SENATE

Explanatory Memorandum

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

Chapter 7 Tax exempt entities that become taxable

Overview

7.1 The amendments contained in Schedule 2 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to insert a new Division 57 to provide for transitional tax issues which arise when an entity the income of which is exempt becomes, for any reason, subject to tax on any part of its income under the provisions of the Act.

Summary of the amendments

Purpose of the amendments

7.2 The amendments will alter the operation of the Act to ensure that all, and only, the income, deductions, gains and losses that relate to the period after an entity's transition to taxable status are taken into account in determining the tax position of the entity [new section 57-1] . The provisions will apply to Government exempt entities which are privatised either by legislation or by sale to private interests and non-Government exempt entities which cease to be exempt.

Date of effect

7.3 The amendments will apply to entities which become taxable on or after 3 July 1995. [Item 2]

Background to the legislation

7.4 There are several possible models for dealing with the tax consequences of a change from exempt to taxable status.

New taxpayer

7.5 Under this model, an entity becoming taxable is treated as if it comes into existence at the moment it becomes taxable. Such a new taxpayer has assets and liabilities and a variety of rights and obligations. Unless costs of its assets and consideration for its liabilities are imputed to it, it will have extreme tax consequences of any realisation of assets or satisfaction of liabilities; the most obvious way of dealing with this is to impute to the new taxpayer costs and consideration based on value at the moment the entity becomes taxable. Depreciation would have to be based on an imputed cost of depreciable assets, as otherwise all depreciation for existing assets would be denied; again, the market value at the moment the entity becomes taxable is an obvious possible starting point. Income and outgoings, if treated on the basis that the entity is a new taxpayer, could fall capriciously: that is, income could be fortuitously derived before or after the moment the entity becomes taxable and comes into existence as a taxpayer, and outgoings could arise similarly. A 'new taxpayer' model suggests that only what is derived or incurred by the new taxpayer is and is wholly relevant to the new taxpayer's tax position.

Continuing taxpayer without modification

7.6 This model involves the application of the existing law without modification. It results in the transition to taxable status having both positive and adverse income tax consequences. For instance, an assessable profit realised after transition will form part of assessable income, even if its value did not increase after transition. Many transitions to the Commonwealth tax net have so far occurred by this 'seamless transition' approach, or have relied on it with only minor modifications.

Continuing taxpayer, apportionment to taxable period

7.7 This model is colloquially referred to as the 'rule the books' approach. It involves ensuring that, to the extent that is practical, only income and deductions, gains and losses and tax effects that relate to the taxable period are included in that period, while those relating to the exempt period are excluded. In many cases, the simplest way to do this in relation to later gains and losses is by reference to the market value of assets and liabilities, when the entity becomes taxable, and so on these issues this will produce the same solutions as the most likely imputed costs and consideration under the 'new taxpayer' model.

7.8 Legislation modifying the Act has been introduced on a 'case by case' approach for Government Business Enterprises (GBEs) that have become taxable. In each case the tax implications of the entity becoming taxable have been considered and the operation of the Act modified for specific tax issues.

7.9 The taxation issues are the same for both private and Government owned entities changing from exempt to taxable status. A privately owned entity that is exempt, for example under paragraph 23(g) of the Act for the promotion of sport, might lose its exempt status, for example when it starts to be carried on for other purposes. A Commonwealth GBE will become taxable when the Commonwealth Government legislates to make the GBE taxable even without any change of ownership. A GBE will cease to be exempt when it is wholly or partially transferred to private beneficial ownership. At present State and Territory GBEs are exempted from income tax as State/Territory bodies under section 24AM of the Act. A GBE ceases to be an STB usually if it ceases to be wholly owned by a State or Territory.

Preferred approach

7.10 To date the approach when government entities are privatised has been either the 'seamless transition' or the continuing taxpayer, apportionment to taxable period models. The previous Government decided however, that the latter model represented the fairest method of bringing new taxpayers into the Commonwealth tax net. The model ensures that an entity's gains, losses, income and deductions that relate to the period of exemption are not included in calculating assessable income. It also ensures that only outgoings which relate to the derivation of assessable income are allowed as deductions when calculating its tax position.

7.11 The previous Government announced on 3 July 1995 that legislative changes would be introduced to give effect to this general rule, and to specific applications of the rule in relation to some particular issues, with effect from the date of announcement. This Bill includes the broad provisions of the general rule and the specific applications announced by the previous Government, other than the specific application to franking credits, which will be put before the Parliament at a later time.

Explanation of the amendments

Entities to which the Division applies

7.12 New Subdivision 57-A sets out the circumstances in which the Division applies. New section 57-5 provides a test to work out if the Division applies to an entity.

7.13 Under new paragraphs 57-5(a) and (b) if at any time;

•

all of the income of an entity is fully exempt from income tax; and

•

immediately afterwards, any of its income becomes assessable to any extent; then

new Division 57 applies.

7.14 The need for all income of an entity to have been exempt for the Division to apply means that entities that receive only partial exemption from income tax on their income are not subject to the provisions if that partial exemption is removed. For example the provisions would not apply to a taxpayer, that is otherwise subject to tax on its income but has an exemption from income tax for one component of its income if that exemption is removed.

7.15 Conversely, the Division applies if any part of a fully exempt entity's income becomes assessable to any extent. So the provisions would apply even if an entity remained exempt from income tax on part of its income, and even if the part of its income that became assessable was only partly so, for instance because only a proportion of that income was to be brought to account as assessable.

7.16 An entity to which new section 57-5 applies because at least part of its income has become at least partly assessable, is termed the transition taxpayer . The time at which at least part of its income becomes assessable to at least some extent is the "transition time" [new paragraphs 57-5(c) and 57-5(d)] . Although the term transition taxpayer is used the term applies to identify the entity in relation to matters arising before, at, and after the transition time.

7.17 Under new paragraph 57-5(e) the year of income of the newly taxable entity in which the transition time occurs, that is, in which at least a part of its income becomes at least partly assessable is called the 'transition year" for the entity.

7.18 The provisions apply to a taxpayer for which a transition time occurs. It is possible for a taxpayer to be wholly exempt from income tax to the end of one year of income and commence to be assessable at the beginning of the following year of income. In that case, the transition time occurs at the beginning of the year in which the taxpayer commences to be assessable, and that year is the 'transition year'. The operative provisions of this Division are designed so that such a transition time does not hinder their operation. There is always a transition year, because the time when at least part of an entity's income becomes at least partly assessable always occurs in a year of income.

Predecessors of the transition taxpayer

7.19 Certain Government owned transition taxpayers may be undertaking activities which were previously undertaken by another Government owned entity or emanation of the State.

