House of Representatives

Explanatory Memorandum

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

Chapter 1 - Strengthening scrip for scrip roll-over, small business and other concessions

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that certain integrity rules in the small business concessions and the scrip for scrip roll-over apply to life insurance companies, superannuation funds and trusts in the same way that they apply to other types of entities.

1.2 Schedule 1 to this Bill also ensures that these integrity rules (and the capital gains tax (CGT) provisions more generally) are applied as if absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and security providers are the owners of relevant assets. That is, under these provisions, the nominal owners are looked through to the underlying owners of such assets.

1.3 All legislative references in this chapter are to the ITAA 1997 unless otherwise stated.

Context of amendments

1.4 The 'connected entity' test in the small business entity provisions ensures that assets and turnover of related entities are taken into account in determining whether the limits for access to the relevant small business concessions have been exceeded.

1.5 The 'significant' and 'common' stakeholder tests contained in the CGT scrip for scrip roll-over are designed to ensure that an entity that has a sufficiently high level of ownership in both the original and acquiring entity cannot use the roll-over to defer tax indefinitely on the disposal of the underlying assets of the original entity.

1.6 Broadly, the connected entity test and stakeholder tests seek to determine whether an entity controls, or has the potential to control or influence another entity having regard to the interests held in that other entity that carry voting, income and capital rights.

1.7 Currently, these tests apply only if entities hold the relevant interests 'for their own benefit'. On one view, this requirement prevents the tests from applying to interests held by life insurance companies, superannuation funds and trusts because these entities do not own these interests for their own benefit, but rather for the benefit of their policy holders, members or beneficiaries.

1.8 As these entities can control or influence other entities by virtue of the interests that they own in those entities, it is appropriate that these tests be based on the legal ownership of interests, rather than on who benefits from those interests.

1.9 However, in determining whether these tests are satisfied, it would be inappropriate to use legal ownership for arrangements involving assets held on trust in respect of which there is an absolutely entitled beneficiary, assets of bankrupt individuals that have vested in their trustee in bankruptcy, assets of a company in liquidation that have vested in the liquidator or assets provided by an entity as security. This is because the intention of the CGT provisions is to treat these underlying entities (that is, the absolutely entitled beneficiary, bankrupt individual, company in liquidation or security provider) as the relevant taxpayer in respect of the asset - rather than the entity that legally owns the asset.

1.10 Currently, the CGT provisions treat an act done by an entity that owns an asset in these circumstances as being done by the underlying entity. However, there is uncertainty as to whether that is sufficient for the stakeholder tests to apply to the underlying owner of the relevant interests. This is because simply treating certain acts done by the owner as having being done by the underlying entity may continue to acknowledge the holding entity as the owner of the asset. There is also uncertainty about how these rules extend to the connected entity test, which is located outside the CGT provisions.

Summary of new law

1.11 Schedule 1 ensures that the small business connected entity test and the CGT scrip for scrip roll-over stakeholder tests apply on the basis of who owns relevant interests in an entity, rather than who benefits from the interests. This ensures that the tests apply to interests owned by life insurance companies, superannuation funds and trusts in the same way that they apply to interests owned by other types of entities.

1.12 Also, for these integrity rules and the CGT provisions more generally, absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and security providers (underlying entities) are treated as the owners of relevant assets. This ensures that the underlying entity, rather than the holding entity, is considered in the connected entity and stakeholders tests and, more broadly, that all CGT consequences in respect of those assets rest with the underlying owner, rather than with the holding entity.

Comparison of key features of new law and current law

Detailed explanation of new law

Stakeholder and connected entity tests

1.13 The small business connected entity test in Subdivision 328-C and the scrip for scrip stakeholder tests in section 124-783 seek to determine whether an entity has the capacity to control or influence another entity by having regard to the ownership of interests in that other entity. Despite this, the tests do not apply if the entity that owns an interest, and thus has control of the entity, does not benefit from the interest.

