House of Representatives

Explanatory Memorandum

(Circulated by 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

Disposal of leases and leased plant

This Bill amends the income tax law to:

•

include an amount in the assessable income of a taxpayer that disposes of an interest in leased plant or a lease of plant;

•

trigger a balancing charge for 100% subsidiaries of wholly-owned groups by treating the subsidiary as having disposed of and reacquired its depreciable plant at market value where:

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the group transfers the majority beneficial ownership in the subsidiary to an entity outside the group that is not in the same business as the group;

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the subsidiary leases out the depreciable plant for a majority of the period it was held by the subsidiary; and

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some or all of the lease period occurred on or after 22February 1999; and

•

where the balancing charge is triggered, make the subsidiary and all the companies that were members of the group immediately before the time the subsidiary was transferred jointly and severally liable if the subsidiary does not pay tax arising from the balancing charge within 6 months of the due date for payment.

Date of effect: The amendments apply to:

•

disposals of interests in leased assets or leases on or after 22February 1999, if the asset was leased for most of the period it was held; and

•

transfers of majority benefical ownership interests in 100% subsidiaries on or after 22 February 1999.

Proposal announced: The proposal was announced in Review of Business Taxation Press Release No. 4 of 22 February 1999, and in Treasurers Press Release No. 58 of 21September 1999 (in particular, refer to Attachment R of that Press Release).

Financial impact: The financial impact of this measure is set out in the table below:

Compliance cost impact: Taxpayers may incur some compliance costs in undertaking additional calculations or obtaining market valuation.

Value shifting through debt forgiveness

This Bill amends the income tax law, to deal with debt forgiveness arrangements entered into between commonly-owned companies. Where a debt is forgiven, the amendments will:

•

require reductions to the cost base of equity interests, and in certain circumstances of debt interests, held directly or indirecly in the creditor company that are subject to CGT; and

•

require compensatory increases in certain circumstances to the cost base of equity interests held directly or indirectly in the debtor company that are subject to CGT.

Date of effect: The amendments apply to debts forgiven on or after 22February 1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release). It is one of the measures to prevent abuse of deficiences in the current business tax system foreshadowed in Treasurers Press Release No. 10 of 22 February 1999.

Financial impact: This measure is estimated to raise revenue of $25million in 2000-2001 and $22 million in 2001-2002. This measure is expected to cease on commencement of consolidation.

Compliance cost impact: Affected taxpayers may incur some compliance costs associated with determining the adjustments to be made to cost bases and reduced cost bases.

Excess deductions

This Bill amends the ITAA 1997 to remove deduction limitson exploration and prospecting expenditure and allowable capital expenditure on mine development.

Date of effect: The amendments apply to excess deductions available at 21 September 1999. For taxpayers whose 1998-1999 income year ends after 21 September 1999 the amendments will apply to excess deductions available on the first day of their 1999-2000 income year.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release).

Financial impact: The financial impact of this measure is set out in the table below:

Compliance cost impact: This measure will reduce compliance costs as it will reduce the need for calculations and record keeping.

Preventing a deduction and a capital loss arising from a single economic loss

This Bill amends the ITAA 1997 to ensure that a taxpayer cannot claim a deduction and a capital loss for the same economic loss when a CGT event occurs in relation to a CGT asset.

Date of effect: The amendments apply to CGT events (such as the disposal of an asset) occurring on or after the date of introduction of this legislation.

Proposal announced: On introduction.

Financial impact: This is a revenue protection measure.

Compliance cost impact: None.

Transfer or creation of assets by companies that are members of linked groups

This Bill amends the ITAA 1997 to defer recognition of capital losses or deductions which would otherwise be realised when:

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an asset is transferred between companies in the same linked group;

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an asset is created in a company in the same linked group; or

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an asset is transferred to, or created in, an entity or an associate of that entity, and that entity is connected with a member of the linked group.

Date of effect: The amendments apply to CGT events (such as the disposal of an asset) occurring on or after the date of introduction of this legislation.

Proposal announced: The original proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release).

Financial impact: The financial impact of this measure is set out in the following table:

Compliance cost impact: Affected taxpayers may incur minimal compliance costs associated with determining whether a capital loss or deduction can be recognised.

Transfer of losses within wholly-owned groups of companies

This Bill amends the income tax law to prevent the duplication of a tax loss or a net capital loss which has been transferred between wholly-owned group companies, where direct or indirect interests in the loss company are realised by:

•

reducing the cost base of equity and debt interests held directly or indirectly in the loss company that are subject to CGT if certain conditions are satisfied;

•

increasing the cost base of interests held directly or indirectly in the income company that are subject to CGT if certain conditions are satisfied; and

•

clarifying the current law intended to prevent the duplication of net capital losses.

Date of effect: The amendments apply where losses are transferred under a written agreement made on or after 22 February 1999. In addition, for tax loss transfers the amendments only apply where CGT events happen in relation to shares or debts on or after 22 February 1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release). It is one of the measures to prevent abuse of deficiences in the current business tax system foreshadowed in Treasurers Press Release No. 10 of 22 February 1999.

Financial impact: This measure is estimated to raise revenue of $35million in 2000-2001 and $20 million in 2001-2002. This measure is expected to cease on commencement of consolidation.

Compliance cost impact: Affected taxpayers may incur some compliance costs associated with determining the adjustments to be made to cost bases of CGT assets.

The continuity of ownership test

This Bill amends the ITAA 1997 to remedy defects in the continuity of ownership test, currently applying to tax losses, net capital losses and bad debts of a company, and proposed to apply to companies with unrealised net losses.

Date of effect: The amendments apply to:

•

tax losses, net capital losses and bad debt deductions claimed in an income year ending after 21 September 1999; and

•

unrealised net losses, in respect of which the continuity of ownership test is failed after 11.45 am AEST on 21September1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release).

Financial impact: The financial impact of this measure is set out in the following table:

Compliance cost impact: The measure may increase compliance costs due to the requirement for companies to demonstrate the maintenance of continuous majority ownership. Depending on the extent to which a companys shareholder is widely-held.

Applying the same business test to unrealised losses

This Bill amends the ITAA 1997 to limit the extent of the duplication of company losses that are unrealised at the time of a substantial change in a companys ownership or control, by applying the same business test.

Date of effect: The amendments apply to losses that are incurred after 11.45 am AEST on 21 September 1999. The amendments providing for the application of the same business test apply to a company that:

•

undergoes a substantial change of ownership or control after 11.45 am AEST on 21 September 1999; and

•

has an unrealised net loss in respect of assets it held at the time of that change.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment Q to that Press Release).

Financial impact: The financial impact of this measure is set out in the following table:

Compliance cost impact: The measure may increase compliance costs faced by companies, depending on the extent and nature of company asset holdings.

Deducting prepayments

This Bill amends the ITAA 1936 to:

•

deny access by medium and large businesses to the 13 month rule, which allows immediate deductions of prepayments for things to be done within 13months; and

•

spread deductions arising from prepayments for those businesses over the period the prepayment covers (to a maximum of 10 years).

Date of effect: The amendments generally apply to prepayments incurred after 11.45 am AEST on 21 September 1999. Special transitional provisions apply if prepayments are made in the income year that includes 21September 1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment J to that Press Release).

Financial impact: The financial impact of this measure is set out in the following table:

Compliance cost impact: This measure is expected to reduce compliance costs over time as the tax treatment of prepayments would be aligned more closely to the accounting treatment.