7.20 The predecessor may have incurred expenditure on long lived assets which, if the entity had been taxable, would have been deductible over several years.

7.21 In such circumstances it is appropriate that the transition taxpayer obtain the benefit of such deductions as would remain to the predecessor if it had become taxable itself at the time when the transition taxpayer became taxable.

7.22 New section 57-10 will therefore ensure that deductions to those transition taxpayers for capital expenditure which is deductible over more than one year will be based on the amount paid originally by the predecessor.

7.23 The following is an example of how this will work in practice:

•

A GBE carries on the complete range of timber operations as defined in Division 10A of the Act. That is; planting, tending , felling, removing and milling.

•

In year 1 the GBE incurs capital expenditure which would (if it were taxable) be deductible under sections 124F (access roads) and 124JA (timber mill building) over a 25 year period.

•

In year 5 the timber milling activities only are transferred to a corporate entity (the transition taxpayer) set up by the Government specifically for that purpose.

•

In year 10 the transition taxpayer is sold to private interests, thus becoming taxable.

The transition taxpayer would therefore be entitled, through the interaction of new sections 57-10 and new Subdivision 57-J to the remaining 15 years of deduction under section 124JA for the expenditure incurred by the GBE.

7.24 The transition taxpayer would not, however, be entitled to any deduction for the expenditure on access roads which relates to the remaining timber operations that were not transferred to it and remain in Government hands.

Income of the exempt period

7.25 New section 57-15 ensures that the 'rule the books' approach applies correctly to income derived by an entity that relates to the period before the transition time. The section ensures that to the extent that income is derived by an entity after the transition time for services rendered or goods provided or the doing of any other thing before that time, the income is treated for the purposes of the Act as having been derived before that time. Interest can be considered to be received in respect of the doing of a thing, being the allowing of a sum of money to a borrower. The interest income would be considered to be derived over the period that the money was lent.

7.26 One of the situations which the provision applies to is the supply of goods in advance of billing. For example an energy utility, which provides gas to customers prior to the transition time but bills customers in the post transition period, will not be assessable in the post transition period to the extent to which unbilled gas had been supplied to customers prior to the transition time.

Income of the taxable period

7.27 New section 57-15 alsoensures that the correct apportionment is made of income derived by an entity that relates to the period after it becomes taxable. The section ensures that to the extent that income is derived by an entity before the transition time for services rendered or goods provided or the doing of any other thing at or after that time, the income is treated for the purposes of the Act as having been derived at or after that time. The income is treated as having been derived at the time or over the period in which the services were rendered or goods provided or the thing was done.

7.28 The situations to which the provision will apply include those in which an entity is paid in advance for goods or services before the transition time but does not earn the income until the goods or services are provided after the transition time.

7.29 An alternative approach would have been to make no legislative provision, but to have relied upon the decision in Arthur Murray (NSW) Pty Ltd v FC. of T (1965)
114 CLR 314 . That decision provides authority for the view that in some circumstances the price of services paid for in advance is derived only as the services are provided.

7.30 The legislative approach was however adopted to place beyond any doubt the treatment that applies to all prepayments for things to be done at or after the transition time, even if the prepayment could be said to be derived earlier and not to be derived after the transition time.

Deductions of the taxable period

7.31 New section 57-20 ensures that the rule the books approach applies correctly to deductions allowable to the transition taxpayer. The section applies to a loss or outgoing incurred by an entity before the transition time to the extent that it is for services rendered, goods provided, or the doing of any other thing once the entity was at least partly taxable. The effect of the provision is to treat the appropriate part of the loss or outgoing as having been incurred for the purposes of the Act at the time when the entity was taxable; the time the services were rendered or the goods provided or the thing was done. That part of the loss or outgoing will therefore be taken to be deductible. The time at which this occurs may fall within the transition year or may extend beyond it over one or more years of income.

7.32 A payment which qualifies for a deduction under subsection 51(1) may be made by an entity before the transition time for services performed for it in part during the month before the transition time and equally during the month after the transition time. The effect of the provision would be to allow one half of such expenditure as a deduction in the post transition period.

Deductions of the exempt period

7.33 It has been suggested in the past that losses or outgoings incurred while a taxpayer's income is exempt might be deductible, so far as they were expected to contribute to assessable income. On this view, an exempt body which planned a change of status might get tax deductions denied to a similar body which became taxable unexpectedly - perhaps because of a change to the law. That view is not correct; and in any event new section 57-20 ensures that deductions depend on the extent to which losses or outgoings relate to the provision of services, goods or other things once the activity has become subject to taxation, not on the extent of the entity's notice of the change. Combined with the provisions of new subdivision 57-E , relating to assets and liabilities, this attributes deductions to their proper periods.

7.34 New section 57-20 also ensures the correct apportionment of deductions incurred by an entity after it becomes taxable. The section applies to a loss or outgoing within the meaning of the general deduction provision, section 51. Such a loss or outgoing may be wholly or partly incurred by an entity at or after the taxable transition but for services rendered or goods provided or the doing of some other thing before the transition time. The loss or outgoing is treated to that extent as having been incurred at the time the services were rendered or the goods provided. So the loss or outgoing will not be deductible to that extent.

Deemed disposal and re acquisition of assets

7.35 The amendments will generally treat the assets of newly taxable entities as having been disposed of immediately before the entity becomes taxable and re-acquired when it becomes taxable, for the purposes of determining future gains or losses arising from disposal of those assets [new subsections 57-25(1) and (2)] . This effectively allocates that part of any gains and losses which relate to the period of exemption to that period and ensures that only increases or decreases in value from the transition time are relevant in determining a gain or loss on a particular asset.

7.36 New subsection 57-25(3) will deem the assets of the newly taxable entity to have been reacquired at 'adjusted market value' at transition time. This provision overcomes the problem of 'double exclusion' or 'double inclusion' of income as a result of the operation of new sections 57-15 and 57-25 in relation to certain assets, if an unadjusted market value was used. This is better illustrated by example.

Example 1:

Assume an exempt taxpayer acquires an interest bearing security at year 1 (T1) for $100; interest of $10 is received in arrears at T2, T3, T4 and T5; the security is redeemed at T5; transition time is T/T; and at T/T $6 of the $10 interest receivable at T3 has accrued. Also, the prevailing interest rates at T/T are the same as those that existed at T1, and the market value of the instrument is $106.

