House of Representatives

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Modifications to exemption for foreign earnings

Schedule 1 to this Bill modifies some aspects of the section 23AG of the Income Tax Assessment Act 1936 foreign employment income exemption. It aims to reduce compliance costs for taxpayers, and to address some specific issues that have arisen. The amendments:

•

provide that a period of foreign service will not end until absences exceed one-sixth of the days of foreign service

•

allow the exemption to potentially apply where a taxpayer dies during a period of foreign service before reaching the requisite 91 days

•

reinstate eligibility for the exemption where a taxpayer was employed in Iraq during the suspension of Iraq's income tax system from 1 January 2003 to 30 April 2004.

Date of effect : Amendments to the treatment of absences from foreign service apply on or after Royal Assent. The amendment relating to foreign service in Iraq will apply for the 2002-03 and later years of income. The amendment relating to deaths in foreign service will apply to deaths that occurred on or after 1 July 2004.

Proposal announced : The amendments relating to the treatment of absences were announced in the 2004-05 Budget. The amendment relating to Australians employed in Iraq was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 005 of 19 January 2005. The amendment relating to death in foreign service has not previously been announced.

Financial impact : The financial impact of the amendment dealing with restoring the exemption to certain Australians employed in Iraq is $1 million for 2005-06. The financial impact of the other amendments is unquantifiable but is not expected to be significant.

Compliance cost impact : The amendments relating to treatment of absences should reduce compliance costs for taxpayers, since it reduces complexity. As the other amendments deal with specific and limited circumstances, compliance costs will be minimal.

Refundable film tax offset - extension to high budget television series

Schedule 2 to this Bill contains amendments that will include high budget television series as an eligible format for the purposes of Division 376 of the Income Tax Assessment Act 1997 (ITAA 1997). This will enable producers of certain eligible television series to apply for the Division 376 tax offset.

Date of effect : These amendments apply to eligible production expenditure incurred on and after 1 July 2004. Effectively, expenditure incurred on television series on or after 1 July 2004 may be eligible under Division 376 of the ITAA 1997.

Proposal announced : The former Minister for Revenue and Assistant Treasurer, the former Minister for Communications, Information Technology and the Arts and the Minister for the Arts and Sport together announced the proposal in joint media release No. C043/04 of 11 May 2004.

Financial impact : This measure will have a cost to revenue as follows:

Compliance cost impact : This measure is expected to have a small impact on compliance costs.

Consolidation

Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 to:

•

clarify the operation of the bad debt rules for multiple entry consolidated (MEC) groups

•

ensure that the modifications to the bad debt rules for consolidated groups and MEC groups also apply to determine whether consolidated groups and MEC groups can deduct swap losses.

Schedule 3 also amends the Income Tax (Transitional Provisions) Act 1997 to extend the time, until 31 December 2005, for head companies of consolidated groups and MEC groups to make or revoke certain choices in relation to setting the tax cost of assets and the utilisation of losses.

Date of effect : These amendments apply from 1 July 2002.

Proposal announced : The amendments relating to bad debts and swap losses were announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 62 of 13 July 2005. The amendments to extend the time for making or revoking certain choices were announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 23 of 20 December 2004.

Financial impact : Nil.

Compliance cost impact : These amendments are expected to have a minimal impact on compliance costs.

Thin capitalisation - transitional provision

Schedule 4 to this Bill amends the Income Tax (Transitional Provisions) Act 1997 to implement changes, for a limited period, to the application of the thin capitalisation regime contained in Division 820 of the Income Tax Assessment Act 1997.

These amendments will ensure that a taxpayer's thin capitalisation position is not immediately affected by changes made to the Australian accounting standards from 1 January 2005 to align those standards with International Financial Reporting Standards.

These amendments allow taxpayers to use accounting standards as they existed prior to 1 January 2005 to undertake thin capitalisation calculations for a period of three years.

Date of effect : These amendments apply to three consecutive income years commencing on or after 1 January 2005.

Proposal announced : These amendments were announced in the Treasurer's Press Release No. 2 of 24 January 2005.

Financial impact : Nil.

Compliance cost impact : If taxpayers choose to take advantage of the amendments, they will be required to undertake thin capitalisation calculations based on old accounting standards. There will be compliance costs involved in determining the relevant figures and in maintaining appropriate records.

Forestry managed investments

Schedule 5 to this Bill extends the operation of the '12-month rule' for certain prepaid expenditure by investors in forestry managed investment schemes. The 12-month rule is currently due to expire on 30 June 2006 but will now be extended until 30 June 2008.

Date of effect : This amendment applies from the date of Royal Assent.

Proposal announced : This measure was jointly announced by the Minister for Revenue and Assistant Treasurer and the Minister for Fisheries, Forestry and Conservation in Press Release No. 035 of 10 May 2005.

Financial impact : The extension of the prepayment rule has an estimated revenue cost of $30 million in 2007-08 and $35 million in 2008-09.

Compliance cost impact : Nil.

Debt and equity interests

Schedule 6 to this Bill:

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deems related party at call loans to small companies to be debt interests under the debt/equity rules

•

makes a number of minor technical amendments to ensure that the debt/equity rules work as intended.

Date of effect : The deemed debt treatment of related party at call loans to small companies applies to schemes entered into on or after 1 July 2005 and schemes entered into before 1 July 2005, in so far as they continue to exist at that date. The technical amendments apply from 1 July 2001.

Proposal announced : The Minister for Revenue and Assistant Treasurer announced the deemed debt treatment of the related party at call loans measure in Press Release No. 063 of 15 July 2005. The Minister for Revenue and Assistant Treasurer had previously announced the technical amendments in Press Release No. 002 of 5 August 2004.

Financial impact : The deemed debt treatment for related party at call loans has an estimated revenue cost of up to $11 million per annum for the 2005-06 income year, increasing to $14 million per annum in the 2009-10 income year. The financial impact of the technical amendments is unquantifiable.

Compliance cost impact : The deemed debt treatment is expected to reduce compliance costs for small business. The technical amendments are expected to have negligible compliance costs.

Summary of regulation impact statement

Regulation impact on business

Impact : The deemed debt treatment is expected to reduce compliance costs for small business.

Main points :

•

The deemed debt treatment will reduce compliance costs of small companies, as such companies will not have to treat related party at call loans as equity interests for income tax purposes.

•

This reduces record keeping requirements because it means that small companies do not need to keep non-share capital accounts for these loans.

•

It also means that small companies will not be forced to bear costs in formalising their loans to avoid equity treatment.

Chapter 1 - Modifications to exemption for foreign earnings

Outline of chapter

1.1 Schedule 1 to this Bill modifies some aspects of the operation of the section 23AG of the Income Tax Assessment Act 1936 (ITAA 1936) foreign employment income exemption. The amendments aim to reduce compliance costs for taxpayers and address some specific issues that have arisen.

1.2 Unless otherwise stated, all legislative references are to the ITAA 1936.

Context of amendments

1.3 Section 23AG exempts foreign employment income of Australian resident individuals engaged in foreign service for a period of 91 continuous days or more (subject to some conditions). Section 23AG was originally introduced as a method of preventing double taxation for individual taxpayers. However, over time as individuals' circumstances and employment conditions have diversified, situations have arisen that were not considered when the legislation was first developed.

1.4 One area of complexity this measure addresses is the 'credits and debits' rule used to allow an individual to be considered to have a continuous period of foreign service despite short absences. This test will be replaced with a simpler and generally more generous rule that allows different foreign service periods to be aggregated, unless the period of absence that separates them exceeds one-sixth of the total number of days of foreign service at any time.

1.5 These amendments also modify section 23AG in two specific situations: where a taxpayer was employed in Iraq during the suspension of the income tax system, and where a taxpayer dies before reaching 91 days of continuous service.

Summary of new law

1.6 These amendments have three components:

•

Individuals will not break a period of foreign service until the time that absences exceed one-sixth of the days in foreign service. This amendment will apply on or after the date of Royal Assent.

•

Foreign earnings of an individual who dies before reaching 91 days of continuous foreign service will be eligible for the exemption if he or she would otherwise have continued to be engaged in foreign service. This amendment will apply in relation to deaths on or after 1 July 2004.

•

Individuals working in Iraq will continue to have access to the section 23AG exemption despite retrospective suspension of the Iraqi income tax system by the Coalition Provisional Authority. This amendment will apply to assessments for the 2002-03 year or later years of income.

Comparison of key features of new law and current law

Detailed explanation of new law

Simplification of section 23AG: the one-sixth rule

1.7 Section 23AG contains rules to allow individuals to take short breaks from foreign service without breaking a continuous period of foreign service. A continuous period of not less than 91 days of foreign service is necessary to claim the exemption.

1.8 Certain types of absences are counted in foreign service under subsection 23AG(6) (eg recreation leave). Other types of absences are not included or not considered to be part of foreign service (eg long service leave). The current rules apply only to absences that are not considered to be part of foreign service.

1.9 The amendments do not change this distinction, but merely substitute a new rule for calculating whether absences that are not included in foreign service break a period of foreign service.

1.10 Under the current rules, absences from work that do not constitute foreign service will not break a foreign service period if the individual's absentee credit balance is greater than nil. Although an individual earns 2.2 hours credit for one day of foreign service the absentee credit balance only counts whole days. An individual can only accumulate a maximum of 31 days credit. For every 24 hour absence the individual incurs a 24 hour debit. Absences from foreign service of less than 24 hours are ignored.

1.11 The 'credits and debits' system will be replaced by a rule that allows periods of foreign service to be added together until a time that absences exceed one-sixth of the days of foreign service.

1.12 The one-sixth rule is generally more generous than the credits and debits system. It allows for more absences and does not have a 31 days credit limit. It will also reduce compliance costs for taxpayers as the calculations will be simpler.

1.13 The amendments allow two or more continuous periods of foreign service to be combined into a total foreign service period until an individual ceases to be engaged in foreign service, or the one-sixth rule is exceeded, whichever occurs first.