Limiting indexation of cost bases of CGT assets

This Bill amends the ITAA 1997 to:

•

freeze indexation of the cost base of an asset at 30 September 1999, if that asset was acquired at or before 11.45 am AEST on 21 September 1999 and disposed of after that date; and

•

deny indexation of the cost base of assets acquired after 11.45am AEST on 21 September 1999.

Date of effect: The amendments apply to the calculation of the cost base of an asset for a CGT event (such as the disposal of the asset) occurring after 11.45 am AEST on 21 September 1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment D to that Press Release).

Financial impact: The financial impact of this measure is included in the estimates reported under the measure dealing with reduced CGT rates for individuals, trusts and other entities.

Compliance cost impact: The measure will reduce compliance costs through simplifying the calculation of the amount of a capital gain to be included in assessable income.

Concessions for capital gains by individuals and some other entities

This Bill amends the ITAA 1997 so that:

•

for assets acquired at or before 11.45 am AEST on 21September 1999 and held for at least 12 months:

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individuals and trusts can choose to calculate any capital gain on an asset by either using an indexed cost base with indexation frozen or reducing by one-half the capital gain without indexation of the cost base; and

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superannuation funds can choose to calculate any capital gain on an asset by either using a frozen indexed cost base or reducing by one-third the capital gain without indexation of the cost base; and

•

for assets acquired after 11.45 am AEST on 21 September 1999 and held for at least 12 months:

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individuals and trusts are allowed a one-half exemption on any capital gain made in relation to the asset; and

-

superannuation funds are allowed a one-third exemption on any capital gain made in relation to the asset.

Date of effect: The amendments apply to capital gains arising from CGT events occurring after 11.45 am AEST on 21 September 1999:

•

Individuals, trusts and superannuation funds can choose how the capital gain is treated for assets acquired at or before 11.45am AEST on 21 September 1999.

•

The exemption will apply to capital gains arising for individuals, trusts and superannuation funds from assets acquired after 11.45 am AEST on 21 September 1999.

Proposal announced: The proposal was announced in Treasurers Press Release No. 58 of 21 September 1999 (in particular, refer to Attachment D to that Press Release).

Financial impact: The financial impact of this measure is part of the estimate for the measures limiting indexation of cost bases of CGT assets in this Bill, CGT concessions for individuals, trusts and other entities, and abolishing averaging for individuals. The provisions relating to the abolishing of averaging are to be included in a later Bill.

The financial impact of these measures is set out in the following table:

Compliance cost impact: Negligible.

Summary of Regulation Impact Statement

Regulation Impact on Business

Impact: The measures contained in this Bill are part of the Governments broad-ranging reforms which will give Australia a New Business Tax System. These reforms are based on the Recommendations of the Review that the Government established to consider reforms to Australias business tax system.

The New Business Tax System will be a simpler and sounder tax system with lower compliance costs.

Main points:

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The potential compliance, administrative and economic impacts of the measures contained in this Bill have been carefully considered, both by the Review and the business sector. The business sector was involved in the substantial consultation process associated with the Review.

•

Most of the measures in this Bill impact on a particular group of taxpayers (e.g. the measures dealing with artificial duplicated losses will impact on companies) or taxpayers that undertake a particular transaction (e.g. the measure dealing with disposals of leases and leased plant apply to taxpayers who undertake these disposals).

•

Some of the measures have a wider impact (e.g. the measure removing CGT indexation will apply to all taxpayers with CGT assets).

•

Most of the measures are expected to decrease compliance costs (e.g. the measure removing CGT indexation will significantly simplify how taxpayers work out capital gains). Where measures may increase compliance costs for some taxpayers, they also provide taxpayers with greater flexibility in managing their affairs or preserve the integrity of the tax system.

•

The administrative costs of implementing the measures in this Bill are expected to be minimal.

Chapter 1 - Disposal of leases and leased plant

Outline of Chapter

1.1 This Chapter explains new Division 45, inserted into the ITAA 1997 by item 12 of Schedule 1 to this Bill. Division 45 will include an amount in the assessable income of a plant lessor when plant which has been used principally for leasing is disposed of on or after 22February1999 and the consideration and other benefits received from the disposal exceed the plants depreciated value. Division 45 will also apply when an interest in leased plant is disposed of, including by the disposal of an interest in a partnership or by a wholly-owned company group selling a majority beneficial interest in shares in a subsidiary company that holds leased plant. It will also apply where there is a disposal of rights under a lease of plant (e.g. the rights to receive a flow of rental income). Some part of the plant lease period must have occurred on or after 22February1999.

1.2 Division 45 will also treat each member of a wholly-owned group of companies as jointly and severally liable for any unpaid tax liability of a leasing subsidiary imposed as a result of the application of the Division to that subsidiary.

1.3 The operation of Division 45 is modified for the period 22February1999 to 11.45 am AEST on 21 September 1999.

Context of Reform

1.4 Under the current law tax can be avoided through arrangements known as lease assignments. While lease assignments may take various forms, their intended effect can be to avoid the tax that would be payable in the later period of a lease when it begins to generate positive taxable income. The assignment is made by disposing of leased plant (or interests in leased plant) after most of the benefits of tax depreciation allowances have been taken so that future deductions will be less than future taxable rentals.

1.5 The proposed measure will ensure that all forms of consideration received in connection with the lease assignment including the benefit of being relieved of debt will be taken into account in calculating the assignors assessable income.

Summary of new law

1.6 Division 45 will apply when plant, or an interest in plant, is disposed of on or after 22 February 1999 where:

•

the plant was a leased asset on or after 22 February 1999;

•

the plant has been used by the lessor primarily for leasing to others; and

•

the lessor has deducted amounts for depreciation.

(For these purposes, the reference to the lessor includes a reference to a related entity see the amendments to section 41-40 of ITAA 1997.)

Division 45 is to apply in the following way:

•

Where the disposal constitutes a balancing adjustment event, the lessors assessable income will include any excess of the money consideration and the value of other benefits obtained from disposing of the plant (or an interest in the plant) over the plants written down value (or relevant proportion thereof).

•

If the lessor disposes of rights under the lease of the plant without disposing of the plant itself, the lessors assessable income will include the money consideration for the disposal plus the value of other benefits obtained as a result of the disposal.

•

Similar consequences as in the 2 previous dot points will follow if a partner in a partnership disposes of an interest in the partnership so as to reduce the partners interest in plant which the partnership has used mainly to lease to other entities, or disposes of rights or an interest under the lease.

•

If an interest in leased plant is effectively disposed of by selling more than 50% of the shares in a wholly-owned leasing subsidiary which owns the plant, the leasing subsidiary will be treated as having disposed of the plant and reacquired it at market value. This means that the depreciation balancing adjustment rules would bring to tax any excess of the plants market value over its written down value at the deemed disposal time. There will be no such effect, however, if the main business of the new owners of the subsidiary is the same as the main business of the former group.

•

If more than 50% of the shares in a wholly-owned subsidiary which is a partner in a leasing partnership changes hands, the subsidiary will be treated as having disposed of its interest in plant that had been used by the partnership principally to lease to other entities. The consequence will be that the de-grouped subsidiary will become liable to tax on the difference between the market value of its interest in the leased plant and the proportion of its written down value attributable to that interest. This rule will not apply, however, if the main business of the new owners of the subsidiary is the same as the main business of the former group.