7.37 At T/T both new section 57-15 and new section 57-25 apply. The total cash flow resulting from the application of new section 57-15 alone is $24; $4 at T3, $10 at T4 and at T5 with no gain or loss at redemption. However, with the application of both new sections 57-15 and 57-25 , using an unadjusted market value, the result is $18; $4 at T3, $10 at T4 and at T5 and a $6 loss at redemption ($106 - $100). Under this approach the $6 interest which accrued prior to the transition time would have been excluded twice from the assessable income - once through the operation of new section 57-15 (at T3) and then again as a deduction for $6 loss on redemption through the operation of new section 57-25 . The market value thus needs an adjustment to ensure that double counting does not occur.

Example 2:

Assume similar facts to example 1 except that interest is received in advance.

7.38 Similar difficulties arise where interest is received in advance. In the example, $4 of the interest received in advance at T2 in respect of the taxable period (ie. for the period from T/T to T3) would be included twice in the assessable income - once through the operation of new section 57-15 and then again as a $4 gain at redemption through the operation of new section 57-25, if an unadjusted market value was used. The gain results because the market value of the asset at transition time is taken as $96 (ie. the $4 interest received in advance at T2 is reflected in the market value) and it is redeemed at $100.

7.39 The double inclusion and exclusion referred to above could happen where interest is received or accrues on an asset on a daily basis. Interest could be received either in advance or in arrears. New section 57-15 will apply at transition time to effectively allocate any interest income relating to the exempt period to that period and will ensure that only interest income relating to the period after transition time is allocated to that period. At the same time new section 57-25 also applies and deems a disposal and re-acquisition of the asset.

7.40 The difficulty as explained above is overcome by new subsection 57-25(3) deeming the re-acquisition of assets at their 'adjusted market value' . The adjusted market value is taken to be the asset's market value at transition time reduced by any amount received or receivable in respect of the asset after the transition time that would have otherwise been included in the assessable income, but for either (i) the operation of new subsection 57-15(2) or (ii) the taxpayer being exempt from tax. The market value will be increased by any amount received or receivable in respect of the asset before the transition time that is included in the assessable income because of the operation of new subsection 57-15(1) or because the transition taxpayer's income ceased to be exempt from income tax. An amount could also be held assessable and thus included in the assessable income of the transition taxpayer by virtue of other provisions, eg subsection 25(1) or Division 16E. Any amount so included will need an adjustment because it will affect the market value the same way it does for amounts included under new subsection 57-15(1) .

7.41 The 'adjusted market value' concept in new subsection 57-25(3) will generally only have an effect on financial assets like interest bearing loans and interest rate swaps which also have a cash flow.

7.42 For instance, an asset which was purchased by the entity for, say, $100 but has a market value of $120 at the time when the entity becomes taxable, will be taken, for the purposes of determining future gains or losses arising from disposal of that asset, to have been acquired by the entity for $120. If the asset is later sold for $125, the maximum amount that could be assessable in respect of the sale is $5.

7.43 There are some exceptions to the general rule established in new subsection 57-25(2) . The general revaluation of assets provided for in that subsection will not apply for the purposes of section 54 to 62AAV, Divisions 10 to 10D or Subdivision B of Division 3 of Part III of the Act [new subsection 57-25(4)] . This provision makes it clear that depreciation and other capital allowance deductions will be based on the original cost of the particular items of plant or property.

7.44 This general rule is considered to be more appropriate than seeking to bring to account on disposal of an asset a proportion of an overall gain or loss, based on the original actual cost of the asset, and apportioned between the part of the time for which the asset was held before the transition time and the balance of the period for which it was held.

7.45 One effect of this general rule is that assets acquired by the entity before the date of effect of the capital gains provisions will nevertheless be treated as acquired later, and so possibly subject to those provisions when sold. This might be thought to be inconsistent with the 'rule the books' approach. However, assets are deemed to have been disposed of and reacquired in any event for the purposes of the capital gains tax provisions once a majority of underlying interests change (see section 160ZZS). As entities most commonly become taxable in the context of progressive privatisation, a failure to apply this general rule could be likely to hinder the orderly privatisation of formerly exempt government entities.

7.46 The exceptions mentioned above are only for the purposes of the operation of those sections. The assets are still subject to the deemed disposal and re-acquisition rule in quantifying any gain or loss made on the subsequent disposal or change in value of that asset.

7.47 Similarly new subsections 57-25(5) and (6) are inserted to ensure that the deemed acquisition rule in new subsection 57-25(2) will not affect the operation of sections 26BB, 26C, 70B or Divisions 3B and 16E of Part III. The dates of effect of those provisions ensure, for example, that certain securities do not come within their operation. Where an asset was acquired before the date of effect of those provisions and therefore should not be affected by those provisions, the deemed acquisition in new subsection 57-25(2) will not make those assets subject to those provisions. For example an asset acquired by an entity on or before 10 May 1989 will not, because of the operation of new subsection 57-25 , now be subject to section 26BB. Again the assets themselves will still be subject to the deemed disposal and re-acquisition rule for the purposes of quantifying any future gain or loss.

7.48 The fact that the transition taxpayer is taken to have purchased its assets at the transition time does not mean that deductions which have been incurred before the first taxing time and which are for goods provided, services rendered or the doing of another thing in that period are reincurred and become deductible. Similarly, the deemed acquisition rule does not mean that a deduction which is incurred at or after the transition but which is in respect of goods provided, services rendered or the doing of some other thing in the exempt period loses its relationship to the exempt period. This is made clear by new subsection 57-25(1) , which provides that the section applies to the disposal of an asset after the transition time.

7.49 A loan asset of a newly taxable entity may have a market value, due to the amount of doubtful debt provision, considerably less than its face value. New subsection 57-25(7) puts beyond doubt that if the market value of the debt is lower than the face value of the debt less the specific provision, then a deduction in the event of writing off the debt as bad is limited to this lower amount.

7.50 The words 'disposed of' are meant to be given the widest possible meaning to cover all forms of disposal. As such an act of disposal would therefore include certain actions which may not effect an alienation of the asset or right to payment like an extinguishment of a debt [new subsection 57-25(8)] .

Deemed cessation and re-assumption of liabilities

7.51 For the purposes of working out deductions that are allowable or gains that are assessable after the transition time, the amendments will treat liabilities of an entity as having been satisfied immediately before the entity becomes taxable and then assumed again immediately after it becomes taxable [new subsection 57-30(1)] . The entity will be taken to have received consideration in return for taking on these liabilities equal to the market value of the corresponding asset or right held by the person to whom the liability is owed. This is because it is not strictly possible to talk about a liability as having a market value of its own. In broad terms, liabilities will be valued at the amount the entity would have had to pay to meet those liabilities immediately before it became taxable.