1.14 When applying the one-sixth rule the numerator is the days absent from foreign service that do not constitute foreign service, and the denominator is the total number of days of foreign service. The days included in a total period of foreign service, at a particular time, are the foreign service days from the beginning of the first of the foreign service periods up until that time. The days included in a total period of absence at a particular time are the days of absence from the beginning of the first foreign service period up until that time. [Schedule 1, item 3, subsections 23AG(6A) and (6B)]

1.15 If the total days of absence exceed one-sixth of foreign service days at any time, an individual ceases to be engaged in a period of foreign service for the purposes of subsection 23AG(1). The individual will begin a new period of foreign service when he or she next engages in foreign service and must determine anew whether that foreign service lasts for at least 91 continuous days. [Schedule 1, item 3, subsections 23AG(6A) and (6B)]

1.16 The definitions of 'total period of foreign service' and 'total period of absence' are only relevant for determining whether multiple periods of foreign service may be combined into a continuous period of foreign service. An absence is not considered to be part of a continuous period of foreign service (subject to subsection 23AG(6)).

1.17 The aim of the amendment is to allow taxpayers a similar total period of absence to that allowed by section 23AF, (ie a foreign employment income exemption for individuals working on approved projects). Section 23AF also contains a one-sixth rule.

1.18 However, the rule in section 23AG differs to that in section 23AF, reflecting differences in the basic structure of the two sections. For example, the one-sixth rule in section 23AF applies only to absences in Australia, while the rule in section 23AG does not have this limitation. Also, the one-sixth rule in section 23AF is not applied on an on-going basis, but to an overall period. The one-sixth rule to be inserted into section 23AG will be applied on an on-going basis, in the same way as the current 'credits and debits'. Individuals will effectively calculate daily whether they remain engaged in a continuous period of foreign service or not.

Example 1.1

Jason, an Australian resident, engages in foreign service for 65 days. He takes five days off due to illness which is in accordance with the terms and conditions of that service. This is considered to be foreign service under paragraph 23AG(6)(b). He then takes a further 10 days off that is not considered to be part of foreign service, and re-commences for a further 40 days. In determining whether these two periods of foreign service constitute one continuous period of foreign service for the 91 continuous days test, he must determine whether the total period of absence exceeds one-sixth of his days of foreign service.

Total period of absence: 10 days

Days of foreign service in first period: 70 days (65 + 5)

10/70 = 1/7 As this is less than one-sixth, the next period of foreign service may be added.

Days of foreign service in second continuous period: 40

Added to foreign service days in the first period: 40 + 70 = 110

10/110 = 1/11

As absences do not exceed one-sixth of the total number of days of foreign service at any time, Jason's two periods of foreign service will be taken to constitute one continuous period of foreign service under subsections 23AG(6A) and (6B). Since he has been engaged in foreign service for 110 days (65 + 5 + 40) he would be entitled to the exemption under section 23AG for earnings from those days.

Example 1.2

Assume the same facts as in Example 1.1, except that instead of 10 days, Jason has 20 days of absence that is not considered to be part of foreign service.

Total period of absence: 20 days

Days of foreign service in first period: 70 days (65 + 5)

20/70 = 2/7 As this is more than one-sixth, the next period of foreign service (ie the further 40 days) may not be added to the first period of 70 days. Jason's total foreign service period was therefore limited to 70 days once his absence exceeded one-sixth of his 70 days in foreign service (ie at day 12 of his total period of absence).

As the first foreign service period was only 70 days, Jason's foreign earnings will not be eligible for the section 23AG exemption. When Jason recommences work for 40 days he will start a completely new period of foreign service and needs 91 days of service before any of his earnings for the period are exempt.

Death during a period of foreign service

1.19 The amendments address the situation where an individual does not meet the 91 continuous days of engagement in foreign service test because of his or her death. In this situation the individual will be taken to have met the 91 day test if he or she would otherwise have continued in foreign service for a continuous period of not less than 91 days. [Schedule 1, item 1, subsection 23AG(1A)]

Iraq amendment

1.20 The exemption in section 23AG does not apply where any of the conditions in subsection 3AG(2) exist, for example, where foreign earnings are exempt from tax in the foreign country because the law of that country does not provide for the imposition of income tax on employment income, or similar income (paragraph 23AG(2)(c)).

1.21 The Iraq Coalition Provisional Authority retrospectively suspended the Iraqi personal income tax system from 1 January 2003 to 30 April 2004. This suspension meant the section 23AG exemption no longer applied to Australian residents deriving foreign earnings in Iraq during that period. This was contrary to the expectations of these Australian residents at the time they decided to take up employment in Iraq.

1.22 An amendment reinstates the exemption by providing that subsection 23AG(2) does not apply to foreign earnings derived from foreign service in Iraq during the period in which the Iraqi personal income tax system was suspended. This is referred to in the amendments as the period 'after 31 December 2002 but before 1 May 2004'. [Schedule 1, item 2, subsection 23AG(2A)]

Application and transitional provisions

1.23 The use of the one-sixth rule to determine whether absences from foreign service break the period of foreign service will apply generally to foreign service performed on or after the date of Royal Assent. [Schedule 1, subitem 5(3)]

1.24 A transitional rule will apply to individuals who are engaged in a continuous period of foreign service the day before Royal Assent; that is individuals who are engaged in foreign service, have a credit balance under current subsection 23AG(6A), or would have had a credit balance if absentee credits were able to be counted in hours. These individuals will be able to add foreign service days from their continuous foreign service period before Royal Assent, to the new total foreign service period.

1.25 As the amendments only apply to foreign service performed on or after Royal Assent, the existing rules apply to determine the days of continuous foreign service before Royal Assent. The absentee credit balance will cease to have any relevance. The one-sixth rule will be applied to the total foreign service period plus the days of foreign service accumulated before Royal Assent. [Schedule 1, subitem 5(4)]

Example 1.3

Amy, an Australian resident, is engaged in foreign service for 50 days before Royal Assent. She therefore has four days and 15 hours credit in her absentee credit balance. After Royal Assent she works for a further 20 days, and is then absent for 10 days that is not considered to be part of foreign service. She then works a further 30 days in foreign service. Amy would apply the one-sixth rule as follows:

Days in foreign service: 70 days (50 days before Royal Assent, 20 days after Royal Assent)

Days of absence: 10 days

10/70 = 1/7

As this is less than one-sixth, Amy can add her next period of foreign service.

Days in foreign service after next foreign service period: 100 days (70 days in first continuous period + 30 days in second continuous period).

As 100 continuous days is more than 91 continuous days, Amy is eligible for the section 23AG exemption for her foreign earnings. The four days in her absentee credit balance cease to have relevance, but are effectively replaced by an absentee allowance of one-sixth of 50 days.

If, however, Amy had not been on foreign service for the four days immediately before Royal Assent, she would have had an absentee credit balance of 15 hours (under the modified definition of that term) immediately before the day of Royal Assent. She would then still have been able to add the 50 days of foreign service to her foreign service performed from that day on.

1.26 The amendment allowing the exemption for foreign earnings to apply to individuals who die before 91 continuous days of foreign service applies to deaths that occur on or after 1 July 2004. The amendment is retrospective to clarify the tax treatment in a small number of recent cases where Australian residents have died during a period of foreign service. [Schedule 1, subitem 5(1)]

1.27 The amendment to remove the application of subsection 23AG(2) to foreign earnings derived from foreign service in Iraq during the period in which the Iraqi personal income tax system was suspended, will apply to assessments for the 2002-03 and later years of income. The amendment potentially covers a longer period than the period of relevant foreign service because in some cases taxpayers may receive the relevant foreign earnings at a later stage (eg a later payment made in a lump sum). [Schedule 1, subitem 5(2)]

Consequential amendments

1.28 The amendments repeal the definition of 'whole day' in subsection 23AG(6J). This term will become redundant with the repeal of the 'credits and debits' rules. [Schedule 1, item 4 ]

Chapter 2 - Refundable film tax offset - extension to high budget television series

Outline of chapter

2.1 Schedule 2 to this Bill contains amendments to include high budget television series as an eligible format for the purposes of Division 376 of the Income Tax Assessment Act 1997 (ITAA 1997). This will enable certain eligible television series to apply for the Division 376 refundable film tax offset.

Context of amendments

2.2 The refundable tax offset for large scale films, contained in Division 376 of the ITAA 1997, was introduced with effect from 4 September 2001. The offset applies at a rate of 12.5 per cent of qualifying Australian production expenditure on the film.

2.3 The Division 376 offset is designed to encourage large scale film productions to locate in Australia, and is aimed at providing greater economic, employment and skill development opportunities. The current formats eligible for the offset are feature films, telemovies and television mini-series.

2.4 These amendments expand eligibility to include high budget television series as an eligible format. Unless otherwise stated, all relevant existing eligibility requirements in Division 376 will apply to television series.

Summary of new law

2.5 These amendments will extend the application of the Division 376 offset to include high budget television series as an eligible format. Television series which meet the new thresholds and requirements of the offset will qualify to claim the refundable 12.5 per cent offset for qualifying Australian production expenditure.

2.6 The broad intent behind this measure is to attract new large scale high budget television series to locate in Australia.

2.7 Specific conditions including production timeframes, thresholds and definitions for qualifying television series are included to ensure that the Division 376 offset is appropriately targeted.

2.8 It is not intended that low budget productions bundled together be able to access the Division 376 offset. The new television series specific conditions are aimed at ensuring this bundling is not possible.

2.9 These amendments ensure that a television series is eligible to apply for the Division 376 offset where it meets specific conditions. These specific conditions require that a series meet:

•

the expenditure thresholds, including the new minimum average A$1 million of qualifying Australian production expenditure per hour

•

the definition of a 'television series' for the purposes of the offset, this excludes and includes certain genres

•

certain specific timeframes for the completion of production.

2.10 In addition, previous conditions for access to the Division 376 offset continue to apply. Specifically:

•

the total of the company's qualifying Australian production expenditure must be at least A$15 million

•

where the value of the qualifying Australian production expenditure is at least A$15 million but less than A$50 million, this expenditure must be at least 70 per cent of total production expenditure for the series. (It is intended that this will encourage the production of the majority of a television series in Australia)

•

where the value of the qualifying Australian production expenditure is A$50 million or more, the production will qualify regardless of the percentage ratio of Australian expenditure to total production expenditure.