•

In either of the cases outlined in the 2 previous dot points, the companies that were in the same group as the de-grouped subsidiary will become liable for the tax upon which the subsidiary was assessed, attributable to the transactions described above, if the former subsidiary does not pay the tax within 6 months of it becoming payable. This tax is imposed by theNew Business Tax System (Former Subsidiary Tax Imposition) Bill 1999 (Imposition Bill).

Comparison of key features of new law and current law

1.7 The legislative rules contained in Division 45 are designed to prevent tax being avoided on profits from plant primarily used for leasing that can occur under the present law from lease assignments.

Current law

1.8 In the early years of a lease, lessors get tax advantages because deductions for depreciation and interest can exceed assessable lease income. Tax losses generated from leases are used to offset the tax liability from other income of the lessor. In later years, this situation is reversed so that rentals exceed deductions as deductions for depreciation of the plant decline. At this point, lessors may seek to get out of the lease by disposing of or assigning their interests in the plant or lease to a tax loss or other tax-preferred entity.

1.9 A tax effective assignment means that the revenue loss during the early tax loss phase of the lease is never redressed by tax collected on the lease income generated in the later tax positive phase.

1.10 Lease assignments generally occur when depreciation allowances relating to the leased asset have been substantially exhausted and the market value of the asset exceeds its tax written down value.

1.11 The appropriate tax outcome when an asset is disposed of for more than its written down value is that the excess of the disposal price over written down value is brought to tax as a balancing charge essentially a recoupment of excess depreciation deductions. Tax effective lease assignments generally ensure the balancing charge is not taxed by utilising a balancing charge roll-over option that is available when there is only a partial change in the ownership of depreciable assets, for example when there is a change in the composition of a partnership.

1.12 Where the roll-over option is taken, the balancing charge is not applied and the new owners continue to depreciate the asset as if it had not changed hands. In lease assignment cases, the usual pattern is for about 99% of the ownership of the asset to change, leaving only a nominal percentage with the original lessor. The new majority owner is usually a tax exempt body, or a taxpayer with substantial tax losses or some other tax preferred entity such as a superannuation fund.

1.13 Another element of a tax effective lease assignment is that the assignor obtains a benefit from being relieved of the obligation to pay outstanding debts relating to the leased asset. The debts are met by the future rentals that have been assigned to the new owner. Invariably, this benefit is not returned as assessable income of the assignor.

New law

1.14 In summary, lease assignments have been designed so that little or no tax is ever paid on the lease rentals. The lessor obtains the benefit of tax losses generated in the early years of the lease, but escapes tax on balancing charges and debt relief when the lease is assigned. Subsequent lease rentals are sheltered from tax because of the assignees tax-advantaged status as a tax-exempt body, tax loss entity or superannuation fund.

1.15 Division 45 will counteract this method of avoiding tax by ensuring that all forms of consideration received in connection with a lease assignment including the benefit of being relieved of debt will be taken into account in calculating the assignors assessable income. It will apply to lease assignments that are effected directly by the disposal of the leased plant or an interest in the leased plant or rights under the lease, or indirectly by the disposal of an interest in a partnership, or the shares in a wholly-owned group leasing subsidiary. To ensure that the Division operates appropriately it will also apply in circumstances where the plant is not subject to a lease at the time of disposal.

Detailed explanation of new law

Disposal of leased plant

1.16 The provisions contain rules for working out an amount to be included in the assessable income of a taxpayer who disposes of leased plant or an interest in leased plant or who, without disposing of the plant, disposes of rights derived from the lease (e.g. some or all of the lease receivables) [section 45-5]. The terms dispose of and acquire in relation to Division 45 have their ordinary meaning. The term plant is defined in section 42-18 of Division 42 of the ITAA 1997.

1.17 The rules apply only if the taxpayers primary use of the plant was to lease it to another entity and some of the lease period occurred on or after 22 February 1999 [subsection 45-5(1)]. They may apply, therefore, to plant that is not being leased at the time of the disposal.

1.18 An amount will be included in a taxpayers assessable income if the taxpayer disposes of plant or an interest in plant on or after 22February1999 and the following tests are satisfied:

•

the taxpayer is entitled to deductions for depreciation of the plant;

•

the taxpayer leased the plant to another entity for most of the time it was the owner or quasi-owner of the plant;

•

some part of the lease period occurred on or after 22February1999;

•

the disposal constitutes a balancing adjustment event as defined in section 42-30, i.e. broadly a disposal or deemed disposal which can trigger a balancing adjustment either assessable or deductible if the disposal price is more or less than the plants written down value; and

•

the total amount of all the benefits obtained by the taxpayer (in relation to the disposal) exceeds the written down value of the plant at the time it is disposed of or, if only an interest in the plant is disposed of, the proportion of the written down value represented by that interest.

[Subsection 45-5(1)]

1. 19 The benefits, (referred to as disposal benefits), that may be obtained from disposing of plant or an interest in plant are:

•

money received or receivable;

•

the amount of any reduction in a liability of the taxpayer; or

•

the market value of any other benefit obtained.

[Paragraph 45-5(1)(e)]

1.20 A liability reduction benefit would apply, for example, if leased plant was sold and liability for a loan that had been taken to finance the plant was transferred to the purchaser. Market value would apply in a case where, although there was no formal agreement to reduce a legal liability of the taxpayer, informal arrangements created such an effect in practice. For example, if the new owner of the leased asset applied the future lease rentals against an ongoing debt obligation of the taxpayer.

1.21 Where the conditions are satisfied, the taxpayer must include in assessable income the difference between the disposal benefits and the written down value (or relevant proportion thereof) of the plant. [Subsection 45-5(2)]

1.22 In summary, the provisions operate to assess the benefits derived from disposing of leased plant, or an interest in leased plant, to the extent that they exceed its written down value. Where the transitional measures apply, the amount assessed is capped at the amount of depreciation deductions obtained for the plant, or the part that was disposed of.

Example 1.1: Consideration for assignment

Avalon Co. owns a leased asset. It assigns a 50% interest in the asset to another entity. The debt obligation owing at the time of assignment is $60,000. The total deductions are $150,000. The deductions attributable to the 50% interest in the asset are $75,000. The tax written down value of the asset is $20,000:

•

The cash consideration for the assignment is $40,000.

•

Under the assignment, the assignee takes over 50% of Avalon Co.s obligation to make debt service payments.

•

Therefore the debt obligation effectively transferred in connection with the assignment is $30,000.

•

The total consideration is $70,000.

•

The amount included in assessable income under Division 45 is $60,000 (the total consideration ($70,000) minus 50% of the assets written down value ($10,000)).

Disposal of lease rights

1.23 An amount will also be included in assessable income where a taxpayers main use of plant was to lease it to other entities and the taxpayer disposed of rights or interests derived from the lease or plant even if there was not a disposal of an ownership interest in the plant. For instance, this would occur where a taxpayer disposes of rights to payments under a lease but not the leased asset itself. Again, some part of the lease period must have occurred on or after 22February 1999 and the taxpayer must be entitled to depreciation deductions for the plant. [Subsection 45-5(3)]

1.24 The amount to be included in assessable income in that case is the total of the disposal benefits (whether in cash, liability reduction or any other form). The amount is included in the income year in which the disposal takes place. [Subsection 45-5(4)]

1.25 Subsection 45-5(3) would not include an amount that was already included under subsection 45-5(1). For example, if the taxpayer disposed of both the leased asset and the lease under the same transaction only subsection 45-5(1) would apply.