1.14 These amendments ensure that the connected entity and stakeholder tests apply having regard only to the legal ownership of the relevant interests, rather than to who benefits from the ownership. As a result, the tests apply to interests held by life insurance companies, superannuation funds and trusts in the same way that they apply to other types of entities. [Schedule 1, items 1 to 4, 7 and 8, paragraphs 124-783(6)(b) and (c), note in subsection 124-783(6), subsection 124-783(7), paragraphs 124-783(9)(b) and (c), and (10)(a) and (b), 328-125(2)(a) and (b), and 328-125(8)(e)]

Example 1.1 : CGT scrip for scrip roll-over stakeholder tests

Zhang Superannuation Fund owns shares in Dollars Ltd, which gives Zhang the right to receive 40 per cent of the dividends in Dollars. Cents Ltd later takes over Dollars, with the result that Zhang replaces its shares in Dollars with shares in Cents.

To determine the CGT consequences of this transaction under the CGT scrip for scrip roll-over, Cents will need to determine whether Zhang is a significant or common stakeholder for the arrangement.

Zhang is a significant stakeholder for the arrangement because it had a right to receive at least 30 per cent of dividends in Dollars (before the arrangement) and it also has a right to receive at least 30 per cent of the dividends in Cents (after the arrangement).

As Zhang is a significant stakeholder for the arrangement, Cents is required to determine the cost base of the shares it acquires in Dollars by reference to the cost base of those shares in the hands of Zhang (see section 124-782).

1.15 In regards to the small business connected entity test, if an entity (the first entity) directly controls a second entity, and that second entity also controls a third entity, the first entity is taken to control the third entity (see subsection 328-125(7)). The indirect control test is designed to look through business structures that include interposed entities. To ensure consistency with direct ownership structures, these amendments also determine whether an entity controls another entity in an interposed structure based on legal ownership of the relevant interests. [Schedule 1, items 7 and 8, paragraphs 328-125(2)(a) and (b), and 328-125(8)(e)]

Example 1.2 : Small business connected entity test

Polish Unit Trust owns 100 per cent of the shares in Shoe Pty Ltd. These are ordinary shares that carry full voting rights. As Polish owns at least 40 per cent of the shares in Shoe that carry full voting rights, this means it controls, and is connected with, Shoe.

Braxton is an individual who owns 100 per cent of the units in Polish that entitle him to 100 per cent of the distribution of capital. As such, Braxton is taken to control Polish. Therefore, as Braxton controls Polish, and Polish controls Shoe, Braxton is taken to control Shoe using the indirect control test.

1.16 It is argued that the law already applies in a way consistent with these integrity amendments. Consistent with that view, some taxpayers have prepared their income tax assessments on a basis consistent with these amendments, having done so based on how they understood the law applied.

1.17 These amendments accordingly ensure that the mere fact that there has been a change in the wording of the law cannot be used as evidence that there has been a change in the meaning of the law. [Schedule 1, items 6 and 10]

Absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and security providers

1.18 The CGT provisions apply on the basis that any act done by a trustee of an absolutely entitled beneficiary, a trustee in bankruptcy, a liquidator or a security holder is treated as if the act was done by the absolutely entitled beneficiary, bankrupt individual, company in liquidation or security provider (the underlying entity) as the case may be.

1.19 However, there is uncertainty as to whether those provisions (apart from the bankruptcy provisions - see paragraph 1.24) are sufficient to treat the underlying entity as the owner of an asset in applying the amended stakeholder tests that rely on the mere ownership or holding of an asset. That is, there is uncertainty whether passive acts (or things that simply happen to the holding entity) can be regarded as an act done by the holding entity. In addition, as the connected entity test is located outside of the CGT provisions, those provisions do not apply for the purposes of that test.

1.20 Accordingly, these amendments ensure that absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and security providers are treated as the owners of an asset for the purpose of the CGT provisions and the connected entity test.