Comparison of key features of new law and current law

2.11 These amendments will add a new eligible format for certification to access the Division 376 offset. A television series not otherwise covered by subparagraph (i) or (ii) of paragraph 376-15(1)(d) will be eligible to apply for certification under the offset. A mini-series of television drama may effectively qualify for certification either under the previous rules for mini-series or through the new rules for television series. [Schedule 2, items 1 and 2, subparagraph 376-15(1)(d)(iii)]

2.12 A television series will not be excluded from certification for access to the offset if it is of a documentary-like nature. However, documentaries will continue to be an excluded genre for films eligible under the previous rules (those covered by subparagraph (i) or (ii) of paragraph 376-15(1)(d)). [Schedule 2, item 3, subparagraph 376-15(1)(e)(i)]

2.13 Similarly, the exclusion for 'a film forming part of a drama program series that is, or is intended to be, of a continuing nature' continues to apply to films covered by subparagraph (i) or (ii) of paragraph 376-15(1)(d). A television series however, will not be excluded from certification for access to the offset under this criterion. Also see section 376-17 which defines 'television series'. [Schedule 2, item 4, subparagraph 376-15(1)(e)(v)]

2.14 There are timeframes for the completion of a television series production. Where a television series is predominantly a digital animation or other animation it must be made within a period of 36 months. This period commences once production expenditure begins to be incurred. The commencement of the 36 month period is not triggered by either pre-production or pilot production activities. Effectively, the 36 month period excludes pre-production activities as mentioned in paragraph 376-25(3)(a), as well as activities associated with the production of a pilot (if there is one). Due to the nature of digital or other animation series, they are given a longer timeframe for completion. [Schedule 2, item 5, subparagraph 376-15(1)(ea)(i)]

2.15 As a guide, 'animation' may be an animated sequence or production that is a series of two-dimensional or three-dimensional images rendered in sequence to create artificial moving images (but does not include a live action sequence or production that records live subjects in motion). 'Digital animation' may be an animation created primarily with the use of digital technology (including computer animation hardware and software).

2.16 A television series other than a series which is predominantly a digital animation or other animation is subject to a different timeframe for completion. Such a series, most likely a 'live action' series, must complete all principal photography within a period of 12 months. This period again excludes activities associated with the production of a pilot episode (if there is one). It is intended that the certification process will verify whether a television series is 'predominantly' an animation or otherwise. Principal photography does not include second unit photography. 'Second unit photography' means the filming of less important scenes in a screen production, including crowd scenes, scenery and stock inserts which do not involve the main characters of a screen production and which are filmed by a secondary or subordinate crew. [Schedule 2, item 5, subparagraph 376-15(1)(ea)(ii)]

2.17 There is an additional expenditure threshold specific to television series. A television series will be required to have a minimum average of at least $1 million of qualifying Australian production expenditure per hour. The intent of this threshold is to ensure low-value series and series which would have been produced in Australia regardless of the extension of the offset, are excluded. The amount of qualifying Australian production expenditure per hour for a television series is worked out by using the formula in subsection 376-15(3). This formula requires that the total qualifying Australian production expenditure for the television series be divided by the total length of the series measured in hours. [Schedule 2, items 5 and 6, paragraph 376-15(1)(eb ) and subsection 376-15(3)]

2.18 The amount worked out by way of the formula in subsection 376-15(3) is an average. Individual episodes of a television series do not need to have a minimum of $1 million of qualifying Australian production expenditure per hour. A series may have a number of relatively inexpensive episodes below the $1 million threshold and a few very expensive episodes above it. As long as the series has a minimum average of at least $1 million of qualifying Australian production expenditure per hour then it may qualify.

2.19 Note, a television series must still meet the minimum total qualifying Australian production expenditure threshold of $15 million.

Example 2.1

A television series titled 3001 Tech Planet intends to claim the Division 376 offset. It contains 26 half-hour episodes for a total of 13 hours. Note, in order to meet the $15 million threshold the series must also spend an average of approximately $1,153,847 of qualifying Australian production expenditure (QAPE) per hour. The series has the following QAPE per episode:

Episode	QAPE (A<$m)
1	$0.1
2	$0.2
3	$0.3
4	$0.4
5	$0.5
6	$0.6
7	$0.7
8	$0.8
9	$0.9
10	$1.0
11	$1.1
12	$1.2
13	$1.3
14	$1.3
15	$1.2
16	$1.1
17	$1.0
18	$0.9
19	$0.8
20	$0.7
21	$0.6
22	$0.5
23	$0.4
24	$0.3
25	$0.2
26	$0.1
Total QAPE	$18.2
Average / hour	$1.4

This series may qualify for the Division 376 offset as it has a total qualifying Australian production expenditure in excess of $15 million, as well as an average qualifying Australian production expenditure per hour exceeding the $1 million threshold.

2.20 The amendments include a definition of 'television series'. A television series must be a film made up of two or more episodes. This multiple-episode film must also be:

•

produced wholly or principally for exhibition to the public on television under a single title

•

contain a common theme or themes

•

contain dramatic elements that form a narrative structure.

[Schedule 2, item 7, subsection 376-17(1)]

2.21 Examples of the types of television series which may fall within this definition are as follows. As a guide, a television series may be:

•

a traditional drama series of two or more episodes where individual episodes contain differing plots but key elements of the show, for example the characters, locations or the occupation of the characters remain the same. The narrative structure may develop as the central concern across the duration of the series or individual episodic plots may be tied together by a secondary narrative stream involving key characters which continue throughout the series

or

•

a television series of two or more episodes where real people are asked to assume contemporary or historical roles in a manufactured setting and the results of this role play are filmed for a specified period. Each episode may include separate scenarios which the participants engage in, but over the length of the series common elements of theme (be they the historical setting or the people or characters) will remain and a narrative will develop, be it imposed by producers or merely developed by documenting the relationships between the participants (see also the explanation of subsection 376-17(3) below).

2.22 A documentary is not excluded from being a television series. It is intended that where a documentary television series also meets the expenditure and other thresholds, it may qualify to access the Division 376 offset. As an example, a television series may be a documentary series of two or more episodes, linked in theme and narrative by ongoing investigations, such as similar events, lives or things, to develop an overall hypothesis. [Schedule 2, item 7, subsection 376-17(1)(note)]

2.23 The definition of 'television series' includes a requirement under subsection 376-17(2) that all of the episodes must be produced wholly or principally for exhibition together, for a national market or national markets. This requirement is designed to prevent the bundling of episodes that were not designed to be exhibited together. (The word 'together' should not be taken to imply that the episodes are broadcast on the same day.) An example of such excluded bundling may be where two series are produced, with the same title, for broadcast in two different national markets, say a French version and an English version. In this case a French episode may not be included with an English episode for the purposes of the offset, as the episodes were not intended to be broadcast together in the same market. [Schedule 2, item 7, paragraph 376-17(1)(d ) and subsection 376-17(2)]

2.24 It is intended that reality television be an eligible genre for qualifying television series. Subsection 376-17(3) provides a specific definition of such reality television series. This definition does not limit the requirement under paragraph 376-17(1)(c) that series contain dramatic elements that form a narrative structure. However, it does specify that a series may meet the requirements under paragraph 376-17(1)(c) if:

•

the depiction of actual events, people or situations is the sole or dominant purpose of the television series

•

the television series depicts those events, people or situations in a dramatic or entertaining way, with a heavy emphasis on dramatic impact or entertainment value.

Nonetheless, whether or not a particular reality television series may be eligible may depend upon the facts of the particular series when considered against the overall interpretation of the definition of 'television series'. [Schedule 2, item 7, subsection 376-17(3)]

2.25 A pilot to a television series (where there is one), is taken to be a part of that television series. [Schedule 2, item 7, subsection 376-17(4)]

2.26 The current section 376-35 will be retitled subsection 376-35(1), with the necessary references updated. [Schedule 2, items 8 to 10, subsection 376-25(5 ), subsection 376-25(6)(note ) and section 376-35 ]

2.27 In relation to a pilot to a television series, where that pilot is shot overseas, production expenditure associated with that pilot is excluded from the calculation of total production expenditure (see subsection 376-35(2)). In effect, if a pilot is produced overseas and the series is subsequently produced as an eligible television series in Australia, then all expenditure reasonably attributable to the production of that pilot episode is to be excluded from the calculation of total production expenditure for the purposes of the offset. The expenditure that is reasonably attributable to the pilot episode is expenditure that is not qualifying Australian production expenditure, and would otherwise be production expenditure but for subsection 376-35(2) (ie it is most likely to be overseas expenditure). The intent of this provision is to encourage series that have already shot a pilot overseas to consider relocating to Australia. This provision enhances Australia's attractiveness as a location, as the exclusion of overseas pilot expenditure lessens the impact of the 70 per cent criterion applicable to the entire series (for series with qualifying Australian production expenditure between $15 million and $50 million). [Schedule 2, item 11, subsection 376-35(2)]

2.28 In relation to a pilot to a television series produced in Australia, the new provisions operate such that pilots shot in Australia will have relevant expenditure counted towards qualifying Australian production expenditure for the purposes of the offset if and only if the television series is an eligible series. In other words the Division 376 offset will not be available on the pilot alone. In order for any qualifying Australian production expenditure on a pilot to be considered, an eligible series which includes the pilot, and which meets all the requirements of the offset, must be submitted for certification. It is intended that this will encourage the production of pilots in Australia.

2.29 The term 'television series' will be included in the Dictionary definitions in Division 995, with the meaning given by section 376-17. [Schedule 2, item 12, subsection 995-1(1 ) definition of ' television series' ]

Application and transitional provisions

2.30 These amendments apply to eligible production expenditure incurred on and after 1 July 2004. Effectively, expenditure incurred on television series on or after 1 July 2004 may be eligible under Division 376 of the ITAA 1997. The application date is consistent with the announcement of the measure in the 2004-05 Budget. [Schedule 2, item 13 ]

Chapter 3 - Consolidation

Outline of chapter

3.1 Schedule 3 to this Bill amends the consolidation provisions in the income tax law.

3.2 Part 1 amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

•

clarify the operation of the bad debt rules for multiple entry consolidated (MEC) groups

•

ensure that the modifications to the bad debt rules for consolidated groups and MEC groups also apply to determine whether consolidated groups and MEC groups can deduct swap losses.

3.3 Part 2 amends the Income Tax (Transitional Provisions) Act 1997 to extend the time, until 31 December 2005, for head companies of consolidated groups and MEC groups to make or revoke certain choices in relation to setting the tax cost of assets and the utilisation of losses.