7.52 The deemed re-assumption of liabilities could have an effect, for instance, where the entity subsequently satisfies a liability that it had before it became taxable. Assume the entity originally received $900 from the issue of a discounted security and is required to pay $1000 to the holder on maturity. If half of the discount period had elapsed at the time of the entity becoming taxable then, in broad terms, half of the discount expense would have accrued during that period. In that case, the entity could expect to obtain a deduction after it becomes taxable of $50, in respect of the remaining discount expense. However, if the market value of the security at the time it becomes taxable was, say, $940, the effect of new subsection 57-30(1) would be to allow a deduction of $60, being the difference between the consideration deemed to have been received at the time of becoming taxable and the amount required to be paid on maturity (ie. $1000 - $940).

7.53 The market value of the right or other asset corresponding to the liability that has been re-assumed has to be adjusted in a similar way to that done for assets in new subsection 57-30(3) . This is done to overcome the problem of 'double exclusion' or 'double inclusion' of an amount of deduction for interest paid as a result of the operation of new sections 57-20 and 57-30 . The following example illustrates the problem.

Example 3:

Assume an exempt taxpayer borrows $100 at T1, interest payments of $10 are due at T2, T3, T4 and T5, the transition time is T/T, at T/T $6 of the interest payment payable at time T3 is due. The prevailing interest rates at T/T are the same as existed at T1, and the market value of the loan at T/T is $106. The loan matures at T5.

7.54 New sections 57-20 and 57-30 both apply at T/T. The total amount of deduction allowable as a result of the application of new section 57-20 alone is $24; $4 at T3, $10 at T4 and at T5 with no gain or loss at final settlement/discharge. However, with the application of both new sections 57-20 and 57-30 using an unadjusted market value, the result is $18; $4 at T3, $10 at T4 and at T5 with a $6 gain on settlement ($106 - $100). Under this approach the $6 interest payment which relates to the exempt period has been excluded twice from deductibility - once through the operation of new section 57-20 and then again through the operation of new section 57-30 total deduction allowable has been reduced by $6 because the liability is taken to be $106 ( ie. at T/T the $6 interest payment relating to the exempt period is reflected in the market value of the corresponding asset). To overcome this problem the market value of the corresponding asset needs adjustment.

Example 4:

assume similar facts to example 3 except that interest is paid in advance.

7.55 Where interest payment is made in advance the $4 interest paid in advance at T2 in respect of the taxable period (ie between T/T and T3) is allowed as a deduction twice - once through the operation of new section 57-20(1) and then again through the operation of new section 57-30 a deduction of $4 is allowable for the loss on final settlement because the liability is taken to be at $96. This loss is also only a paper loss. An adjustment to the market value of the corresponding asset is required to overcome this problem.

7.56 The difficulty as explained above is overcome by new subsection 57-30(2) which deems the liabilities to have been re-assumed at the transition time in return for consideration equal to the 'adjusted market value' of the right or the corresponding asset.

7.57 The 'adjusted market value' of the right or other corresponding asset is taken to be the market value of the right or corresponding asset reduced by any amount paid or that became payable in respect of the liability that is not an allowable deduction either because of new subsection 57-20(2) or because of any other provision of the Act; and increased by any amount paid or that became payable in respect of the liability that is allowed or allowable as a deduction either because of new subsection 57-20(1) or because of any other provision of the Act.

7.58 The definitions of asset and liability have been deliberately cast widely to ensure that appropriate assets and liabilities are included in the revaluation [new section 57-35] . Trading stock has been excluded from the definition of asset because it is dealt with in new section 57-115 .

7.59 Assets and liabilities which would not be appropriately treated under new Subdivision 57-E would be those dealt with under the specific provisions of new sections 57-15 and 57-20 . For example, the transition taxpayer may have derived, but not received, income before the transition time. At transition time it will have an asset viz. the right to receive income. When the income is actually received the asset is arguably disposed of. In this case a specific provision [new section 57-15] will have correctly allocated the income so there is no further function for new section 57-25 to perform.

Superannuation contributions

7.60 Section 82AAC of the Act allows a deduction, in general terms, for superannuation contributions made by an employer to a complying superannuation fund for the benefit of an employee.

7.61 New section 57-40 modifies how section 82AAC applies to contributions under a defined benefit scheme made by a transition taxpayer in relation to an employee.

7.62 New section 57-45 allows a deduction to a transition taxpayer in the transition year for any surplus existing at the transition time in respect of a defined benefit scheme.

7.63 New section 57-50 modifies how section 82AAC applies to contributions made by a transition taxpayer to superannuation funds generally. Contributions will include those made to accumulation funds and to defined benefit schemes.

7.64 In each case, superannuation contributions that would otherwise be allowable are available only to the extent that they exceed unfunded liabilities at the transition time and outstanding contributions at that time. New section 57-55 will ensure that deductions are not reduced under both new sections 57-40 and 57-50 .

Defined benefit contributions

7.65 New section 57-40 applies to a superannuation contribution made by a transition taxpayer:

•

under a defined benefit scheme (within the meaning of section 6A of the Superannuation Guarantee (Administration) Act 1992) ; and

•

in relation to a person who was ever, whether before or after the transition time, an employee of the entity [new subsection 57-40(1)] .

The section will deny a deduction for contributions to defined benefit schemes to the extent of any overall shortfall at the transition time in defined benefit schemes.

7.66 New subsection 57-40(2) provides that such contributions are not tax deductible if total contributions in a year of income don't exceed a threshold amount, termed the 'defined benefit threshold amount' . This term is defined in new subsection 57-40(4) to mean, if the relevant year is the transition year, the transition taxpayer's 'unfunded liability amount' . The latter amount refers to the deficit which occurs when the transition taxpayer has outstanding unfunded liabilities to provide benefits for its employees, based on actuarial principles.

7.67 In a year of income after the transition year, new paragraph 57-40(4)(b) provides that the 'defined benefit threshold amount' is the amount worked out for the transition year as reduced by contributions denied as a deduction to the transition taxpayer in previous years under new subsections 57-40(2) or (3) . The amount will be progressively reduced in this way until it is extinguished.

7.68 If total contributions in a year of income exceed the 'defined benefit threshold amount' , the excess is deductible. New subsection 57-40(3) is required because it is possible to make more than one contribution in a year and each separate contribution is potentially deductible. The subsection provides that if the sum of all superannuation contributions in a year exceed the deduction limit in new subsection 57-40(2) , then an allocation of a part of the deduction limit to be disallowed is made to each superannuation contribution made in the year. This has the effect of allocating to each individual deduction a proportion to be disallowed based upon the ratio of the threshold limit to the total deductions otherwise allowable.