Absolutely entitled beneficiaries

1.21 These amendments ensure that, just after a beneficiary becomes absolutely entitled to an asset of a trust (disregarding any legal disability), the asset is treated as an asset of the absolutely entitled beneficiary (and not an asset of the trustee) for the purpose of the CGT and connected entity provisions. In conjunction with treating any acts done by the trustee as being done by the absolutely entitled beneficiary, this has the effect that everything that happens to, or in respect of, the asset is taken into account in working out any CGT consequences in respect of that asset in the hands of the beneficiary. It also ensures that the connected entity and stakeholder tests in respect of the asset are determined by reference to the beneficiary. [Schedule 1, items 17 and 19, section 106-50 and note 2 in subsection 328-125(1)]

1.22 These amendments do not disregard the transfer of a taxpayer's asset to a trustee in the same way that the vesting of the asset is ignored in the case of bankrupt individuals, companies in liquidation and security providers - see paragraphs 1.24 to 1.34. Disregarding the transfer of the asset to the trustee may prevent that transfer giving rise to a CGT taxing point in an appropriate case.

Example 1.3 : Absolutely entitled beneficiary

Mary owns 50 per cent of the shares in Soil Limited. These are ordinary shares that give Mary full voting rights. Mary transfers these shares into a trust, and therefore CGT event E2 happens.

One year later, Marina becomes absolutely entitled to those shares and, as a consequence, CGT event E5 happens.

For the purposes of the CGT and the connected entity provisions, Marina is treated as the owner of the shares just after she becomes absolutely entitled to those shares.

Following this, Soil merges with Dirt Limited, with the shareholders in Soil exchanging their shares for shares in Dirt. To determine the CGT consequences of this transaction under the CGT scrip for scrip roll-over, Dirt will need to determine whether Marina is a significant or common stakeholder for the arrangement.

Marina is a significant stakeholder for the arrangement because she owned at least 30 per cent of the shares in Soil that carry voting rights before the arrangement and she now owns at least 30 per cent of the shares in Dirt that carry voting rights.

1.23 CGT events E1 and E2 do not happen if a taxpayer creates a trust over an asset or transfers an asset to an existing trust, so long as the taxpayer is absolutely entitled to the asset as against the trustee (see the conditions in subsections 104-55(5) and 104-60(5)). Whilst these amendments do not affect the operation of this exception, these cases still benefit from the amendments described in 1.21.

Bankrupt individuals

1.24 Section 106-30 provides that, for the purpose of the CGT provisions, the vesting of an asset in a trustee in bankruptcy under the Bankruptcy Act 1966 is ignored. This ensures that the bankrupt individual continues to be treated as the owner of the asset for the purpose of the CGT provisions so that all CGT consequences flow to that entity.

1.25 The amendments extend the disregarding of the vesting so that the bankrupt individual is also treated as the owner of the asset for the purpose of the connected entity test. In conjunction with treating any acts done by the trustee as being done by the bankrupt individual, this ensures that the test is conducted with reference to the bankrupt individual, rather than to the trustee. [Schedule 1, items 12 to 14 and 19, subsections 106-30(1) and (2), and note 1 in subsection 328-125(1)]

1.26 As the vesting of the asset in the bankrupt trustee is ignored under section 106-30, it is not possible for a CGT event to happen as the asset is treated as though it continues to be owned by the bankrupt individual. Therefore, these amendments remove the bankruptcy exception in the CGT acquisition rules and in CGT event A1. [Schedule 1, items 11 and 18, subsection 104-10(7) and section 109-15]

Companies in liquidation

1.27 Generally, liquidators control the assets of a company in liquidation because they control the company. However, in some rare cases, the Court may order that the assets of the company vest in a special purpose liquidator.

1.28 Accordingly, these amendments ignore the vesting of the assets in the liquidator, ensuring that for the purposes of the CGT and the connected entity provisions, a company under liquidation continues to be treated as the owner of the asset. In conjunction with treating any acts done by the liquidator as being done by the company, this has the effect that everything that happens to or in respect of that asset is taken into account in working out any CGT consequences in respect of that asset in the hands of the company. It also ensures that the connected entity and stakeholder tests are determined by reference to the company. [Schedule 1, items 16 and 19, section 106-35 and note 1 in subsection 328-125(1)]

1.29 As the vesting of the asset in the liquidator is ignored under these amendments, it is not possible for a CGT event to happen as the asset is treated as though it continues to be owned by the company. Therefore, these amendments remove the liquidation exception in the CGT acquisition rules and in CGT event A1. [Schedule 1, items 11 and 18, subsection 104-10(7) and section 109-15]

Example 1.4 : Company in liquidation

Debbie Liquidators Pty Ltd has been appointed as a special purpose liquidator for Shandil Limited. All of Shandil's assets vest in Debbie.