Context of amendments

Modification to the bad debt rules for MEC groups

3.4 The bad debt rules specify the circumstances in which an entity (the claimant) can deduct a bad debt. Broadly, the claimant can deduct a bad debt only if it and any entity that has been owed the debt for a period satisfies certain conditions (including the continuity of ownership test or the same business test). The consolidation bad debts rules modify those conditions so that they apply appropriately to a consolidated group.

3.5 As MEC groups are structured differently to ordinary consolidated groups, further modifications are required to clarify the operation of the bad debt rules for MEC groups.

Swap losses

3.6 Swap losses arise if the amount of a debt that is extinguished under a debt/equity swap is greater than the equity value of the shares or units received. The tests to determine whether a taxpayer can deduct bad debts also apply to determine whether a taxpayer can deduct swap losses. Therefore, the modifications to the bad debt rules for consolidated groups and MEC groups also need to apply to determine whether consolidated groups and MEC groups can deduct swap losses.

Making and revoking certain choices

3.7 The consolidation regime provides for a number of irrevocable choices that the head company of a consolidated group or a MEC group can make in respect of setting the tax cost of its assets and for the utilisation of losses. Currently, these choices must be made on or before 31 December 2004.

3.8 Amendments which could affect a head company's decision in relation to these choices were passed earlier this year in the Tax Laws Amendment (2004 Measures No. 6) Act 2005 and the Tax Laws Amendment (2004 Measures No. 7) Act 2005. Therefore, to give consolidated groups and MEC groups time to consider the implications of these amendments before certain choices they make in relation to setting the tax cost of assets and the utilisation of losses become irrevocable, the time for making and revoking these choices has been extended by 12 months, to 31 December 2005. This will ensure that consolidated groups and MEC groups are not disadvantaged as a consequence of the amendments.

Summary of new law

Modification to the bad debt rules for MEC groups

3.9 Part 1 of Schedule 3 to this Bill modifies the application of the bad debt rules so that, for MEC groups:

•

the continuity of ownership test is applied to the top company of the group

•

if the head company is a listed public company, the same business test is applied to the head company.

Swap losses

3.10 Part 1 of Schedule 3 also ensures that the modifications to the bad debt rules for consolidated groups and MEC groups apply to determine whether consolidated groups and MEC groups can deduct swap losses.

Making and revoking certain choices

3.11 Part 2 of Schedule 3 to this Bill extends the time, until 31 December 2005, within which the head company of a consolidated group or a MEC group can make or revoke each of the following choices:

•

The choice to retain the tax cost of a joining entity's assets.

•

The choice to cancel a loss by the head company of a consolidated group or MEC group.

•

The choice to use the value donor concessions.

•

The choice to waive the capital injection rules.

•

The choice to use certain losses over three years.

Comparison of key features of new law and current law

Detailed explanation of new law

Modification to the bad debt rules for MEC groups

3.12 A company can deduct a bad debt under section 25-35 only if, among other things, there has been no change in ownership or control of the company or the company has carried on the same business.

3.13 Broadly, the consolidation bad debt rules in Subdivision 709-D modify the operation of section 25-35 so that the claimant can deduct the debt, or part of it, only if each entity that was owed the debt for a debt test period could have deducted the debt if it had been written off as bad at the end of the period (section 709-210). For these purposes, the standard continuity of ownership test (section 165-123) and the same business test (section 165-126) principles are modified to make allowance for the different entity types that may be owed a debt within the consolidated group context.

3.14 The amendments in Part 1 of Schedule 3 insert new Subdivision 719-I which makes further modifications to the application of the continuity of ownership test (section 165-123) and the same business test (section 166-40) to ensure that they apply appropriately to MEC groups. [Schedule 3, item 1, section 719-450 ]

3.15 The modifications are required because MEC groups are structured differently to ordinary consolidated groups. Broadly, the modifications ensure that, for MEC groups:

•

the continuity of ownership test is applied to the top company (rather than the head company) of the group

•

if the head company is a listed public company, the same business test is applied to the head company.

When do the MEC group modifications to the bad debt rules apply?

3.16 The MEC group modifications to the bad debt rules apply for the purposes of working out whether the head company of a MEC group can deduct a debt that is incurred by a member of the MEC group (either directly by the head company or by another member of the group) and that is written off as bad. [Schedule 3, item 1, paragraph 719-455(1)(a)]

3.17 The modifications also apply for the purposes of working out whether the head company of a MEC group could have deducted a debt as described in subsection 709-215(2). [Schedule 3, item 1, paragraph 719-455(1)(b)]

3.18 In this regard, the head company of a MEC group could have deducted a debt as described in subsection 709-215(2) because, broadly:

•

a debt is incurred by a subsidiary member of the MEC group prior to it joining the group and is subsequently written off either by the head company of the group or by a subsidiary member that has left the group

or

•

a debt is incurred by a member of the MEC group whilst it is part of the group and is written off after a subsidiary member has left the group.

When the head company is taken to meet the continuity of ownership test

3.19 If the MEC group modifications to the bad debt rules apply, then the head company is taken to meet the continuity of ownership test in section 165-123 only if the top company (the 'test company') for the MEC group at the start of the ownership test period would have met the continuity of ownership test for that period on the assumptions (if applicable) that:

•

nothing happened in relation to certain things that would affect whether the test company would meet the continuity of ownership test

•

the test company would have failed to meet the continuity of ownership test in certain circumstances.

[Schedule 3, item 1, subsection 719-455(2)]

3.20 The continuity of ownership test is applied to the top company for the MEC group to ensure that it is the ultimate owners of the debt that are tested. It would be inappropriate to test the head company of the MEC group as the group's ability to satisfy the continuity of ownership test would change depending on which eligible tier 1 company was chosen as the head company.

3.21 Although the top company is the test company for the purposes of determining whether the head company of a MEC group satisfies the continuity of ownership test, for the purpose of applying the test:

•

the ownership test period referred to in section 165-123 is determined by reference to the head company (rather than the test company)

•

the debt referred to in section 165-123 is a reference to the debt owed to the head company.

Assumption about nothing happening to affect direct and indirect ownership of the test company

3.22 The first assumption that is made for the purpose of applying the continuity of ownership test to the test company is about nothing happening in relation to certain things that would affect whether the test company would meet the continuity of ownership test. [Schedule 3, item 1, paragraph 719-455(2)(a)]

3.23 This assumption must be made whenever there is a change in the identity of the top company for the MEC group during the ownership test period. [Schedule 3, item 1, subsection 719-460(1)]

3.24 The assumption is that, after the change in identity of the top company, for the purpose of applying the continuity of ownership test to the test company, there are no further changes in the membership interests or voting power of:

•

the company that was the top company for the MEC group before the change (the former top company)

or

•

any entity that at the time of the change was interposed between the former top company and the company that became the top company for the MEC group as part of the change (the new top company).

[Schedule 3, item 1, subsection 719-460(2)]

3.25 This assumption ensures that it is the ultimate owners of the MEC group that continue to be tested if the original top company is replaced by a new top company during the ownership test period.

Assumption about the test company failing to meet the continuity of ownership test conditions

3.26 The second assumption that is made for the purpose of applying the continuity of ownership test to the test company is about the test company failing to meet the continuity of ownership test conditions in section 165-123. [Schedule 3, item 1, paragraph 719-455(2)(b)]

3.27 The assumption is that the test company (and therefore the head company of the MEC group) is taken to have failed the continuity of ownership test at the time that certain events happen after the start of the ownership test period in relation to:

•

the MEC group

or

•

the potential MEC group whose membership was the same as the membership of the MEC group.

[Schedule 3, item 1, subsection 719-465(1)]

3.28 One event that could happen after the start of the ownership test period that causes the assumption to apply is that the potential MEC group ceases to exist. [Schedule 3, item 1, subsection 719-465(2)]

3.29 A second event that could happen after the start of the ownership test period that causes the assumption to apply is something that happens in relation to the membership interests of either:

•

a company that, just before the event happens, was an eligible tier 1 company of the top company for the MEC group

or

•

an entity interposed between a company that, just before the event happens, was an eligible tier 1 company of the top company and the company that was the top company for the group just before that time,

where that thing causes a change in the top company for the potential MEC group (but does not cause the potential MEC group to cease to exist). [Schedule 3, item 1, subsection 719-465(3)]

3.30 A third event that could happen after the start of the ownership test period that causes the assumption to apply is the MEC group ceasing to exist because there ceases to be a provisional head company of the group. [Schedule 3, item 1, subsection 719-465(4)]

3.31 If this assumption applies because one of those three events happen, the test company is taken to have failed the continuity of ownership test. However, this does not limit the circumstances in which the test company can fail that test. [Schedule 3, item 1, subsection 719-465(5)]

Head company's failure to meet the continuity of ownership test

3.32 The head company is taken to fail the continuity of ownership test only at the following times (which ever is relevant):

•

The first time the test company failed the continuity of ownership test having regard to the assumptions outlined in sections 719-460 and 719-465.

•

The test time (as described in section 166-40) for the test company if both:

-

Division 166 (which modifies the way in which the continuity of ownership test applies to a listed public company) is relevant in determining whether the test company satisfies the continuity of ownership test having regard to the assumptions outlined in section 719-460

-

the test company is not assumed under section 719-465 to fail the continuity of ownership test before the test time.

[Schedule 3, item 1, subsection 719-455(3)]

Application of the same business test to a head company

3.33 If the head company fails the continuity of ownership test, it will not be able to deduct a bad debt unless it satisfies the same business test (which is contained in Subdivision 165-C).

3.34 Section 166-40 modifies the way in which Subdivision 165-C applies to a company that is a listed public company at all times during the relevant period (the test period) for the purposes of determining whether that company can deduct a bad debt.

3.35 If section 166-40 directly affects whether the head company can deduct a bad debt, then the provisions under that section relating to the same business test are applied to the business of the head company of the MEC group (rather than the test company) just before the time described in subsection 719-455(3). [Schedule 3, item 1, subsection 719-455(4)]

Swap losses

3.36 Section 63E of the Income Tax Assessment Act 1936 (ITAA 1936) specifies the circumstances in which a taxpayer can deduct swap losses. Swap losses arise if the amount of a debt that is extinguished under a debt/equity swap is greater than the equity value of the shares or units received. Section 63E, among other things, specifies that Subdivisions 165-C, 166-C and 175-C of the ITAA 1997 apply to a swap loss deduction in the same way that they apply to a bad debt deduction.