What happens if an amount is already included in assessable income?

1.26 Amounts will not be included in assessable income under Division 45 to the extent that they are already directly included in assessable income by another provision (e.g. as a balancing charge), or would be included except for specific relieving provisions (e.g. where it is subject to roll-over relief to a related entity). [Subsection 45-5(5)]

1.27 The rule excluding an amount from assessment in Division 45 if that amount is included by another provision avoids the double counting of an amount and establishes that the other provision takes precedence over provisions contained in Division 45.

1.28 A transitional rule applies for disposals before 11.45 am AEST on 21September 1999. Such disposals can be subject to CGT. The transitional provisions contain a modified double counting rule to ensure that for disposals before 21 September 1999, Division 45 will take precedence over the CGT provisions. [Item 18, Schedule1, subsection 45-3(3) of the IT (TP) Act 1997]

1.29 Another transitional rule caps the amount that Division 45 will include in assessable income on a disposal of plant, or an interest in plant, that constitutes a balancing adjustment event. The cap is equal to the total deductions available for depreciation of the plant. If the disposal was only of an interest in the plant, the cap is the part of those deductions attributable to the interest. [Item 18, Schedule 1, subsection 45-3(2) of the IT (TP) Act1997]

1.30 The transitional measure arises because during the transitional period any excess of the disposal proceeds over the cost of the asset may be subject to the CGT provisions. From 21 September 1999 depreciable assets will be excluded from the CGT regime so the cap is no longer necessary.

Example 1.2: The interaction between section 45-5 and the balancing adjustment provisions in the ITAA 1997

Merlin Pty Ltd assigns a 50% interest in leased plant it owns to another entity. The debt obligation owing at the time of assignment is $60,000. Total depreciation deductions taken amount to $140,000 and the market value of the leased asset at the time of assignment is $160,000. The tax written down value is $20,000:

•

The cash consideration for the assignment is $50,000.

•

Under the assignment, the assignee takes over 50% of Merlin Co.s obligation to make debt service payments.

•

Therefore the debt obligation effectively transferred in connection with the assignment is $30,000.

•

The total consideration is $80,000.

•

The amount assessable under Division 45 is $70,000 (the total consideration ($80,000) minus 50% of the assets written down value ($10,000)).

Amount otherwise taxed (section 45-5(5)):

•

The assignment is a balancing adjustment event (section 42-30 and Subdivision 42-J).

•

The balancing charge, and the amount included in assessable income, under section 42-190 is $140,000.

•

Therefore, the additional assessable amount under Division 45 is nil (if the balancing charge amount is not included in assessable income then the assessable amount under Division 45 is $70,000).

Disposal of an interest in partnership

1.31 There are similar rules where a partner disposes of an interest, or part of an interest, in a partnership and, in so doing, either disposes of or reduces its interest in plant (that the partnership has used mainly to lease to other entities) or disposes of rights or an interest in the lease. [Section 45-10]

1.32 Thus, an amount must be included in a partners assessable income if the partner disposes of its interest in partnership plant on or after 22 February 1999 and the following tests are satisfied:

•

the partnership is entitled to deductions for depreciation of the plant which would be reflected in the partners share of the partnership net income or partnership loss;

•

the partnership leased the plant to another entity for most of the time it held the plant;

•

some part of the lease period occurred on or after 22February1999;

•

the disposal constitutes a balancing adjustment event as defined in section 42-30, for example where there is a partial change in the ownership of, or in the interests of entities in, the plant; and

•

the total amount of all the benefits obtained by the taxpayer (in relation to the disposal) exceeds the proportion of the plants written down value that represents the interest in the plant that the partner has disposed of.

[Subsection 45-10(1)]

1.33 All of the following are included in the benefits, (the disposal benefits) that may be obtained from disposing of an interest in partnership plant:

•

money received or receivable;

•

the amount of any reduction in a liability of the taxpayer; or

•

the market value of any other benefit obtained.

[Paragraph 45-10(1)(f)]

1.34 Liability reduction would apply if, for example, when the interest in the partnership plant was disposed of, the acquirer of that interest perhaps a new partner undertook the outgoing partners legal obligations in relation to a loan by which the partnership had financed the plant. Market value would apply in a case where, although there was no formal agreement to reduce a legal liability of the partner, the arrangements by which the disposal or part disposal of that plant took place caused such an effect in practice, for example, if future rentals were applied against debts for which the partner had a legal obligation.

1.35 Whilst in that circumstance, there may be no change in any of the legal obligations of the taxpayer as a partner, the effect of the assignment would be to dilute in a practical sense both the benefits and liabilities of being a partner. In that case, any monetary consideration received for the assignment plus the amount of the benefit of any de facto reduction of a partners share of partnership liabilities would be treated as the relevant benefit from the disposal. [Paragraph 45-10(1)(f)]

1.36 The amount that is included in the partners assessable income in the disposal year is the excess of the disposal benefits over the partners proportion of the plants written down value. [Subsection 45-10(2)]

1.37 However, if the transitional provisions apply, the amount included in the partners assessable income is capped at the share of the plant depreciation deductions reflected in the partners share of partnership net income or loss. [Item 18, Schedule 1, subsection 45-3(4) of the IT (TP) Act 1997]

Disposal of lease rights by a partner

1.38 An amount is also included in a partners assessable income if the partnership has leased the plant for most of the period it has held it and, on or after 22 February 1999, the partner disposes of rights or interests derived from the lease, or interest in the plant, without causing a depreciation balancing adjustment event as defined in section 42-30 of the ITAA 1997. [Subsections 45-10(3) and (4)]

1.39 In this regard, it has been argued that a partner who disposes of part of its interest in a partnership by assigning that part is not thereby disposing of a proprietary interest in partnership assets. On that view, no balancing adjustment event is required.

1.40 The amount included in assessable income is the total of any monetary consideration for the disposal, the amount of any reduction in a liability of the taxpayer that occurs in connection with the disposal, and the market value of any other benefit obtained by the taxpayer in connection with the disposal. [Subsection 45-10(4)]

1.41 Notwithstanding that there may be no change in any of the legal obligations of the taxpayer as a partner, the effect of an assignment of a partnership interest as described would be to dilute in a practical sense both the benefits and liabilities of being a partner. In that case, any monetary consideration received for the assignment plus the amount of any de facto reduction of a partners share of partnership liabilities would be the relevant benefits from the disposal.

Avoiding double counting

1.42 A partner will not be required to include an amount in assessable income to the extent that the amount:

•

is otherwise included in its assessable income under another provision of the ITAA 1936 or ITAA 1997; or

•

would be included as a taxable balancing charge on the disposal of plant, but instead is offset against the written down value of other plant.

[Subsection 45-10(5)]

1. 43 Again, if the disposal occurs before 11.45 am on 21 September 1999, an amount would be included under these provisions before it would be included as a capital gain. [Item 18, Schedule 1, subsection 45-3(5) of the IT (TP) Act 1997]

Example 1.3: Proportionate balancing charge where an interest in a leased asset is relinquished

Jason is a partner who holds a 50% interest in a partnership that is formed to lease plant costing $150,000. The plant is not currently being leased, but has been leased for most of the time the partnership has owned it. He assigns his interest in the partnership to a tax-advantaged entity. Jason and the other partners elect to take the roll-over relief provided under section 42-335. The partnership has deducted $140,000 for depreciation of the plant. The cash consideration is $60,000, the partnership debt is $80,000 and Jasons share of the debt service repayments is $40,000, (which the other partner has agreed to take over).