7.69 In the transition year the 'unfunded liability amount' is defined by new subsection 57-40(5) as the actuarial value of the liabilities for superannuation benefits which the transition taxpayer must provide for employees or dependants of employees of the transition taxpayer, that:

•

had accrued at the transition time;

•

were, based on actuarial principles, unfunded at that time; and

•

related only to defined benefit schemes.

Fund surpluses

7.70 A defined benefit scheme may have a surplus in the reserves of the scheme. The surplus would be available to meet the benefit obligations of the scheme and would therefore reduce the actuarial value of the unfunded obligations of the scheme in determining the 'unfunded liability amount' of the scheme.

7.71 New section 57-45 provides therefore that a transition taxpayer will be entitled to a tax deduction in the transition year for the amount of any remaining surplus in excess of the unfunded liabilities. The deduction is only allowable where an amount has been set aside for the sole purpose of meeting unfunded liabilities.

Contributions generally

7.72 Whereas a defined benefit scheme provides an agreed level of benefits for members of the scheme at retirement, accumulation funds provide benefits to a member based on the amount contributed to the fund.

7.73 New section 57-50 ensures that superannuation contributions made after transition are not tax deductible to the extent that they are in respect of liabilities that accrued during the period the entity was exempt from tax. The contributions for which deductions are limited may relate to employees employed at any time, before the entity became taxable, or on or after that time.

7.74 New subsection 57-50(2) provides that deductions to which the section applies are not allowable if they don't exceed the 'general superannuation threshold amount'. This term is defined in new subsection 57-50(4) to mean, if the relevant year is the transition year, the transition taxpayer's 'undischarged superannuation liability amount'. The latter amount refers to the deficit in the transition taxpayer's obligations to make contributions in respect of service by its employees.

7.75 In a year of income after the transition year, the 'general superannuation threshold amount' is the amount worked out for the transition year as reduced by an amount of contributions denied as a deduction to the entity in previous years under new subsections 57-50(2) or (3) . The amount will be progressively reduced in this way until it is extinguished.

7.76 If total contributions in a year of income exceed the 'general superannuation threshold amount' , the excess is deductible. New subsection 57-50(3) is required because it is possible to make more than one contribution in a year and each separate contribution is potentially deductible. The subsection provides that if the sum of all superannuation contributions in a year exceed the deduction threshold amount in new subsection 57-50(2) , then an allocation of a part of the deduction threshold amount to be disallowed is made to each superannuation contribution made in the year. This has the effect of allocating to each individual deduction a proportion to be disallowed based upon the ratio of the threshold limit to the total deductions otherwise allowable.

7.77 The transition taxpayer's 'undischarged superannuation liability amount' is determined by way of a five step method in new subsection 57-50(5) . A net figure is reached for each employee after subtracting actual contributions in Step 2 from required contributions in Step 1. These individual figures are added together in order to arrive at the transition taxpayer's total amount.

7.78 Step 3 of new subsection 57-50(5) ensures that contributions are matched only against individual obligations in respect of a particular employee. Where a transition taxpayer makes excess contributions in respect of any employee, those contributions will not reduce the total shortfall for all employees. That is, contributions which are still outstanding in respect of employee X (because of an award etc. or superannuation guarantee requirement) cannot be offset by excess contributions applied to employee Y. If a contribution in relation to a particular employee is greater than the obligation in relation to that employee, then the figure obtained after step 2 would be negative. In such a case, step 3 converts the negative amount to zero, so that when the total ' undischarged superannuation liability amount' is determined, the overall figure is not reduced.

7.79 The amounts in paragraphs (a), (b) and (c) in new subsection 57-50(5) refer to those contributions that the transition taxpayer is required to make in respect of an employee because of an award etc, or because of the superannuation guarantee obligation. The amounts in paragraphs (d) and (e) of new subsection 57-50(5) are those which are contributed by the transition taxpayer either because of an award etc or superannuation guarantee legislation requirement, or voluntarily.

7.80 The component parts (a), (b) and (c) of new subsection 57-50(5) also address the various possible scenarios which may apply to employees employed by the transition taxpayer at any time before the transition time. This measure is necessary because the shortfall amount before the transition time may vary for different employees, as demonstrated by the following examples:

•

Employee A is subject to an award from the time he or she commences employment until the Superannuation Guarantee (Administration) Act 1992 (SGAA) came into effect. The shortfall for that period is therefore measured by required award etc. contribution amounts less any actual contributions. From the time of the SGAA coming into effect and for a further period, the superannuation guarantee minimum is higher, and the shortfall for this period is measured by the required superannuation guarantee contribution amount less actual contributions. At some later stage the award changes so that the award amount is higher up until the transition time. The shortfall amount in relation to this period is the required award amount less actual contributions. The total shortfall for employee A is calculated by adding these three net figures together.

•

Employee B is subject to a different award. For this employee the award minimum is higher for the entire period up until the transition time, and therefore the shortfall is measured by the required award etc. contribution amounts less actual contributions.

•

Employee C commences employment after the SGAA comes into effect, and although an award applies, the superannuation guarantee minimum amount is always higher up until the transition time. Therefore the shortfall for this employee is measured by the required superannuation guarantee contribution amounts less actual contributions.

7.81 The 'superannuation guarantee period' is that period beginning at the start of the earliest contribution period (as defined by the SGAA) and ending at the transition time [new subsection 57-50(6)]. This provision also ensures that new section 57-50 is applicable to superannuation obligations which have accrued as at the transition time, as the component parts of new subsection 57-50(5) refer to either the period before the commencement of the superannuation guarantee period, or the superannuation guarantee period itself. Therefore, as the latter is defined as that period of time ending at the transition time, only those obligations which arose before the transition taxpayer became taxable are to be included.

7.82 The term 'required award etc. contribution amount' as used in new subsection 57-50(5) is defined in new subsection 57-50(7) as the amount required to be contributed to an employee superannuation fund under an award, arrangement, law, or applicable superannuation scheme or otherwise.

7.83 The term 'required superannuation guarantee contribution amount' is defined in new subsection 57-50(8) as the amount that would need to be contributed by an employer in respect of a contribution period, as defined by the SGAA, so that no superannuation guarantee shortfall would arise for that period.

7.84 New section 57-55 ensures that there is not a double reduction in deductibility because of new sections 57-40 and 57-50 For example, where the transition taxpayer contributes $50 to a fund, and both the 'defined benefit threshold amount' [new subsection 57-40(4)] and the 'general superannuation threshold amount' [new subsection 57-50(4)] are $25, the amount to be denied as a deduction will be $25 and not $50 [new paragraph 57-55(b)] .

7.85 New section 57-55 also deals with the case where one section would result in a greater denial, for example, where the threshold amounts are $35 and $25 respectively. New paragraph 57-55(a) provides that the greater denial applies.