3.37 To ensure that the swap loss rules in section 63E apply appropriately to consolidated groups and MEC groups, the modifications to the bad debt rules for consolidated groups and MEC groups will also apply to determine whether consolidated groups and MEC groups can deduct swap losses. [Schedule 3, items 2, 3 and 19, sections 709-205, 709-215 and 709-220 ]

Making and revoking certain choices

3.38 Part 2 of Schedule 3 to this Bill extends the time within which the head company of a consolidated group or a MEC group can make or revoke each of the following choices:

•

the choice to retain the tax cost of a joining entity's assets

•

the choice to cancel a loss by the head company of a consolidated group or MEC group

•

the choice to use the value donor concessions

•

the choice to waive the capital injection rules

•

the choice to use certain losses over three years.

3.39 The amendments do not extend the consolidation transitional period (which is from 1 July 2002 to 30 June 2004) and do not override any existing requirement that a loss be transferred to the head company of a consolidated group or a MEC group before 1 July 2004.

The choice to retain the tax cost of assets ('stick' or 'spread')

3.40 The head company of a consolidated group that is a transitional group can, in certain circumstances, make a choice, or revoke an earlier choice, for a joining entity to be a chosen transitional entity (section 701-5 of the Income Tax (Transitional Provisions) Act 1997). Currently, this choice, or the revocation of the choice, must have been made by the end of 31 December 2004. If a joining entity is a chosen transitional entity, the tax cost of the joining entity's assets are not reset. This choice is commonly referred to as a choice to 'stick' or 'spread'.

3.41 The time within which the head company must make, or can revoke, this choice will be extended until the end of 31 December 2005. [Schedule 3, items 21 and 22, paragraphs 701-5(2)(b) and 701-5(4)(a) of the Income Tax (Transitional Provisions) Act 1997]

The choice to cancel the transfer of a loss by the head company of a consolidated group

3.42 Losses made by the joining entity of a consolidated group prior to joining the group are, provided certain tests are satisfied, generally transferred to the head company of the group (section 707-120 of the ITAA 1997). The head company can make a choice to cancel the transfer of the loss (section 707-145). A head company may make this choice to, for example, avoid having to recalculate available fractions for its existing bundle of losses when a new loss entity joins the group. Broadly, the available fraction specifies the rate at which losses made by the joining entity of a consolidated group prior to joining the group can be utilised by the head company.

3.43 If an affected entity leaves the consolidated group, the head company can revoke the choice to cancel the transfer of the loss, provided that all affected entities agree (section 707-145 of the Income Tax (Transitional Provisions) Act 1997). Currently, the revocation of the choice must have taken place before 1 January 2005.

3.44 The time within which the head company can revoke a choice made under section 707-120 of the ITAA 1997 will be extended so that the revocation of the choice must take place before 1 January 2006. [Schedule 3, item 23, paragraph 707-145(a) of the Income Tax (Transitional Provisions) Act 1997]

The choice to cancel the transfer of a loss by the head company of a MEC group

3.45 When a company joins an existing MEC group and becomes an eligible tier 1 company of the group or an ordinary consolidated group converts to a MEC group, sections 719-305, 719-310 and 719-315 of the ITAA 1997 may require the head company of the group to:

•

establish an available fraction for any prior year losses of the new eligible tier 1 company

•

adjust the available fractions for bundles of losses of the existing MEC group.

3.46 The head company of a MEC group can choose to cancel all the losses in certain bundles of losses (section 719-325). This choice can be revoked by the head company. However, currently, the revocation of the choice must have taken place before 1 January 2005 (section 719-310 of the Income Tax (Transitional Provisions) Act 1997).

3.47 The time within which the head company can revoke a choice made under section 719-325 of the ITAA 1997 will be extended so that the revocation of the choice must take place before 1 January 2006. [Schedule 3, item 32, section 719-310 of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to use the value donor concessions

3.48 The available fraction for a bundle of losses transferred to the head company of a consolidated group is worked out by, broadly, dividing the modified market value of the real loss maker at the time of the transfer by the transferee's adjusted market value at that time (section 707-320 of the ITAA 1997).

3.49 As a transitional rule, the value donor concessions allow, in certain circumstances, the transferee to increase the available fraction for a bundle of losses by, broadly, choosing to work out the available fraction using some or all of the modified market value of a company other than the real loss maker (section 707-325 of the Income Tax (Transitional Provisions) Act 1997).

3.50 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 24, paragraph 707-325(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.51 In addition, the time within which this choice can be amended or revoked will be extended until 31 December 2005. [Schedule 3, item 25, subsection 707-325(6 ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.52 Where the transferee has chosen to apply section 707-325 of the Income Tax (Transitional Provisions) Act 1997 and uses some or all of the modified market value of a company other than the real loss maker to work out the available fraction for a bundle of losses, the transferee can also choose to treat certain losses made by the value donor as being included in the real loss maker's loss bundle (section 707-327 of the Income Tax (Transitional Provisions) Act 1997).

3.53 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 26, subparagraph 707-327(5)(a)(ii ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.54 In addition, the time within which this choice can be revoked will be extended until 31 December 2005. [Schedule 3, item 27, paragraph 707-327(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to waive the capital injection rules

3.55 The capital injection rules prevent a consolidated group from being able to inflate a joining entity's available fraction by a capital injection or by undertaking a non-arm's length transaction prior to the joining entity becoming a member of the group (section 707-325 of the ITAA 1997).

3.56 As a transitional rule, in certain circumstances where the transferee chooses to apply the value donor concessions, the transferee can also make a choice so that the capital injection rules do not apply to work out the joining entity's available fraction (section 707-328A of the Income Tax (Transitional Provisions) Act 1997).

3.57 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 28, subparagraph 707-328A(4)(a)(ii ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.58 In addition, the time within which this choice can be amended or revoked will be extended until 31 December 2005. [Schedule 3, item 29, paragraph 707-328A(4)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to use certain losses over three years

3.59 As a transitional rule, certain losses transferred to a head company can be utilised over three years rather than being limited to an available fraction (section 707-350 of the ITAA 1997). Broadly, this transitional rule applies to losses that were made during an income year ending on or before 21 September 1999 and that were transferred to the head company because they satisfied the continuity of ownership test. The transferee must make a choice to apply this transitional rule.

3.60 The time within which the transferee can make this choice will be extended until the later of:

•

the day on which the transferee entity lodges its income tax return for the first income year for which it utilises any losses transferred

•

31 December 2005.

[Schedule 3, item 30, paragraph 707-350(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.61 In addition, the time within which this choice can be revoked will be extended until 31 December 2005. [Schedule 3, item 31, subsection 707-350(6 ) of the Income Tax (Transitional Provisions) Act 1997 ]

Application and transitional provisions

3.62 The amendments in Schedule 3 will apply from 1 July 2002 (being the commencement date of the consolidation regime). [Schedule 3, items 20 and 33, section 719-450 of the Income Tax (Transitional Provisions) Act 1997 ]

3.63 These amendments clarify the application of the bad debt rules in the income tax law to MEC groups and give all consolidated groups (including MEC groups) more time to make certain irrevocable elections. Having the amendments apply from 1 July 2002 will provide maximum certainty and minimise the risk of arbitrary outcomes arising from a later commencement date.

Consequential amendments

Modification to the bad debt rules for MEC groups

3.64 Consequential amendments are made to include a reference to new Subdivision 719-I (which contains the modifications to the bad debt rules for MEC groups) in:

•

various provisions and notes to provisions in the Financial Corporations (Transfer of Assets and Liabilities) Act 1993

•

various provisions and notes to provisions in the ITAA 1936

•

various reference tables and notes to provisions in the ITAA 1997.

[Schedule 3, items 4 to 18, section 22 of the Financial Corporations ( Transfer of Assets and Liabilities ) Act 1993, section 427 of the ITAA 1936, sections 266-35, 266-85, 266-120, 266-160, 267-25, 267-65 and 271-60 in Schedule 2F to the ITAA 1936 and sections 12-5, 25-35 and 165-120 of the ITAA 1997 ]

Chapter 4 - Thin capitalisation - transitional provision

Outline of chapter

4.1 Schedule 4 to this Bill explains a transitional provision that allows taxpayers who are subject to the thin capitalisation regime, to use values based on Australian accounting standards as they existed on 31 December 2004 for thin capitalisation purposes. The transitional arrangements are available for three income years commencing on or after 1 January 2005.

4.2 This measure will ensure that a taxpayer's thin capitalisation position is not immediately affected by changes made to the Australian accounting standards from 1 January 2005. On 1 January 2005 Australian accounting standards were aligned with International Financial Reporting Standards.

4.3 This chapter covers:

•

electing to use the transitional provision

•

reconstructing accounts and record keeping

•

transitional arrangements for authorised deposit-taking institutions

•

asset revaluations

•

associate entity excess amount

•

consolidated and multiple entry consolidated (MEC) groups.

Context of amendments

4.4 The measure implements the Treasurer's announcement of 24 January 2005 in Press Release No. 2 that taxpayers will be able to undertake calculations for thin capitalisation purposes using Australian accounting standards as they existed on 31 December 2004, for a three year transitional period.

4.5 For reporting periods commencing on or after 1 January 2005 Australian accounting standards are the equivalent of International Financial Reporting Standards. International Financial Reporting Standards have been adopted as the basis for accounting in Australia to allow for direct comparisons between Australian and foreign country financial statements.

4.6 There are a number of differences between Australian accounting standards as they existed on 31 December 2004 (AGAAP) and Australian accounting standards post-31 December 2004 (AIFRS). For example, AIFRS takes a more conservative approach to balance sheet values, in particular intangible assets.

4.7 As thin capitalisation calculations are derived from financial accounts prepared on the basis of Australian accounting standards, there is the possibility that a number of taxpayers will be disadvantaged from a tax perspective from 2005. The full impact of such a change on the thin capitalisation regime cannot be assessed until taxpayers prepare accounts using the new standards. For most taxpayers this will not be until the end of the 2005-06 financial year.

4.8 In order to allow time to properly assess the impact of the new accounting standards on the thin capitalisation regime, the transitional amendments seek to ensure that taxpayers are not immediately disadvantaged.