As a result of a fire, certain CGT assets of the business are destroyed. These amendments ensure that any CGT consequences associated with the destruction of the assets rest with Shandil, rather than with Debbie.

Security provider

1.30 A security holder may own an asset while some of the rights of ownership remain with the security provider. This may happen where an asset is sold and the vendor holds the asset to secure payment for that sale from the purchaser. Although the vendor is the legal owner of the asset, it must exercise any voting rights at the direction of the purchaser, and it is the purchaser who is entitled to benefit from the income and capital of the asset.

1.31 Subdivision 106-D applies to acts done only 'for the purpose of enforcing or giving effect to a security, charge or encumbrance the entity holds over the asset'. A security holder may also do acts on behalf of a security provider that are not for this purpose. For example, they may exchange shares in a scrip for scrip transaction as part of a merger of the company that issued the shares held as security. Accordingly, these amendments ensure that any act done in relation to maintaining a security, charge or encumbrance over an asset is also taken to be done by the security provider and covers, for example, any act that is done to look after, protect and manage the asset whilst it is under a security arrangement. [Schedule 1, item 17, subsection 106-60(2)]

1.32 These amendments also ignore the vesting of an asset in a security holder, ensuring that, for the purposes of the CGT and connected entity provisions, the security provider is still treated as the owner of the assets. In conjunction with treating any acts done by the security holder as being done by the security provider, this has the effect that everything that happens to or in respect of that asset is taken into account in working out any CGT consequences in respect of that asset in the hands of the security provider. For the connected entity and stakeholder tests, this ensures that those provisions are determined with reference to the security provider. [Schedule 1, items 17 and 19, section 106-60 and note 3 in subsection 328-125(1)]

1.33 Where a security holder continues to own an asset that has vested in them from a security provider, but they cease to hold a security, charge or encumbrance over that asset, these amendments treat the asset as having vested in the security holder at that time. This ensures a CGT taxing point arises as a result of the vesting, recognising there has been a change in ownership and control of that asset from the security provider to the security holder. [Schedule 1, item 17, paragraph 106-60(1)(b)]

1.34 As the vesting of the asset in the security holder is ignored, no CGT consequences arise when the asset is transferred to the security holder, or redeemed from the security holder as a result of the security arrangement coming to an end as the asset is treated as though it continues to be owned by the security provider. Therefore, these amendments remove the security holder exception in the CGT acquisition rules and in CGT event A1. [Schedule 1, items 11 and 18, subsection 104-10(7) and section 109-15]

Example 1.5 : Security provider

Cissie owns shares in Chen Ltd which gives her rights to receive 30 per cent of the voting power and dividends of Chen Ltd. Cissie enters into a loan with Boyd Bank and transfers her shares in Chen Ltd as security.

Chen's shareholders enter into a scrip for scrip transaction with another entity. Boyd Bank chooses the CGT scrip for scrip roll-over on behalf of Cissie for the capital gains that would otherwise be made.

Although accepting a scrip for scrip transaction is not an active act for the purpose of enforcing a security, these amendments ensure that any act done in relation to maintaining the security arrangement is done by Cissie. Cissie is also treated as the owner of the shares for the purposes of the CGT and connected entity provisions.

No CGT consequences arise when the original shares are transferred to Boyd Bank or subsequently when the replacement shares are redeemed from the Bank on completion of the security agreement.

Application provisions

1.35 Table 1.1 describes the application provisions that are relevant to the integrity amendments to the connected entity and stakeholder tests.