7.86 However, new section 57-55 is to be disregarded for the purposes of calculating the 'defined benefit threshold amount' [new subsection 57-40(4)] and the 'general superannuation threshold amount' [new subsection 57-50(4)] in a year of income after the transition year. This ensures that where a contribution by an employer is subject to the deduction limit under both new sections 57-40 and 57-50 , both the thresholds are reduced by the amount of the contribution [new paragraphs 57-40(4)(b) and 57-50(4)(b)].

Pre-transition time accrued leave entitlements

7.87 New section 57-60 ensures that long service leave and annual leave payments (including leave loadings) otherwise allowable, whether for employees before or after the transition time [new subsection 57-60(1)] , are not deductible under subsection 51(1) to the extent of obligations and potential obligations existing immediately before the entity became taxable.

7.88 The amount of (or remaining amount of) pre-existing obligations is known as the '(pre-transition time service) leave amount' [new subsection 57-60(5)] . Deductions for annual or long service leave will be denied until, in total, they exceed this amount [new subsections 57-60(2) (3) and (4)] .

7.89 There are two types of leave amounts which make up this total. The first is an amount payable for long service leave and annual leave that (at the transition time) employees are eligible to take. An example is an amount for long service leave of employees who have worked ten or more years but have not taken the leave where the award provides that employees are entitled to the leave after ten years' service. This sort of amount is valued as at transition time, at the current rate of pay of employees to whom it relates.

7.90 The other type of leave is that which is not a vested entitlement of a particular employee at the time the entity becomes taxable. For example, at the time of transition an entity may have an employee who only has two years of employment for long service leave purposes and therefore the entity has no legal obligation in respect of long service leave for that employee. However if that employee later becomes entitled to long service leave (for example after completing another eight years' service), that leave would relate in part to the exempt period.

7.91 The Bill will therefore provide a means of determining the amount of long service leave and annual leave accrued at the date the exempt entity becomes taxable where that leave has not become an entitlement for the period of service due to, for example, an insufficient period of service by an employee.

7.92 The entity may choose from two options in calculating this annual or long service leave obligation. The entity may simply assume that all employees have become entitled at transition time and calculate the obligation on that basis [new paragraph 57-60(5)(c)] . This is a simple calculation and is provided as an option for those entities who do not wish to make more complex calculations.

7.93 Because not all employees will necessarily remain in employment and qualify for long service leave and in some cases annual leave, the entity may elect to use an actuarial calculation [new paragraph 57-60(5)(b) and new subsection 57-60(6)] . This method allows an entity to calculate the present value of an amount needed to satisfy annual leave and long service leave liabilities which would reasonably be expected to arise. This calculation would take into account, for example, the probability that not all employees would eventually become entitled to the leave because of resignation, death etc. It would also take into account salary increases and inflation, over the period before which the leave would be taken, and the return on any amounts set aside at transition.

7.94 It would be expected that in most transitions in which an entity is acquired by a new owner, the new owner would carry out a calculation of leave liability. This requirement should therefore not add to the compliance costs of such purchasers.

Pre-transition time provision for bad debts

7.95 After an entity becomes taxable it will be entitled to tax deductions in respect of bad debts it writes off. The Bill will deny deductions otherwise available for bad debts written off by an entity to the extent to which debts were known to be doubtful before the entity became taxable. [New section 57-65]

7.96 At the transition time an entity will need to identify the amount which, under generally accepted accounting principles, would represent an appropriate doubtful debt provision for each of the debts of the entity. This is called the 'pre-transition doubtful debt limit' [new subsection 57-65(5)] . This amount may be fully reflected in the final accounts of the entity at transition time. However the limit is expressed in terms of an objective test and so the proper amount will be required by the section in situations of under, over or nil provisioning.

7.97 Where the 'doubtful debt provision limit' has included in it a specific provision against a debt, and the debt is recovered in excess of the net amount (that is, debt less the provision), then the 'doubtful debt provision limit' will be reduced by the excess amount. The new subsection 57-65(6) will enable the 'doubtful debt provision limit' to be adjusted to reflect the actual situation in relation to debts.

7.98 Deductions for bad debts written off after the transition time will be disallowed until this limit is exhausted. This will be so even if the debt came into existence after the transition time. If the sum of all deductions otherwise allowable for bad debts written off in a year of income exceeds the 'doubtful debt provision limit' (defined as the 'pre-transition doubtful debt limit' , reduced by the amount of any bad debt deductions denied under this provision in earlier years, in new subsection 57-65(4)] ) the limit will be apportioned over all of the deductions for that year [new subsection 57-65(3)] .

7.99 The rule will not apply to general provisioning for doubtful debts which covers non-specific, unidentified risks. Where such general provisioning bears no relationship to any particular debt, it would not be appropriate to take it into account in denying deductions in respect of any debts written off after the entity becomes taxable. It would not represent doubtful debt provisioning under generally accepted accounting principles.

7.100 There are generally two ways in which debts are covered by specific provisions for doubtful debts. The first way is when specific provision is made against an individual debt. The second way is when debts of a particular class are covered by a specific provision for doubtful debts against that class of debts. An example of the second type is where a financial institution makes a specific provision against all credit card debts. Both types of bad debt provisioning make up the 'pre-transition doubtful debt provision limit' .

7.101 New section 57-65 applies to deductions for writing off a bad debt based on the original face value of the debt. The deemed disposal and re acquisition of the debt by virtue of new subsection 57-25(2) does not allow a deduction to which new subsection 57-65 applies to exceed the market value of the debt at the transition time.

Eligible termination payments

7.102 The Bill will deny deductions for eligible termination payments made by an entity to a person who was employed at any time before the transition time [new section 57-70] . The deduction denied will be so much of the deduction as relates to the period of service before the transition date [new subsection 57-70(2)] .

7.103 Approved early retirement scheme payments and bona fide redundancy payments (as defined in section 27A(1) of the Act) are excluded from the operation of this section [new subsection 57-70(3)] . This is because essentially these payments are an expense of the trading entity in restructuring for the future and are properly referrable to the taxable period.

7.104 The fact that deductions will be fully allowable for approved early retirement scheme payments and bona fide redundancy payments does not mean that the Government is encouraging the use of such payments as a device by entities. Only legitimate arrangements are likely to meet the definitions of approved early retirement scheme payments and bona fide redundancy payments. Wrongful dismissal laws also discourage entities considering large scale dismissals as a device for avoiding the limit on deductions for eligible termination payments.

Domestic losses

7.105 Generally, a company is entitled to carry forward losses incurred in one income year for deduction against its assessable income in subsequent years, subject to certain limitations. Section 79E of the Act provides that domestic losses incurred in the 1989/90 and later income years may be carried forward indefinitely until absorbed. Section 80 provides that domestic losses incurred in pre-1989/90 income years could be carried forward for a maximum of seven years.