Summary of new law

4.9 For a period of three income years commencing on or after 1 January 2005, taxpayers can choose, for any or all of those three years, to use AGAAP as a basis for undertaking their thin capitalisation calculations.

4.10 This includes taxpayers using the authorised deposit-taking institution outward or inward rules. Such taxpayers will be able to calculate their thin capitalisation position on the basis of AGAAP and prudential standards as they existed on 31 December 2004. If an authorised deposit-taking institution chooses to use AGAAP for any of the three income years, that authorised deposit-taking institution must also use prudential standards as they existed on 31 December 2004 in that year.

Comparison of key features of new law and current law

Detailed explanation of new law

Broad outline

4.11 Under the proposed measure, taxpayers subject to the thin capitalisation regime will be able to choose to use AGAAP for thin capitalisation purposes. The transitional arrangements are available for three income years commencing on or after 1 January 2005.

4.12 The measure seeks to ensure that taxpayers are not disadvantaged in determining their thin capitalisation position from 1 January 2005 when Australian accounting standards were aligned with International Financial Reporting Standards.

4.13 The thin capitalisation provisions (Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997)) operate when the amount of debt used to finance the Australian operations of an entity exceeds specified limits. They disallow a certain proportion of otherwise allowable debt deductions (eg interest).

4.14 Debt deductions are denied where an entity's debt to asset ratio exceeds certain limits under the safe harbour debt test, the arms length debt test, or the worldwide gearing debt test. The classification and values of the assets and liabilities of the entity used in these tests are determined by accounting standards (subsection 820-680(1) of the ITAA 1997). Accounting standards has the same meaning as in the Corporations Act 2001.

4.15 In regards to authorised deposit-taking institutions, debt deductions will be reduced where the equity capital used to fund the Australian operations is less than the minimum equity requirement as determined by either the safe harbour capital amount, the arm's length capital amount or, in the case of outward investing authorised deposit-taking institutions, the worldwide capital amount.

4.16 The minimum equity requirement for authorised deposit-taking institutions is a function of the risk-weighted assets and prudential capital deductions of the entity. The risk-weighted assets and prudential capital deductions of the entity are determined in accordance with accounting standards and prudential standards. The prudential standards are determined by the Australian Prudential Regulation Authority (APRA) and are influenced by accounting standards.

4.17 On 1 January 2005, Australian accounting standards were aligned with International Financial Reporting Standards. This could have a significant impact on thin capitalisation outcomes for some taxpayers and that will ultimately affect their tax position.

Electing to use the transitional provision

4.18 Taxpayers can choose to use AGAAP for thin capitalisation purposes in any year covered by the transitional arrangement. The transitional provision covers the income years 2005-06, 2006-07 and 2007-08. For late December balancers, it will cover the income years 2004-05, 2005-06 and 2006-07. [Schedule 4, item 1, subsection 820-45(1)]

4.19 Where the thin capitalisation provisions apply to a taxpayer for a part-year period, the taxpayer may choose to use the transitional provisions for that period if it falls within the three year transitional period.

4.20 There is no requirement that having used the transitional arrangement in one year (or part-year period) the taxpayer must continue to use the arrangements for the rest of the transitional period. For example, a taxpayer may choose to use the transitional arrangement in 2005-06. In 2006-07 the taxpayer may rely on AIFRS and in 2007-08 the taxpayer may choose to use the transitional arrangement.

4.21 Where a taxpayer chooses to use the transitional provision, calculations will be based on AGAAP in determining adjusted average debt and maximum allowable debt. It is expected that most taxpayers will determine the maximum allowable debt using the safe harbour debt amount. Where a taxpayer uses the arms' length debt amount or the worldwide gearing debt amount, calculations should reflect AGAAP. [Schedule 4, item 1, subsection 820-45(2)]

4.22 Where a taxpayer chooses to use the transitional provision, all calculations for the year (or part-year period) must be based on AGAAP. For example, opening and closing balances or more frequent measurements must reflect AGAAP.

4.23 The calculation of associate entity excess amount allows a minor departure from the principle that all calculations must be based on AGAAP (discussed below).

4.24 The transitional provision is only for the purposes of undertaking thin capitalisation calculations in Division 820 of the ITAA 1997. [Schedule 4, item 1, subsection 820-45(2 ), note ( 2)]

4.25 All taxpayers subject to the thin capitalisation rules can choose to use the transitional arrangement. For example, a taxpayer that did not exist as at 31 December 2004 may choose to use the transitional arrangement. Similarly, a taxpayer whose operations have changed significantly over the transitional period may choose to use the transitional arrangement. This is to ensure that all taxpayers face a similar thin capitalisation regime over the transitional period.

4.26 If a taxpayer does not choose to use the transitional provision, AIFRS must be used when calculating its thin capitalisation position. [Schedule 4, item 1, subsection 820-45(5)]

Reconstructing accounts and record keeping

4.27 To take advantage of the transitional arrangement it is not a requirement that taxpayers maintain accounting systems based on AGAAP. Nor is it necessary that taxpayers produce a set of accounts based on AGAAP. [Schedule 4, item 1, subsection 820-45(2 ), note ( 1)]

4.28 For the purposes of the transitional arrangement while the recognition and measurement requirements of AGAAP will apply, the disclosure requirements will not.

4.29 However, for the purposes of undertaking calculations under the thin capitalisation transitional arrangement, taxpayers must use figures that are reasonable approximations for figures that would have been produced using AGAAP.

4.30 Taxpayers must keep sufficient records to be able to demonstrate how they determined the figures they are using for thin capitalisation calculations under the transitional arrangement. What is sufficient will depend on the materiality of any differences between values based on AGAAP and AIFRS.

4.31 Taxpayers will not need to prepare a full set of financial statements under AGAAP in order to use the transitional provision. Taxpayers may take their AIFRS accounts as a base, and then make appropriate adjustments to reflect any material differences between the old and new standards. The AIFRS accounts so adjusted, may be used to calculate amounts under Division 820 of the ITAA 1997.

4.32 Most affected taxpayers will have already identified and disclosed the areas of any material difference between the AGAAP and AIFRS standards in their financial reports for the periods that immediately preceded their transition from AGAAP to AIFRS. With those areas identified, it would generally be sufficient for taxpayers to consider only those differences in making adjustments to their AIFRS accounts for thin capitalisation calculations. However, if there has been a change in a taxpayer's business since transition, the taxpayer will need to consider whether this change has given rise to any 'new' material differences. The level of materiality that the taxpayer adopted for the purposes of disclosing differences at transition, should suggest the level of materiality that would be expected for thin capitalisation purposes.

Example 4.1

DM Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. DM Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet prepared at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

The balance sheet prepared at 31 December 2005 (under AIFRS) has assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision, the opening balance will be:

$30 million + $10 million = $40 million

and the closing balance:

$50 + $10 million = $60 million.

(Assuming the intangibles would still be valued at $10 million under AGAAP.)

Example 4.2

Wendy Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. Wendy Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

During the year the value of the internally generated intangible assets increased by $5 million to $15 million. The balance sheet at 31 December 2005 (under AIFRS) shows assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision the opening balance will be:

$30 million + $10 million = $40 million

and the closing balance:

$50 + $15 million = $65 million.

(Assuming that the increase in internally generated intangible assets is recognised under AGAAP.)

Example 4.3

NK Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. NK Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

During the year the value of the internally generated intangible asset decreases by $5 million. The balance sheet as at 31 December 2005 (under AIFRS) has assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision the opening balance will be:

$30 million + 10 million = $40 million

and the closing balance:

$50 million + $5 million = $55 million.

(Assuming that the decrease in internally generated intangible assets is recognised under AGAAP.)

Authorised deposit-taking institutions

4.33 Authorised deposit-taking institutions and other taxpayers using authorised deposit-taking institution outbound and inbound rules at Subdivisions 820-D and 820-E can choose to use the transitional provision. If they do, calculations will be based on AGAAP in determining adjusted average equity capital or average equity capital. In determining the minimum capital amount, taxpayers will be required to apply AGAAP and prudential standards as at 31 December 2004 to determine amounts used in the calculations, for example, in determining risk-weighted assets and prudential capital deductions. [Schedule 4, item 1, subsections 820-45(2) and (4)]

4.34 The transitional provision is only for the purposes of undertaking thin capitalisation calculations in Division 820 of the ITAA 1997. [Schedule 4, item 1, subsections 820-45(2) and (4 ), note ( 2)]

4.35 To take advantage of the transitional arrangement it is not a requirement that taxpayers maintain a full set of accounts based on AGAAP and a full set of capital adequacy calculations based on prudential standards at 31 December 2004. [Schedule 4, item 1, subsections 820-45(2) and (4 ), note ( 1)]

4.36 For the purposes of undertaking calculations under the thin capitalisation transitional arrangement, authorised deposit-taking institutions must use figures that are reasonable approximations for figures that would have been produced using AGAAP and prudential standards at 31 December 2004. Authorised deposit-taking institutions must keep sufficient records to be able to demonstrate how they determined the figures they are using for thin capitalisation calculations under the transitional arrangements. What is sufficient will depend on the materiality of any differences between values based on AGAAP and AIFRS and the relevant prudential standards.

4.37 In the case of authorised deposit-taking institutions, if the taxpayer does not choose to use the transitional provision, AIFRS and current prudential standards apply to that entity's thin capitalisation calculations. [Schedule 4, item 1, subsection 820-45(6)]

Asset revaluations

4.38 Subsection 820-680(2A) of the ITAA 1997 excludes taxpayers from certain record keeping requirements associated with the revaluation of assets for thin capitalisation calculations. For the purposes of applying the transitional arrangement, the requirements of subsection 820-680(2A) can be satisfied where it is reasonable to expect that the revaluation of an asset would have been reflected in statutory financial statements based on AGAAP for the period. For example, where a class of assets has been revalued at regular intervals and this has been reflected in past statutory financial statements.

Associate entity excess amount

4.39 Subdivision 820-I of the ITAA 1997 sets out thin capitalisation rules related to associate entities. The associate entity excess amount allows the taxpayer to take advantage of excess debt capacity in an associate entity.

4.40 Where both the taxpayer and the associate are using the transitional arrangement the calculation of the associate entity excess amount will be based on AGAAP figures for the associate entity.