•

The total consideration for the assignment is - ($60,000 + $40,000) $100,000.

•

Written down value of the formerly leased plant $10,000.

•

Jasons share of the written down value $5,000.

•

Taxable consideration $100,000.

•

The amount assessable under section 45-10 is theexcessreferredto in paragraph 45-10(1)(f) whichis($100,000 $5,000) $95,000.

Therefore $95,000 is assessable.

•

However, if the transitional provisions apply, (because the assignment occurred between 21 February 1999 and 11.45 am AEST on 21 September 1999) the amount included in assessable income is the lesser of $95,000; and

•

Jasons share of amounts deducted for depreciation of the plant, which is $70,000.

In this case, $70,000 is assessable.

In addition, some further amount may be assessable as a capital gain.

Reduction in the amount to be included in assessable income in relation to plant acquired before 21 September 1999

1.44 An amount required to be included in a taxpayers assessable income due to the disposal of an interest in leased plant or a lease of plant (subsection 45-5(2)) or of an interest in a leasing partnership (subsection 45-10(2)) will be reduced in certain circumstances. This is necessary to give effect to the indexation of assets subject to CGT. However, the Government announced on 21 September 1999 that for depreciable assets subject to CGT that are acquired before, but disposed of after, 21September 1999 indexation will be frozen as of 30September 1999.

1.45 Such a reduction in the amount to be included in assessable income will occur if the plant, or an interest in the plant, is acquired before, but disposed of after, 21 September 1999 and the sum of the disposal benefits (whether in cash, liability reduction or any other form) exceeds the cost of the plant or the part of the cost attributable to the disposed interest. [Subsection 45-30(1)]

1.46 If these conditions are met, the amount to be included in those provisions is reduced by the lesser of:

•

any excess of the cost base of the plant, or the part attributable to the disposed interest in the plant, over the cost of the plant or the interest in it. The excess is calculated as at the day of disposal. Refer to sale price 1 in Diagram 1.1; and

•

the difference between all disposal benefits (whether in cash, liability reduction or any other form) and the cost of the plant, or the interest in it. Refer to sale price 2 in Diagram 1.1.

[Subsection 45-30(2)]

1.47 However, the amount included in assessable income will not be reduced as described above, if:

•

the plant was a pre-CGT asset (as defined in section 149-10 of the ITAA 1997) at the time of the disposal [paragraph 45-30(3)(a)] ; or

•

if a capital gain or loss from certain plant, or interests in certain plant, is disregarded by virtue of sections 118-5, 118-10 or 118-12 of the ITAA 1997 and that gain or loss arises from CGT event A1 (as defined in section 104-10 of the ITAA 1997) that occurs at the time of the balancing adjustment event. Specifically, sections 118-5, 118-10 and 118-12 concern cars, motor cycles, valour decorations, collectables, personal use assets and plant used to produce exempt income [paragraph 45-30(3)(b)] .

1.48 In these cases, the amount included in assessable income under Division 45 is limited [subsection 45-35(1)] . The purpose of the limit is to preserve the effect of the CGT exemption for these assets despite the general removal of depreciable assets from the CGT regime.

1.49 In relation to the disposal of an interest in leased plant or a lease of plant (subsection 45-5(2)) the limit is the lesser of:

•

the amount by which the disposal benefits exceed the written down value of the plant or that part of it attributable to the interest disposed of [paragraph 45-5(1)(e)] ; and

•

the depreciation amounts deducted (or able to be deducted) for the plant, or the part of those deductions attributable to the interest disposed of.

[Subsection 45-35(2)]

1.50 In relation to the disposal of an interest in a leasing partnership (subsection 45-10(2)) the limit is the lesser of:

•

the amount by which the disposal benefits exceed the written down value of the plant attributable to the interest in it being disposed of [paragraph 45-10(1)(f)] ; and

•

the amount of the depreciation deductions claimed by the partnership for the plant that are, or would be, reflected in the partners share of the partnership net income or loss (the partnership amount), or where the partner disposes of an interest in the plant so much of that partnership amount attributable to the interest disposed of.

[Subsection 45-35(3)]

Sale of a group company that owns leased plant

1.51 By selling shares in an entity that owns a leased asset, rather than selling the asset, an ultimate owner can avoid the application of a balancing charge that would otherwise have applied. This is particularly relevant where the entity that holds the asset is a 100% subsidiary in a wholly-owned group because any losses from accelerated depreciation can be transferred to other entities in the group before the subsidiary is disposed of.

Disposal of shares in a 100% leasing subsidiary

1.52 Rules covering these cases apply to any disposal of a majority beneficial ownership of shares in a 100% owned subsidiary, or in a 100% owned subsidiary in a leasing partnership, whose main business was to lease assets, and prior to the disposal any plant owned was primarily used for leasing to other entities. [Sections 45-15 and 45-20]

1.53 In the case of a 100% owned leasing subsidiary of a wholly-owned group, (referred to as the former subsidiary), more than 50% of the former subsidiarys beneficial ownership must be acquired by one or more entities not in the same wholly-owned group [section 45-15] . The term wholly-owned group is defined in section 975-500 of the ITAA 1997.

1.54 Diagram 1.2 provides an example of this case. Subsidiary A has leased plant out for most of the time it has owned it. Section 45-15 will apply if Company Z sells more than a 50% direct beneficial interest, or Company X sells more than a 50% indirect beneficial interest, in Subsidiary A after 21 February 1999. It does not matter if the 50% beneficial interest in Subsidiary A is transferred via a single transaction or a number of transactions. If Subsidiary A had simply sold the leased plant, section 45-15 would not apply, but section 45-5 would have applied instead.

1.55 Further conditions that must be satisfied if the rules are to apply to the disposal of a leasing subsidiary are that:

•

the subsidiarys main business was to lease assets to another entity;

•

it owned plant that was primarily used for leasing; and

•

some of the lease period of that plant occurred on or after 22February 1999.

[Subsection 45-15(1)]

1.56 It does not matter that the plant was not being leased at the time of the disposal of the shares.

1.57 The disposal will create a balancing adjustment event for the purposes of section 42-30 of the ITAA 1997. The 100% subsidiary will be treated as disposing of the plant at market value (and reacquiring it at the same price) where there is a change in the controlling interest of the subsidiary on or after 22 February 1999. [Paragraph 45-15(1)(f)]

1.58 Treating the former subsidiary as disposing of and reacquiring the plant will have no effect for tax purposes on any lease to which the plant may be subject at that time. [Subsection 45-15(3)]

1.59 The balancing adjustment offset elections under sections 42-285 and 42-290 are not available for the balancing adjustment events created by section 45-15. [Subsection 45-15(4)]

1.60 In summary, for the disposal of a 100% subsidiary to come within the provisions, the following requirements must be met:

•

the subsidiary must be entitled to deductions for depreciation of plant;

•

it must have leased the plant to another entity for most of the time it was the owner or quasi-owner of the plant;

•

its main business must have been to lease assets;

•

at least some of the lease period must have occurred on or after 22February 1999;

•

the beneficial ownership of more than 50% of the shares in the subsidiary must have been acquired by one or more entities outside the subsidiarys wholly-owned group on or after 22February 1999; and

•

at the time of the disposal, the written down value of the plant must have been less than its market value.