7.106 A loss is incurred in any income year if the company's allowable deductions, other than any unrecouped losses brought forward from an earlier year, exceed the sum of its assessable income and the net exempt income of the year. This loss may be carried forward and deducted in arriving at the taxpayer's taxable income of succeeding income years.

7.107 New section 57-75 ensures that losses incurred while the transition taxpayer was exempt are not recognised because these losses occurred at a time when income was exempt and carry forward losses were non-deductible.

7.108 Therefore, where a transition taxpayer applies section 79E, 79F, 80, 80AAA or 80AA of the ITAA for the purposes of calculating any tax loss that may be carried forward, new section 57-75 effectivley ensures that:

•

exempt income derived before the transition time, in the transition year, cannot be used to reduce any loss of the transition year [new paragraph 57-75(a)] ; and

•

non-loss deductions (as defined in section 79E) can include only those non-capital expenses which were incurred at or after the transition time [new paragraph 57-75(b)] .

Opening written down value of depreciable assets

7.109 The Bill will ensure that depreciable assets are brought into the tax system at a value which reflects the fact that they have been used since they were first acquired or constructed. [New section 57-80]

7.110 For instance, where an item was acquired originally by a government department and was later transferred to a corporatised government entity which is then sold (and so becomes taxable) new section 57-80 in conjunction with new section 57-10 ensure that the item is notionally depreciated from the original date of acquisition of the item by the government department. Notional depreciation means, in effect, that it is assumed that both the government department and the corporatised entity were tax paying entities and therefore subject to the depreciation provisions.

7.111 This effect follows because the new section applies to every unit of plant or articles that an entity owns at the transition time. It applies wherever the entity (or an associate) acquired or constructed the unit at some time before transition, so that the unit has been owned by the entity or its associate continuously from that time to the beginning of the depreciation period. [New subsection 57-80(1)]

7.112 Such a unit of property is treated as having been depreciable to the entity or any relevant associate from the time it was so acquired or constructed. This produces the opening written down value at the transition time. [New subsection 57-80(2)]

7.113 An entity can choose either the prime cost or diminishing value method of depreciation. However, the Bill will ensure that the method used to obtain the opening written down value at transition time is the method used for the remainder of the life of the asset [new subsection 57-80(3)] . This ensures that the entity receives the same treatment that other taxpayers receive when making an election under section 56 of the Act.

7.114 In new subsection 57-80(1) the Bill refers to property being plant or articles. This is not the same as saying 'property subject to depreciation'. There is no argument therefore that property is not subject to this provision because an entity was exempt and not subject to depreciation.

Capital allowances and certain other deductions

7.115 New Subdivision 57-J deals with capital allowances and certain other deductions which would otherwise be allowable to the transition taxpayer had they always been taxable. Such expenditure is recognised as having a benefit which may endure into the taxable period and, to the extent to which it does endure, should become deductible. Where a transition taxpayer has incurred this type of expenditure before the transition time, deductions will be apportioned in the transition year according to whether the expenditure was incurred in a year before the transition year, or in the transition year before the transition time.

7.116 Many capital allowance and other provisions allow expenditure to be written off over a number of years. Alternatively, expenditure may be written off entirely in the year of income in which the expenditure was incurred. In both cases, new sections 57-85, 57-90 and 57-95 apportion expenditure incurred while the transition taxpayer was exempt, in two scenarios:

•

expenditure is incurred in a year before the transition year and the transition taxpayer becomes taxable in a later year, within the time limit for writing off expenditure;

•

expenditure is incurred in the transition year before the transition time, where the transition year is the first year of amortisation, or the deduction is allowable in full in that year.

7.117 New section 57-85 sets out the expenditure provisions of the Actto which the new rules will apply. Each of these provisions are described as a 'modified deduction rule' for the purposes of apportionment of expenditure before the transition time.

7.118 New section 57-90 assumes a notional write down. The assumption is that for the purposes of calculation of deductions, all of the modified deduction rules had applied at all times. For example, it ensures that where a transition taxpayer has incurred capital expenditure which is deductible over more than one year, and the transition year is a year of income later than that in which the expenditure was incurred, the remaining deductions will be allowed as if the transition taxpayer had always been taxable. That is, after the transition year, the taxable entity will be able to write off expenditure using the original expenditure as a basis.

7.119 New section 57-95 ensures that expenditure is apportioned in the transition year in order to address both of the scenarios described above. Expenditure incurred before the transition time is apportioned according to the formula set out in new subsection 57-95(1) . This formula applies whether or not expenditure is incurred during the transition year, and is based on the number of whole days in the transition year after the transition time, divided by the 'post expenditure part' .

7.120 Where expenditure was incurred before the transition year, the ' post expenditure part' is defined as the number of days in the transition year [new paragraph 57-95(1)(a)] . This addresses the scenario where expenditure is written off over several years, and was incurred in a prior year. For example, a transition taxpayer may have otherwise been entitled to a deduction under section 70A in the 1990/91 income year for the connection of mains electricity. This deduction would ordinarily be written off over 10 years. In the 1995/96 income year, the transition taxpayer becomes taxable. Therefore, for the purposes of apportioning expenditure in the transition year, the 'post expenditure part' is based on the number of whole days in the transition year, and the deduction amount is based on the amount that the transition taxpayer would have been entitled to had it been taxable in the 1990/91 income year. The taxpayer will then continue to claim the remaining deductions between the years 1996/97 and 1999/2000.

7.121 Where the expenditure was incurred in the transition year but before the transition time, the 'post expenditure part' is defined as the number of days in the period from the beginning of the day on which the expenditure is incurred until the end of the transition year. This method of apportionment takes into account the length of time between the incurring of the expenditure and the transition time. Since a deduction is allowable in full if the expenditure is incurred after the transition time, the formula allows a deduction which approaches the full amount of deduction for the year, the closer the incurring is to the transition time. The formula applies both where the expenditure is fully deductible in the year in which it is incurred, and where it is allowed over several years.

7.122 New subsection 57-95(2) provides that the section does not apply to an amount to which new paragraph 57-110(1)(b) applies. This paragraph deals with apportionment of a balancing deduction which the transition taxpayer would otherwise have claimed under the relevant balancing adjustment provisions of the Act. New subsection 57-95(2) ensures that the balancing deduction referred to in new paragraph 57-110(1)(b) is not included in the capital allowance and other deduction provisions, and is therefore not apportioned in the manner set out in new section 57-95 .