4.41 Where the taxpayer does not use the transitional arrangement but the associate does, the calculation of the associate entity excess amount will be based on the AIFRS accounts of the associate entity. [Schedule 4, item 1, subsection 820-45(2)]

4.42 Where the taxpayer is using the transitional arrangement and the associate entity does not, the taxpayer has a choice whether to calculate its associate entity excess amount on the basis of the AIFRS accounts used by the associate entity or on the basis of AGAAP figures constructed by the taxpayer from the AIFRS accounts of the associate entity. [Schedule 4, item 1, subsection 820-45(3)]

4.43 The taxpayer is given the choice of using AIFRS to calculate its associate entity excess amount notwithstanding it is using AGAAP for its other thin capitalisation calculations, because of the potential compliance costs and difficulties that it might have accessing information to construct AGAAP figures from the associate entity's AIFRS accounts. This choice is the only departure from the general principle that a taxpayer using the transitional arrangement must use AGAAP figures when undertaking all of its thin capitalisation calculations.

4.44 Where the taxpayer bases its thin capitalisation calculations on AGAAP figures constructed from the associate entity's AIFRS accounts the taxpayer must maintain appropriate records that demonstrate how the taxpayer determined the figures.

Consolidated groups and MEC groups

4.45 Where a head company or single company chooses to use the transitional arrangement, this applies to all entities in the thin capitalisation group, including permanent establishments.

Application and transitional provisions

4.46 The amendments apply to three income years commencing on or after 1 January 2005.

Chapter 5 - Forestry managed investments

Outline of chapter

5.1 Schedule 5 to this Bill extends the operation of section 82KZMG of the Income Tax Assessment Act 1936, which was set to expire on 30 June 2006, until 30 June 2008. The amendment ensures that investors in forestry managed investment schemes can continue to claim deductions for certain prepaid expenditure for a further two years.

Context of amendments

5.2 Section 82KZMG provides a '12-month rule' that, in effect, facilitates an immediate deduction for certain prepaid expenditure incurred under a plantation forestry managed agreement. The 12-month rule applies to expenditure for 'seasonally dependent agronomic activities' that will be carried out during the establishment period of a particular planting of trees. The provision applies to expenditure incurred on or after 2 October 2001 and on or before 30 June 2006.

5.3 In the Minister for Revenue and Assistant Treasurer's Press Release No. 35 of 10 May 2005, the Government announced its intention to extend the operation of the 12-month rule until 30 June 2008. The Government stated that the extension for a further two years of the 12-month rule would allow an extensive review to be conducted into all aspects of support for the plantation timber industry.

Summary of new law

5.4 Schedule 5 ensures that eligible taxpayers may continue to claim a deduction for certain prepaid expenditure provided the expenditure is incurred on or before 30 June 2008.

Comparison of key features of new law and current law

Chapter 6 - Debt and equity interests

Outline of chapter

6.1 Schedule 6 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

•

deem related party at call loans to small companies to be debt under the debt/equity rules (paragraphs 6.2 to 6.32)

•

make a number of minor technical amendments to ensure that the debt/equity rules work as intended (paragraphs 6.33 to 6.39). The technical amendments will have effect from 1 July 2001.

Context of amendments - related party at call loans

6.2 A 'related party at call loan' is an undated loan repayable on demand by a connected entity. Many small companies acquire finance by at call loans. In many cases the owners of the company will deposit cash into the company's bank account as required and withdraw cash when the company has sufficient funds. The owners generally treat deposits as a loan or loans and each withdrawal as a repayment or part repayment.

6.3 The debt/equity rules in Division 974 of the ITAA 1997 determine which interests in a company are debt and which are equity for income tax purposes. Under the debt/equity rules, at call loans may be characterised as equity interests rather than debt interests. This means that outgoings in relation to the loan may be treated as frankable dividends. Generally, record keeping is more onerous and compliance costs greater if the loans are treated as equity than otherwise would be the case.

6.4 The Minister for Revenue and Assistant Treasurer announced in Press Release No. 063 of 15 July 2005 that the Government would amend the income tax law to deem certain related party at call loans to small businesses to be debt under the debt/equity rules.

6.5 The objective of this measure is to lower compliance costs for small business.

Summary of new law - related party at call loans

6.6 The amendments will deem certain schemes to be debt under the debt/equity rules in Division 974. This means the scheme will be treated as a debt interest in a company for tax purposes. The amendments apply if:

•

the scheme is a related party at call loan

and

•

at the end of an income year, the company has an annual turnover of less than $20 million.

Comparison of key features of new law and current law - related party at call loans

Detailed explanation of new law - related party at call loans

6.7 The amendments deem, in a year of income, certain schemes to be debt under the debt/equity rules in Division 974. This means that such a scheme will be treated as a debt interest in a company for tax purposes in that year of income. The amendments apply if, in the year of income:

•

the scheme is a related party at call loan [Schedule 6, item 8, paragraph 974-75(6)(a)]

and

•

the company satisfies the turnover test [Schedule 6, item 8, paragraph 974-75(6)(b)] .

6.8 If these conditions are satisfied, Division 974 will deem all related party at call loans of the company to be debt interests for that year of income. [Schedule 6, item 8, subsection 974-75(6)]

6.9 If these conditions are not satisfied, the related party at call loan may give rise to an equity interest depending on the pricing, terms and conditions of the scheme.

Step 1: are there any schemes that are related party at call loans to a company?

6.10 The deeming only applies to schemes which are related party at call loans:

•

The scheme must take the form of a loan to a company by a connected entity.

•

The loan must not have a fixed term.

•

The loan must be repayable on demand by the connected entity or on the death of the connected entity.

[Schedule 6, item 6, paragraph 974-75(4)(c); item 8, paragraph 974-75(6)(a)]

6.11 A loan is 'repayable on demand' if, under its express or implied terms, the lender can demand repayment at any time. An example of such a loan is one where there are no express terms, but it is apparent from the circumstances that parties anticipate repayment on demand.

6.12 A loan may be repayable on demand if there is a notice period between the time of demand and the time payment is due, so long as the period is not longer than is reasonably necessary to arrange payment. For example, a loan which is expressly stated to be repayable 'within 14 days of written demand by the lender' may be repayable on demand.

6.13 The terms 'scheme' and 'connected entity' are defined in subsection 995-1(1) of the ITAA 1997. A 'scheme' is any arrangement, plan, proposal, action, course of conduct or action, whether unilateral or otherwise. A 'connected entity' of the company is any 'associate' or member of the same wholly-owned corporate group. 'Associate' is defined in subsection 995-1(1) of the ITAA 1997.

Example 6.1: Schemes that are related party at call loans

Meggan owns and controls a small company, Meggan Pty Ltd.

The company requires an additional $5,000 cash to cover operating expenses in the next month. Meggan transfers this amount from her personal cash account to the company's account. Meggan anticipates the company will repay this amount whenever she seeks it. This will likely be when the company has sufficient profits or cash flow. The company records a liability owed to Meggan in its accounts. Otherwise, there is no documentation of the loan.

The company also needs $100,000 to purchase new equipment. Meggan agrees to lend this amount to the company and has her solicitor draw up a loan agreement between her and Meggan Pty Ltd. The agreement says the loan is 'repayable within 14 days of written demand by the lender'. The agreement does not specify a term for the loan. No interest is payable.

In deciding whether the loans to Meggan Pty Ltd are related party at call loans, the relevant taxpayer is Meggan Pty Ltd.

As Meggan owns the company she is an associate of the company and therefore a 'connected entity'.

Neither loan has a fixed term.

Both loans are repayable on demand because Meggan may demand repayment at any time and the company is obliged to pay her. This is the case even though the first loan is silent as to repayment and the second loan requires 14 days notice.

Step 2: does the company pass the turnover test?

6.14 The second step is to determine if the company satisfies the turnover test. [Schedule 6, item 8, paragraph 974-75(6)(b)]

Turnover test

6.15 To pass the turnover test, the company's annual turnover must be less than $20 million. A company's annual turnover is to be calculated in the same way that it is for goods and services tax (GST) purposes. 'Annual turnover' is measured as prescribed in Division 188-10 of the A New Tax System (Goods and Services Tax) Act 1999. [Schedule 6, item 8, subsection 974-75(7)]

Consequences of qualifying for deemed debt treatment

6.16 If a scheme qualifies for 'deemed' debt treatment, it means the scheme will receive debt treatment under subsection 974-75(6) of the debt/equity rules in Division 974. [Schedule 6, item 8, subsection 974-75(6)]

What happens when the scheme ceases to qualify or begins to qualify?

6.17 A scheme may qualify for deemed debt treatment under the debt/equity rules in one year but not the next year because the company ceases to satisfy the turnover test. This means that related party at call loans to the company could change from being debt interests to being equity interests.

6.18 On the other hand, a scheme may not qualify in one year, but begin to qualify in the next year. This would be because the company does not pass the turnover test in the first year but passes the test in the second year. In this case, deeming applies to related party at call loans to the company from the beginning of the second income year. [Schedule 6, item 8, subsection 974-75(6)]

6.19 In light of this, taxpayers may wish to alter their loans so they are debt interests under the debt/equity rules. Taxpayers that are private companies may elect to treat this change as if it occurred at the beginning of the previous income year. They must make this election before the earlier of the due date for the company's tax return or the date of actual lodgement for that year. This removes the need to treat the loan as an equity interest for that previous year. [Schedule 6, items 9 to 12, subsections 974-110(1A) and (1B)]

6.20 Diagram 6.2 illustrates what happens when a private company makes the election.

Application and transitional provisions - related party at call loans

6.21 The amendments apply to:

•

schemes entered into on or after 1 July 2005

and

•

schemes entered into before 1 July 2005, in so far as they continue to exist at that date.

[Schedule 6, item 13 ]

6.22 Under subsection 974-75(4) all related party at call loans are treated as debt interests until 1 July 2005.

6.23 The treatment of related party at call loans entered into before 1 July 2005 and still in existence on that date may change on that date. If the scheme qualifies for deemed debt treatment, it will continue to be treated as a debt interest. If the scheme does not qualify, this may give rise to an equity interest, depending on their particular pricing, terms and conditions.