1. 61 The provisions do not apply to a change in beneficial ownership in a wholly-owned leasing subsidiary if the main business of all the entities that acquire the controlling interest is the same as the main business of the former group [subsection 45-15(2)] . For example, if a commercial banking group transfers beneficial ownership in a 100% leasing subsidiary to a superannuation fund, the transfer would be caught by the rules because the superannuation fund is not in the same business as the banking group.

Example 1.4: Balancing charge arising from the sale of an interest in a 100% subsidiary

A company group ceases to hold a majority beneficial interest in a subsidiary. The following details relate to the depreciable plant and equipment held by the subsidiary company:

•

Market value $100,000.

•

Depreciated value $10,000.

•

Balancing charge if the company sold the asset $90,000.

•

Total assessable amount under section 42-190- ($100,000 $10,000) is $90,000.

1.62 Example 1.4 demonstrates that the company is treated as having disposed of and reacquired the asset at market value. This reflects the fact that the former owners of the company have effectively disposed of the assets held by the company. The re-acquisition rule allows the company to commence depreciating the asset from its market value, but requires tax to be paid on the same basis as if the company had sold the asset.

1.63 Another rule applies if there is a disposal of shares in a 100% subsidiary that leases plant in partnership. Where the requirements are satisfied the disposal of the subsidiary will also be treated as a disposal by the subsidiary of its interest in the plant for the purposes of Division 42 and section 45-10. The effect of this kind of disposal of plant at market value is discussed under the partnership rule in section 45-10 subject to the modifications outlined below. [Section 45-20]

1.64 There are some requirements additional to those in section 45-10. The former subsidiary must have been a 100% subsidiary in a wholly-owned group at the time it was a member of the leasing partnership and the main business of the partnership must have been to lease assets. In addition, more than 50% of the beneficial ownership of the former subsidiary must have been acquired by an entity outside the subsidiarys wholly-owned group on or after 22February1999. Further, at the time of this acquisition the written down value of the plant must be less than its market value.

1.65 Again, the former subsidiary is not treated as having disposed of and reacquired its interest in the plant at market value if the main business of each of the entities that acquired beneficial ownership of the subsidiary is the same as the main business of the wholly-owned group of which the former subsidiary was a member. [Subsections 45-20(2)]

1.66 The balancing adjustment offset rules under sections 42-285, 42-290 and 42-293 are not available for the balancing adjustment events created by the deemed disposal. Section 42-293 is to be inserted into the ITAA 1997 by the New Business Tax System (Capital Allowances) Bill1999. In the event of section 42-293 not being enacted, the reference to it in Division 45 will become redundant. [Subsection 45-20(4)]

Former group member(s) liable to pay outstanding tax

1.67 In some circumstances a 100% leasing subsidiary that has been degrouped may not have the funds to pay the tax liability arising from the operation of sections 45-15 or 45-20. This may occur for a number of reasons. For example, the former group may have previously taken most of the resources from the subsidiary.

1.68 Therefore, where the leasing subsidiary (the former subsidiary) does not pay the tax arising from this balancing adjustment within 6months of the due date of the assessment, members of the former group will also become liable for the outstanding amount of the tax associated with the balancing adjustment. The former subsidiary will continue to be liable to pay the outstanding amount associated with the adjustment. The outstanding amount is the income tax debt of the former subsidiary reduced by any payments of tax imposed under the Imposition Bill. [Section 45-25]

1.69 In that case, both the former subsidiary and the companies that were members of the former group at the time the interest in the former subsidiary was acquired will also become jointly and severally liable for any interest accruing on the primary tax liability, including the interest that accrued in the first 6 months after the due date. This joint liability to tax is imposed on the other company members of the wholly-owned group by the Imposition Bill. [Subsection 45-25(2)]

Application of the New Business Tax System (Former Subsidiary Tax Imposition) Bill 1999

1.70 The Imposition Bill requires the tax payable under section 45-25 of the ITAA 1997 to be paid by any company that was a member of the former subsidiarys wholly-owned group at the time the direct or indirect beneficial ownership of more than 50% of the shares in the former subsidiary was acquired by an entity or entities outside that wholly-owned group. [Section 3, Imposition Bill]

1.71 The Imposition Bill makes companies in the former group liable as if the tax payable were an amount of income tax payable by that company [subsection 4(1), Imposition Bill] . The amount is the lesser of either:

•

the outstanding amount of tax in section 45-25 of the ITAA 1997 arising for the former subsidiary for that income year, including any interest for late payment that is attributable to that amount; and

•

the amount of income tax, including any interest for late payment, that would be payable by the former subsidiary under section 45-25 of the ITAA 1997 for that income year in which an amount is included in the assessable income of the company under section 45-15 or 45-20 of the ITAA 1997. For this purpose it is assumed that the tax arising from the balancing adjustment was the only amount that was assessed to the former subsidiary in that year, and it was not able to deduct any amount or claim any tax offset in that income year. [Subsection 4(2), Imposition Bill]

1.72 When the tax on an amount that is included in the subsidiarys assessable income under section 45-15 or 45-20 is paid in accordance with the Imposition Bill, by any of the jointly and severally liable companies (except the former subsidiary, refer to paragraph 1.53), the other jointly liable companies cease to be liable to the extent of the amount paid [subsection 4(3)] . When an amount of tax arising from the operation of sections 45-15 or 45-20 of the ITAA 1997 is paid by the former subsidiary itself, this payment reduces the outstanding amount in section 45-25 of the ITAA 1997.

1.73 Section 259 of the ITAA 1936 provides for contribution between taxpayers that are jointly and severally liable and applies to the joint and severally liable companies in Division 45.

Common rule 1 roll-over relief for related entities

1.74 Common rule 1 of Division 41 allows roll-over relief to be used to delay balancing adjustments on the transfer of property between related entities. Section 41-40 changes the balancing adjustments on final disposal where no roll-over relief is taken. It also attributes to the final transferor certain characteristics of previous transferors.

1.75 The amendments insert a new subsection into section 41-40 which adds to the characteristics the transferee is assumed to have. [Item 8, Schedule 1, subsection 41-40(4)]

1.76 These characteristics are:

•

if the transferor leased out the plant on or after 22February1999, the transferee is also taken to have done so;

•

if the transferor primarily used the plant for leasing to others, then the transferee is taken to have done so too; and

•

if the transferors main business was to lease assets to others then the transferees main business is taken also to have been leasing assets.

1.77 For the purposes of Division 45, the above characteristics do not apply to roll-over relief under Common rule 1 if the sum of all the disposal benefits is equal to, or greater than, the market value of the plant, or interest in it, disposed of.

1.78 A further characteristic is added for disposals between 22February 1999 and 21 September 1999. It attributes deductions of the transferors partnership to the transferee so that the limit on the amount assessed for disposals during that period can be calculated for the transferee. [Item 16, Schedule 1, paragraph 41-40(4)(d) of the IT (TP) Act 1997]

Application and transitional provisions

1.79 The proposed measures relating to the assignment of leased property will apply to arrangements entered into on or after 22February1999. [Item 19, Schedule 1]

Consequential amendments

1. 80 Schedule 1 also amends various provisions in the ITAA 1997 as a consequence of the enactment of Division 45.