[Schedule 1, items 5 and 9]

Implications for provisions outside the wine equalisation tax regime

1.36 The integrity changes that affect the CGT provisions are retrospective to ensure that transactions that have taken place after the announcement are covered by these amendments. This provides certainty for transactions that have occurred since the time of announcement. [Schedule 1, items 5 and 9]

1.37 To the extent that provisions are affected other than the CGT and wine equalisation tax regimes, the amendments apply from the 2011-12 income year and later income years. This covers the concept of a small business entity in the Excise Act 1901 , the Customs Act 1901 and in the provisions listed in items 5 to 12 in the table in section 328-10. This date ensures that taxpayers are not affected by these changes mid-way through an income year. [Schedule 1, items 5 and 9]

Implications for the wine equalisation tax regime

1.38 The connected entity test is used to define an 'associated producer' for the purposes of the A New Tax System (Wine Equalisation Tax) Act 1999 (WETA 1999). These rules ensure that a wine producer cannot access an additional amount of wine equalisation tax rebate by dividing its business into separate entities.

1.39 Eligibility for the wine equalisation tax rebate is based on financial years rather than income years. Therefore, to be consistent with these provisions and to ensure there are no retrospective impacts on the WETA 1999, these changes apply from the first financial year on or after the commencement of the amendments. [Schedule 1, item 9]

Look-through treatment for certain entities

1.40 Table 1.2 describes the application provisions that are relevant to the amendments that provide look-through treatment for certain entities.

[Schedule 1, item 20]

1.41 Whilst these look-through changes can be retrospective, they are only so at the option of the taxpayer. Therefore, taxpayers are not disadvantaged by the potential retrospectivity.

1.42 To the extent these provisions affect non-CGT provisions, they apply automatically from the first income year (or financial year for WETA 1999 cases) on or after the day these amendments commence. This ensures taxpayers will not be disadvantaged by these changes mid-way through an income year and may be particularly relevant for provisions under the WETA regime (see paragraphs 1.38 to 1.39).

Amendment of assessments

1.43 The operation of section 170 of the Income Tax Assessment Act 1936 (which provides time limits for amending assessments) is modified for these amendments if they apply prior to their commencement. Therefore, taxpayers can seek an amended assessment to access changes where their amendment period would otherwise expire. Broadly, taxpayers are able to seek an amended assessment in these circumstances within two years of these amendments commencing. [Clause 4]

Consequential amendments

1.44 Consequential amendments provide an example to the CGT bankruptcy provisions demonstrating that disregarding the vesting in the bankruptcy trustee produces no CGT taxing point when the vesting occurs. In addition, any CGT consequences associated with that asset are taken to be made by the bankrupt individual, rather than the bankruptcy trustee. [Schedule 1, item 15, example in section 106-30]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

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

Strengthening scrip for scrip roll-over, small business and other concessions

1.45 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

1.46 Schedule 1 ensures that the small business connected entity test and the scrip for scrip roll-over stakeholder tests apply on the basis of who owns relevant interests in an entity, rather than who benefits from the interests. This ensures that the tests apply to interests owned by life insurance companies, superannuation funds and trusts in the same way that they apply to interests owned by other types of entities.

1.47 Also, for these integrity rules and the CGT provisions more generally, absolutely entitled beneficiaries, bankrupt individuals, companies in liquidation and security providers are treated as the owners of relevant assets. This ensures that the underlying entity, rather than the holding entity, is considered in the connected entity and stakeholders tests and, more broadly, that all CGT consequences in respect of those assets rest with the underlying owner, rather than with the holding entity.

Human rights implications

Integrity changes

1.48 The integrity changes largely apply from the time of announcement to provide certainty for transactions that occur from this time. Whilst these changes are retrospective, it is not expected that this produces any disadvantage that taxpayers were unaware of, as taxpayers were put on notice about these amendments, including the application date for them, by the 2011-12 Budget announcement. A proposals paper detailing these changes was released shortly after the announcement on 27 May 2011.

Look-through treatment for certain entities

1.49 Whilst the look-through changes are largely retrospective from the 2008-09 income year, they are only so at the option of the taxpayer. Therefore, taxpayers are not disadvantaged by the retrospectivity of these changes.

Conclusion

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

Assistant Treasurer, the Hon David Bradbury