6.24 The terms and conditions of a related party at call loan may be changed before 1 July 2005 so it becomes a debt interest under section 974-15 of the ITAA 1997. This Bill ensures that the debt/equity rules will treat the loan as a debt interest on and after 1 July 2005. [Schedule 6, item 22, subsection 974-75(5)]

6.25 These amendments will apply from 1 July 2005. The existing transitional provision in subsection 974-75(4) which deemed related party at call loans to be debt, expired on 30 June 2005. The 1 July 2005 application date will ensure continuing deemed debt treatment for the related party at call loans of those small companies that qualify for deemed debt treatment.

6.26 Although these amendments are retrospective, taxpayers will not be adversely affected. The amendments, in combination with the technical amendments, will provide all taxpayers with the opportunity to enjoy the compliance cost savings of debt treatment for related party at call loans.

Consequential amendments - related party at call loans

6.27 This Bill amends the existing rule which treats related party loans as debt interests until 1 July 2005. It ensures this transitional rule defines 'related party at call loans' in the same way as for small business deemed debt treatment. This is to remove any doubt that the small business deemed debt treatment and the existing transitional rule apply to the same type of loans. [Schedule 6, item 6, paragraph 974-75(4)(c)]

6.28 This Bill amends the non-share capital account provisions to clarify that a company will have a non-share capital account if:

•

a debt interest in a company changes to an equity interest as a result of a material change under subsection 974-110(1) or (2)

•

a related party at call loan that is taken to be a debt interest under subsection 974-75(4) prior to that provision ceasing to have effect becomes an equity interest on 1 July 2005 because the company does not qualify for deemed debt treatment

or

•

the small company deemed debt treatment applies to a related party at call loan in a particular year of income but not the subsequent year of income and such loan will be an equity interest at the start of that subsequent year of income.

[Schedule 6, item 1, paragraphs 164-10(1)(c) to (e)]

6.29 This Bill also ensures there will be a credit to the non-share capital account where a non-share capital account arises as a result of:

•

a debt interest in a company changing to an equity interest as a result of a material change under subsection 974-110(1) or (2)

•

a related party at call loan being treated as an equity interest on 1 July 2005 because subsection 974-75(4) no longer applies and the company does not qualify for deemed debt treatment

or

•

the small company deemed debt treatment applies to a related party at call loan in a particular year of income but not the subsequent year of income and such loan will be an equity interest at the start of that subsequent year of income.

[Schedule 6, item 2, subsection 164-15(2)]

6.30 Where a related party at call loan gives rise to a non-share equity interest during a year of income but subsequently the at call loan is taken to be a debt interest by subsection 974-75(6) or 974-110(1A) in relation to the year of income, a credit is taken never to have arisen. [Schedule 6, item 3, subsection 164-15(5)]

6.31 There is a debit to the non-share capital account if:

•

an equity interest in a company changes to a debt interest as a result of a material change under subsection 974-110(1) or (2)

•

an equity interest of a private company changes to a debt interest as a result of the application of subsection 974-110(1A)

or

•

the small business deemed debt treatment applies to an interest that was an equity interest at the end of the previous year. This debit will occur at the start of that second year of income.

[Schedule 6, item 4, subsection 164-20(3)]

6.32 Where a related party at call loan appears to give rise to a debt interest during the year of income but it is subsequently determined that this is not the case a debit in the non-share capital account in respect of the loan, being classified as a debt interest, is taken never to have arisen. [Schedule 6, item 5, subsection 164-20(4)]

Context of amendments - technical amendments

6.33 The Minister for Revenue and Assistant Treasurer announced in Press Release No. 002 of 5 August 2004 that the Government would amend the debt/equity rules in light of technical issues raised by taxpayers. The amendments will ensure that the provisions operate as intended.

Summary of new law - technical amendments

6.34 This Bill makes technical amendments to ensure that the debt/equity rules in Division 974 of the ITAA 1997 operate as intended.

Detailed explanation of new law - technical amendments

6.35 This Bill makes the following technical amendments to the ITAA 1997 and the Income Tax Assessment Act 1936 (ITAA 1936):

•

ensures that the issue of non-equity shares does not give rise to a capital gain [Schedule 6, items 16 to 21 and 28 to 32, paragraphs 104-35(5)(c) and (e ), 104-155(5)(c) and (e ) and section 109-10 ]

•

corrects a defect in the transitional rules for the debt/equity rules so that a non-share capital account and credits to that account arise appropriately when the taxpayer elects to apply the debt/equity rules from 1 July 2004 [Schedule 6, items 26 and 27, subitems 118(2 ) and 118(9 ) of Schedule 1 to the New Business Tax System ( Debt and Equity ) Act 2001 ]

•

corrects several errors in section references [Schedule 6, items 14, 15, 23 and 24, subsections 160AOA(2), 160APAAAB(6), 974-105(1) and 974-110(1) and (2)] .

Application and transitional provisions - technical amendments

6.36 These amendments are to be taken to have commenced immediately after the commencement of the New Business Tax System (Debt and Equity) Act 2001. That Act commenced on 1 July 2001. [Schedule 6, item 25 ]

6.37 The amendments relating to non-equity shares apply in two stages. The first stage is in items 16 to 24 of the Schedule. These amendments will be taken to have commenced on 1 July 2001, which was the commencement date for the inclusion of the debt/equity rules in the ITAA 1997. These amendments therefore will date back to a time before the definition of 'non-equity share' was inserted into the ITAA 1997 (that definition was not inserted until 29 June 2002). This means they must instead refer to the definition of that expression that was then in the ITAA 1936.

6.38 The second stage is in items 28 to 32 of the Schedule. These commence on Royal Assent, to take account of the fact that 'non-equity share' is now defined in the ITAA 1997 as having the same meaning as it has in the ITAA 1936.

6.39 These amendments are retrospective. However, taxpayers will not be adversely affected. The amendments will address technical issues brought to the attention of the Minister for Revenue and Assistant Treasurer by taxpayers and reduce confusion caused by defects in the debt/equity rules.

REGULATION IMPACT STATEMENT

Policy objective

6.40 The objective of the proposed amendment is to lower compliance costs for small business in respect of their related party at call loans.

Background

6.41 The treatment of related party at call loans under the debt/equity rules in Division 974 carry record keeping and other compliance costs for companies. While larger companies are capable of absorbing these costs, smaller companies may be adversely affected by the additional compliance costs.

Implementation options

6.42 The issue of compliance costs for small companies has arisen because of the possible treatment of related party at call loans as equity interests under the debt/equity rules in Division 974 of the ITAA 1997. These compliance costs arise from the need to keep specific tax accounts as a result of their related party at call loan being treated as an equity interest or incur costs in formalising their at call loan agreements so as to avoid equity treatment. Equity treatment would mean any interest payments would lose their tax deductibility.

6.43 Various options (see below) were considered for reducing the compliance costs of small companies with related party at call loans.

Assessment of impacts

Impact group identification

Small companies

6.44 The reduction in compliance costs for small companies is to be achieved by deeming their related party at call loans to be debt interests in accordance with the debt/equity rules in Division 974 of the ITAA 1997. The impact of the amendments on small companies will likely flow through to the tax agents of those small companies.

Australian Taxation Office

6.45 As the Australian Taxation Office (ATO) is charged with administering the debt/equity rules, it will be directly affected by the amendments.

Analysis of costs / benefits

6.46 This section outlines the costs and benefits of all options considered. The following analysis of costs and benefits is qualitative because a quantitative analysis was not possible due to the lack of data available on small companies. The ATO would incur some small, initial costs in staff becoming familiar with the test, but going forward there is expected to be less need for work on related party at call loan issues.

Option 1: qualification for loans where a company is eligible for small business CGT $5 million net asset value test

Small companies

6.47 Submissions, particularly those received following the release of the Treasury discussion paper Review of the application of the debt/equity provisions of the income tax law to certain post-30 June 'at call' loans in April 2004, advanced many options, though this option was generally favoured.

6.48 The use of the net asset value test in this context would involve using the test more regularly than currently is the case. At present, the test is applied only on disposal of a capital gains tax (CGT) active asset. The test is also relatively costly in terms of compliance, as an annual valuation of assets would need to be undertaken.

6.49 This option could also increase workloads for tax agents and other specialists required to provide asset valuation services.

Option 2: qualification based on annual turnover of the company

Small companies

6.50 This option was supported by participants at a consultation meeting on 4 April 2005, and in subsequent submissions. This test is already used by small companies for GST purposes. It is expected that this option will have minimal compliance costs due to small company familiarity with annual turnover, and would not impact on taxpayer behaviour.

6.51 This option may well reduce the demand for tax agent services.

Option 3: allowing private companies to formalise their at call loans so that they will be debt interests

Small companies

6.52 This option would provide private companies with the opportunity to ensure debt treatment of related party at call loans, avoiding the compliance costs associated with equity treatment.

6.53 However, private companies which choose to formalise loans to ensure debt treatment of related party at call loans would bear costs from the drafting of the loan contract and the tracking of the loan through accounting systems.

6.54 This option is expected to increase the workload of tax agents in assisting private companies to formalise related party at call loans.

Consultation

6.55 In line with the Government's commitment to community consultation on tax policy and law design (Treasurer's Press Release No. 022 of 2 May 2002), the Treasury has conducted a targeted public consultation process.

6.56 On 7 April 2004, the Treasury published a discussion paper on the taxation of related party at call loans. Almost 40 parties made submissions in response to the discussion paper.

6.57 In March 2005, the Government invited parties who had made submissions to view draft legislation and make comments. Treasury officials met with interested parties.

Conclusion and recommended option

6.58 The Government decided to apply an annual turnover test of less than $20 million to determine whether a company's related party at call loan should be subject to the debt/equity rules. The Government also decided to allow private companies with a turnover of $20 million or more to formalise their related party at call loans to ensure debt treatment and thus reduce compliance costs.

6.59 Option 1 was discarded because its application would impose high compliance costs.

6.60 The estimated cost to revenue is up to $14 million per annum. Based on assumptions used to determine the impact of the amendments on the Budget, it is estimated that the related party at call loans of approximately 98,000 companies will be deemed as debt under the debt/equity rules.

6.61 The Treasury and the ATO will monitor these taxation measures, as part of the whole system, on an ongoing basis.

Index

Schedule 1: Modifications to exemption for foreign earnings

Schedule 2: Tax offset for Australian production expenditure on television series

Schedule 3: Consolidation

Schedule 4: Thin capitalisation

Schedule 6: Debt and equity interests