Income Tax Assessment Act 1997

Entities that must pay income tax

1.81 The lists in sections 9-1, 9-5, 10-5 and 12-5 of the ITAA 1997 are amended. The first amendment adds to the list of entities that pay income tax those companies that are members of a wholly-owned group when a former subsidiary of that group is treated as having disposed of plant and does not pay all the income tax resulting from that treatment. [Item 1 of Schedule 1]

1.82 These companies are also added to the list in section 9-5 of entities who work out their income tax by reference to something other than taxable income (in this case, by reference to the former subsidiarys unpaid tax debt). [Item 2 of Schedule 1]

1.83 The list of assessing rules in section 10-5 is updated to include references to Division 45 [items 3 and 4 of Schedule 1] . The section 12-5 list of provisions about deductions is also updated [items 5 and 6 of Schedule 1] .

Meaning of termination value

1.84 The number of ways the balancing adjustment is affected is increased from 2 to 3 because of the amendment discussed in paragraph 1.76. [Item 7 of Schedule 1]

1.85 The table in section 42-205 is amended to explain that the termination value for plant you are taken to have disposed of under section 45-15 is the market value of the plant. [Item 9 of Schedule 1]

Offsetting balancing adjustments

1.86 Notes are added to subsections 42-285(1) and 42-290(1) of the ITAA 1997 to alert the reader that the offsetting mechanisms they provide are not available when a company or corporate partner is treated as disposing of and reacquiring plant by sections 45-10, 45-15 or 45-20. [Items 10 and 11 of Schedule 1]

Depreciation of plant previously owned by an exempt entity

1.87 Division 58 of the ITAA 1997 introduces the concept of a notional written down value for plant in certain circumstances where the plant was previously owned by an exempt entity. Paragraph 58-85(6) of that Division modifies the meaning of cost in section 42-200 which describes how the written down value of plant is worked out. Division 45 will require an amendment to that paragraph to signpost that the cost of the plant under section 42-200 and sections 45-5 and 45-10 will be the notional written down value of the plant at the transition time (as defined in Division 58) plus any amounts of capital expenditure that have been incurred in improving the plant. [Item 13 of Schedule 1]

1.88 The definition of written down value in the dictionary in subsection 995-1 is amended to include a reference to section 58-85. This amendment to the dictionary corrects a previous omission in relation to Division 58. [Item 6 of Schedule 10]

Income Tax (Transitional Provisions) Act 1997

1.89 As part of introducing the New Business Tax System, the Treasurer announced, on 21 September 1999, that plant and equipment would be removed from the CGT regime. This measure has effect from 11.45 am AEST on 21 September 1999.

1.90 Because the main provisions on lease assignments commence on 22 February 1999, there is a need to have transitional provisions to cover the period from 22 February 1999 until 11.45 am AEST on 21 September 1999 when plant and equipment were within the CGT regime. The transitional provisions will be included in the IT (TP) Act 1997. How the transitional measures affect the lease assignments provisions are discussed in paragraphs dealing with these provisions. Their effect on Common rule 1 is discussed at paragraph 1.75.

1.91 The link note before Division 42 is amended [item 15 of Schedule 1] . The link note at section 43-110 is repealed [item 17 of Schedule 1] . This is necessary because of the insertion of Divisions 41 and 45, respectively.

Application of consideration rules in sections 45-5 and 45-10 to plant formerly owned by tax exempt entities

1.92 The amendments made by section 45-40 ensure that the amounts calculated by subsections 45-5(2) and 45-10(2) are the same as if Division 58 had applied to the disposal of the leased plant or an interest in leased plant [section 45-40] . The amendments are necessary because the amounts included by those sections would not otherwise include the full amount that would be incorporated by Division 58.

1.93 Division 58 of the ITAA 1997 sets out special rules that apply in calculating depreciation deductions and balancing adjustments for plant that was previously owned or quasi-owned by an exempt entity. It places a cap on the depreciation deductions that are available for that plant when it enters the tax net.

1.94 Division 58 provides for a special balancing adjustment calculation if the plant is on-sold (for more than that cap) after it enters the tax net. The special balancing adjustment recovers both:

•

the depreciation deducted since the asset entered the tax net; and

•

the difference between the depreciation cap and the market value at the time it entered the tax net (or up to the sale price if the sale price is less than that market value). Note: where the plant is sold for an amount in excess of that market value, capital gains would normally apply. However, capital gains will no longer apply from 11.45 am AEST on 21 September 1999, apart from a frozen indexation amount.

1. 95 Diagram 1.3 demonstrates the operation of the special balancing adjustment.

1. 96 Section 45-40 will only apply in the case of disposals to tax exempt and other tax advantaged entities [subsection 45-40(3)] . Where the plant or interest is disposed of to a taxable entity and roll-over relief is available, the depreciation cap will still operate to limit future deductions. In that case it is appropriate that sections 45-5 and 45-10 operate without modification. Where there is no roll-over, Division 58 will apply.

Modification of written down value

1. 97 The written down value of plant is generally its cost less amounts deducted for depreciation. When an entity enters the tax net (the transition time) it can choose to calculate its tax depreciation based on the notional written down value of the plant at that time. Division 58 modifies the definition of written down value (contained in section 42-200) so that the cost of the plant to that entity is taken to be its notional written down value at the transition time. The amendments will therefore modify the definition of written down value in subsection 995-1(1) of the ITAA 1997. [Item 6 of Schedule 10]

Chapter 2 - Value shifting through debt forgiveness

Outline of Chapter

2.1 Schedule 2 to this Bill inserts new Division 139 into the ITAA 1997. Division 139 deals with CGT value shifting that occurs where, broadly, a debt owed by one commonly owned company to another is forgiven.

2.2 New Division 139 deals with these value shifts by requiring cost base and reduced cost base reductions to be made to equity acquired on or after 20 September 1985 (post-CGT) and, in certain circumstances, to post-CGT debt interests held directly or indirectly in the creditor company. In some cases, compensatory cost base and reduced cost base increases will be necessary for post-CGT equity interests held directly or indirectly in the debtor company.

Context of Reform

2.3 CGT value shifting describes transactions and other arrangements which shift value out of, and usually between, assets (including shares in companies). Value shifting is a problem because it distorts the calculation of capital gains and capital losses when assets are realised. Decreased value assets can be sold to bring forward losses whilst gains are deferred on increased value assets.

2.4 A particular type of value shifting is asset stripping, where the removal of asset value from an entity affects the value of interests in that entity. Asset stripping is currently dealt with by Division 138 of the ITAA1997.

2.5 Broadly, Division 138 of the ITAA 1997 applies to value shifts which occur between companies under common ownership, where the value shift occurs by the transfer or creation of an asset at undervalue. Undervalue can mean for less than the assets market value or, in some cases, for less than its cost base.

2.6 Where there has been a value shift, Division 138 of the ITAA 1997 may require a reduction in the cost base and reduced cost base of shares and loans (and indirect interests held in shares and loans) in the company transferring or creating the asset at undervalue. This Division also provides for increases to the cost base and reduced cost base of shares (and indirect interests in shares) in the company to which the value is shifted.

2.7 Division 138 of the ITAA 1997 does not apply to value shifting by way of debt forgiveness because this does not involve the transfer or creation of an asset. The commercial debt forgiveness (CDF) provisions (contained in the ITAA 1936) also generally do not require a compensating adjustment where the face value of the debt forgiven is equal to its market value.