Elections

7.123 Certain deductions in the 'modified deduction rule' list in new section 57-85 include provisions allowing elections, declarations or the giving of a notice by the taxpayer. A taxpayer would, were it not exempt, be entitled to make such an election or declaration or give such a notice in relation to a year of income in certain circumstances. Although notional deductions can be calculated on the basis that the taxpayer was not exempt at the relevant time, it is not possible to determine whether a particular taxpayer would have made an election or declaration or provided a notice in a given circumstance. New section 57-100 provides therefore that these elections, declarations or notices are to be disregarded for the purpose of working out the transition taxpayer's allowable deductions under a modified deduction rule [new paragraph 57-100(a)] .

7.124 Further, new paragraph 57-100(b) provides that any such election, notification or notice under a modified deduction rule in relation to the transition year has no effect in so far as it relates to expenditure incurred before the transition time. This ensures that a transition taxpayer cannot make an election or declaration, or give a notice, in relation to the transition year, unless the expenditure to which it relates is incurred after the transition time. Expenditure incurred before transition time cannot therefore be transferred to another taxpayer. An exception to this is provided for a declaration under subsection 124AZDA(1). This declaration is a prerequisite for obtaining a deduction for expenditure on Australian films so is necessary if a deduction is to be obtained.

Special rules for mining and quarrying

7.125 New subsection 57-105(1) assumes that no exploration or prospecting expenditure is incurred prior to the transition time. This assumption ensures that there will be no deduction after the transition time for expenditure incurred before the transition time.

7.126 Without this provision it is arguable that a transition taxpayer could claim a deduction for all expenditure of this type which it incurred before the transition time. As such expenditure clearly relates to the exempt period it is appropriate that a deduction is not available.

7.127 The rules under new subdivision 57- J effectively create a notional write off for capital expenditure. Certain mining capital expenditure may be able to be carried forward if there is insufficient income against which to deduct it. New subsection 57-105(2) effectively ensures that no unused deductions under the mining provisions can be carried forward into the tax net. It does this by assuming that the expenditure will be fully written off in each year before the transition year.

Balancing adjustments

7.128 Certain provisions of the Actallow for a balancing adjustment where property in respect of which a deduction is allowable is disposed of lost or destroyed. Ordinarily, where a taxpayer disposes of, loses or destroys the property to which capital expenditure relates, they are entitled to a deduction where the consideration received in respect of the disposal etc, or the value of the property at the date of disposal, plus deductions allowable, is less than the total capital expenditure in respect of that property. The amount of the difference is allowable as a deduction. Where the consideration received on disposal, or the value at that time, plus deductions allowable, is greater than the total capital expenditure in respect of that property, the taxpayer is required to declare the excess in their assessable income.

7.129 In the case of an exempt taxpayer the deductions allowable over a period of years are notional until the transition time. After that time the taxpayer will be able to claim the remaining actual deductions, as provided by new section 57-90 . In order to reflect the fact that capital expenditure was incurred on property that was used for exempt purposes for some of the period of use by the taxpayer, the balancing adjustment will therefore be apportioned in the manner set out in new section 57-110 . This apportionment will apply to amounts included or deducted in the transition year or in a later year of income.

7.130 New subsection 57-110(1) provides a formula which determines how much of the balancing adjustment will be included in the assessable income of the transition taxpayer, or is allowable as a deduction, as the case may be. The relevant amount isdetermined by multiplying the balancing adjustment otherwise allowable by the following formula:

Actual deductions divided by actual deductions plus notional deductions

'Actual deductions' is defined as the sum of all actual deductions actually allowed or allowable to the transition taxpayer for the expenditure under the deduction rule to which the balancing adjustment provision relates.

'Notional deductions' is defined as the sum of all deductions for the expenditure that would have been allowable to the transition taxpayer under the deduction rule to which the balancing adjustment provision relates, if the transition taxpayer had never been wholly exempt from income tax.

7.131 The 'balancing adjustment provisions' are described in new subsection 57-110(2) . These are provisions of the Act which entitle the taxpayer to a balancing deduction or impose a balancing charge on disposal, loss or destruction of property to which capital expenditure relates.

7.132 The 'deduction rules' are set out in new subsection 57-110(3) . These are the provisions of the Act to which the relevant balancing adjustment relates, and are categorised as follows:

•

Subdivision A of Division 3, which contains a balancing adjustment provision in section 59 in respect of depreciated property;

•

Division 10C, which contains a balancing adjustment provision in section 124ZE in respect of expenditure on short-term traveller accommodation;

•

Division 10D, which contains a balancing adjustment provision in section 124ZK in respect of expenditure on building and structural improvements;

•

in any other case, the balancing adjustment provisions contained in the 'modified deduction rule' list set out in new section 57-85 . It should be noted that not all of the provisions in that list contain a corresponding balancing adjustment provision.

Trading stock

7.133 The existing trading stock provisions provide a mechanism which allows a deduction in the year of income for the cost of producing stock which was sold in the year of income. This is achieved by allowing the excess of opening stock over closing stock as a deduction in the year of income.

7.134 The trading stock provisions require the value at the beginning of a year of income to be the value at the end of the immediately preceding year (section 29). The amendments effectively provide that this is the value immediately before the transition time. [New subsection 57-115(2)]

7.135 Section 28 of the Act requires a taxpayer to ascertain the difference in value of trading stock at the beginning and end of the year in order to determine whether they have assessable income or an allowable deduction. New subsection 57-115(1) requires that, for the purposes of that calculation in the transition year, the only trading stock that is to be taken into account as being on hand at the beginning of the transition year is such trading stock as was on hand at the transition time. This effectively excludes all pre transition purchases and disposals from the calculation.

7.136 The above provisions effectively ensure that the transition taxpayer is only assessed for trading stock purposes, in the transition year, on changes in value from transition time to the end of the year.

7.137 To ensure that transition taxpayers are able to calculate their net taxable income for the first tax year on a realistic basis, a mechanism similar to the existing trading stock provisions in section 28 is provided. Transition taxpayers will be allowed to bring stock on hand at the transition time into account for the purpose of determining taxable income in a similar way as other taxpayers, either at cost, market or replacement value.

7.138 The section will also allow transition taxpayers to change the basis of valuation for closing stock in a similar way as the existing trading stock provisions, ie. cost, market or replacement value. However, this could allow a paper loss to be claimed as a deduction before the stock is actually disposed of.

7.139 An anti-avoidance measure [new subsection 57-115(3)] will defeat those taxpayers who would seek to manipulate stock values, where the stock is not disposed of, to obtain a once only paper deduction by selecting a high opening value, eg. market, and then opting for a lower value, eg. cost, for closing stock. This measure will only have an effect for the transition year.