement under which the joining entity joined the group commenced between 10 February 2010 and 30 March 2011, the interim rules will apply to allow a deduction for the tail of claims in all income years.

Application of the prospective rules

3.125 The prospective rules apply to the head company of a consolidated group or multiple entry consolidated group for an income year in respect of an entity that becomes a member of the group if:

•

the joining time is on or after 31 March 2011; and

•

neither the pre-rules nor the interim rules apply to the arrangement.

[Schedule 3, item 49 and subitems 50(1) and (4 )]

Special rule for private rulings

3.126 The amendments will not apply where a claim is covered by:

•

a private binding ruling issued before 31 March 2011; or

•

written advice given by the Commissioner before 31 March 2011 under an Annual Compliance Arrangement.

[Schedule 3, subitems 51(1) and (2 )]

3.127 In these circumstances, if the ruling or written advice was issued under the original 2010 law, that law will apply to the transaction

3.128 However, if the head company requests an amendment in relation to a matter covered by a ruling or written advice after it has been issued, item 51 does not apply to the extent that the request is inconsistent with or contrary to the ruling or advice. [Schedule 3, subitem 51(3 )]

Commencement of an arrangement

3.129 The time that an arrangement is taken to commence is outlined in Table 3.1. [Schedule 3, item 52]

No interest payable on income tax refunds or where additional tax becomes payable

3.130 Attachment A of the then Assistant Treasurer's Media Release No. 159 of 25 November 2011 specified that the amendments will ensure that no interest is payable on income tax refunds for the period prior to 12 May 2010 as a result of an amendment to allow a deduction because of the changes to the original 2002 rules. However, the amendments will not apply where the interest has already been paid to taxpayers.

3.131 In addition, no interest or penalties will be payable where additional tax becomes payable because the Commissioner amends an assessment that issued before 31 March 2011, or further amends an amended assessment that issued before that date, to disallow a deduction for a claim under the pre-rules or the interim rules.

3.132 The amendments to implement these changes are still being developed and will be introduced in a later bill.

Amendment of assessments

3.133 Generally, the Commissioner can amend an assessment of a company, other than a small business entity, within four years from the date of the notice of assessment (section 170 of the Income Tax Assessment Act 1936 ).

3.134 As the pre-rules and the interim rules apply to periods in respect of which the four year amendment period has wholly or partly expired, the period for amending assessments will be extended. That is, the operation of section 170 will be modified so that it does not prevent the amendment of an assessment if:

•

the assessment was made before the date of commencement of the amendments (that is the day on which the amendments receive Royal Assent);

•

the amendment is made within two years after that date; and

•

the amendment is made for the purpose of giving effect to the amendments in Schedule 3.

[Section 4]

Consequential amendments

3.135 Consequential amendments are made to:

•

modify the list of provisions about deductions under the prospective rules;

•

correct cross references in section 701-58; and

•

remove redundant definitions.

[Schedule 3, items 5, 25, 26, 45, 46 and 47, sections 12-5 and 701-58]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Consolidation

3.136 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

3.137 This Schedule amends the ITAA 1997 to modify the consolidation tax cost setting and rights to future income rules so that the tax outcomes for consolidated groups are more consistent with the tax outcomes that arise when assets are acquired outside the consolidation regime. Human rights implications

3.138 This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

3.139 This Schedule is compatible with human rights as it does not raise any human rights issues.

Assistant Treasurer, the Hon David Bradbury