2.8 Example 2.1 demonstrates value shifting by way of debt forgiveness.

Example 2.1

Holdco capitalises Subco with $200 post-CGT and receives 200 shares of the same class. Subco lends $100 back to Holdco. The loan is then forgiven and no consideration is given for the forgiveness. Assuming the market value of the loan is equal to its face value, Subco does not make a capital loss on the ending of the loan (because Subco is taken to have received market value capital proceeds). However, there has been a value shift of $100 from Subco to Holdco.

If Holdco immediately sold Subco, Holdco could realise a loss of $100 (as the market value of Subco would now be $100). This loss would be artificial as the company group has not suffered any economic loss from the arrangement.

2.9 The provisions contained in this Bill will address this deficiency in Division 138 of the ITAA 1997.

Interaction with the commercial debt forgiveness provisions

2.10 The existing CDF provisions do not adjust the tax attributes (such as its carry forward losses) of a debtor to the extent the cost base of the debtors asset has been reduced under the CGT provisions as a result of the forgiveness of a debt (refer to paragraph 245-85(1)(c) of the ITAA1936).

2.11 If adjustments required by new Division 139 were not excluded from this rule, the CDF adjustment could be inappropriately reduced on the forgiveness of a valuable debt. This would be the case where the debt being forgiven was between a subsidiary company (creditor) and its holding company (debtor) (as in example 2.1).

2.12 For example, if a debt with a face value of $100 and market value of $50 were forgiven, and no consideration was received for the forgiveness, Division 139 could cause a cost base reduction of $50 to interests held in the creditor subsidiary company (for example, the shares held by the debtor holding company). This would reflect the value shifted out of the creditor subsidiary company by the forgiveness.

2.13 The CDF provisions would usually apply to adjust the tax attributes of the debtor holding company (and related companies) in respect of the difference between the face value of the debt ($100) and its deemed market value ($50) at the time of the forgiveness.

2.14 Under the existing rules, the Division 139 adjustment of $50 would have to be subtracted from the potential CDF adjustment amount, reducing that amount to nil. No adjustment would therefore be made under the CDF measures to reflect the gain to the debtor holding company as a result of the forgiveness.

2.15 Therefore, the introduction of new Division 139 will require a consequential amendment to the CDF provisions to deal with this situation.

Example 2.2

Assume the same facts as in Example 2.1 except that the loan to Holdco had a market value of $60 at the time of its forgiveness. When the loan is forgiven and no consideration is given for the forgiveness, Subco will generally realise a capital loss of $40, being the difference between the reduced cost base of the loan (i.e. its face value) and its market value.

There has been a value shift of $60 from Subco to Holdco, to which new Division 139 would apply. Division 139 would require the cost base of the shares in Subco to be reduced by $60 so that it would now be $140.

In addition, under the amended CDF provisions there would be a net forgiven amount of $40 which would have to be used to reduce certain amounts in Holdco. Assuming Holdco and Lossco had no carry forward losses and Holdcos only asset was its shares in Subco, the cost base of the shares would be reduced to $100. If the shares in Subco were then sold, no loss would be realised.

The overall effect of both the amended CDF provisions and new Division 139 is that a loss of $40 is allowed to Subco reflecting the $40 economic loss made by the group.

2.16 In many cases, either the CDF provisions or new Division 139 (but not both) will require adjustments as a result of the forgiveness of a debt.

2.17 For example, where the market value of a debt which is forgiven is equal to its face value, the CDF provisions will not generally require an adjustment but new Division 139 will apply. Alternatively, where the market value of a debt forgiven is nil, new Division 139 will have no application (because there would be no value shift) but the CDF provisions may require an adjustment.

Summary of new law

2.18 New Division 139 will apply where:

•

a debt owed by one company to another is forgiven;

•

at the time of the forgiveness, the creditor and debtor companies are under common ownership; and

•

the debtor is not a 100% subsidiary of the creditor company.

2.19 Where this occurs, the usual case is that cost base and reduced cost base reductions will be required firstly to post-CGT equity interests held directly in the creditor company and, in some cases, also to post-CGT debt interests owned directly in the creditor company. Cost base and reduced cost base reductions may also be required to indirect interests in post-CGT equity and debt in the creditor company. In addition, compensatory cost base and reduced cost base increases may also be required to shares held in the debtor company (and to indirect interests in such shares).

2.20 The reductions to the cost base and reduced cost base of interests held directly in the creditor company are calculated using a formula approach to provide certainty. However, this approach is not used in certain cases if it gives an unreasonable outcome. Other adjustments are to be made on a reasonable basis having regard to various stated factors.

Detailed explanation of new law

2.21 New Division 139 will be inserted into the ITAA 1997 to deal with value shifts involving the forgiveness of debts. Division 139 will apply to a taxpayer where:

•

a company (the debtor company ) has an obligation to pay a debt to another company (the creditor company ); and

•

the taxpayer has a share in, a loan to, or an indirect interest in a share or loan in the creditor company, or a share in, or an indirect interest in a share in the debtor company.

[Subsection 139-10(1)]

2. 22 In addition, the conditions in one of the following scenarios must be satisfied.

Scenario 1

2.23 CGT event C2 (the trigger event ) must happen to the debt or part of the debt (the surrendered amount ) at a time (the forgiveness time ) on or after 22 February 1999 and the capital proceeds the creditor company receives or is entitled to receive from the trigger event are less than the market value of the surrendered amount at the forgiveness time. In addition, the debtor and creditor companies must be under common ownership at the forgiveness time. [Subsection 139-10(3)]

2.24 CGT event C2, contained in section 104-25 of the ITAA 1997, deals with the ending of the ownership of a CGT asset in certain circumstances. Those circumstances include the satisfaction or release of an asset. CGT event C2 would apply where a debt is forgiven. It would also apply where part of a debt is forgiven, as section 108-5 of the ITAA1997 provides that a CGT asset includes part of an asset.

2.25 Where a debt is forgiven and the capital proceeds are less than the market value of the debt, there can be a value shift from the creditor to the debtor company. The amount of the value shift will be the difference between the market value of the debt and the amount of the capital proceeds. This is the amount of value shift that new Division 139 will address.

2.26 New Division 139 will only apply where the capital proceeds the creditor company receives or is entitled to receive from the CGT event are less than the market value of the surrendered amount at the forgiveness time. When determining the capital proceeds for the forgiveness of a debt, the market value substitution rules are ignored. [Section 139-20]

Scenario 2

2.27 There must be a substantial and permanent reduction in the value of the debt because of something done (the trigger event) by the creditor company or by both companies at a time (the forgiveness time) on or after 22 February 1999 and the money and market value of other property (if any) received or receivable by the creditor company for the reduction are less than the amount of the reduction. In addition, the debtor and creditor companies must be under common ownership at the forgiveness time. [Subsection 139-10(4)]

2.28 A substantial and permanent reduction is a reduction which is not insignificant compared to the market value of the debt and which, on an objective examination of the facts, is one not likely to be reversed. Whether a reduction is substantial and permanent must be determined by taking into account the facts of the particular case.

2.29 A substantial and permanent reduction in the value of a debt may occur where the rights attached to a debt are altered. For example, the debt may be converted to subordinate debt or the date for repayment of the debt may be significantly extended. In some instances, the value of the debt would be expected to fall substantially and permanently in these circumstances.

2.30 Where there is a reduction in the value of a debt and the amount received or receivable by the creditor company for the reduction is less than the amount of the reduction, there will be a value shift from the creditor to the debtor company. The amount of the value shift will be the difference between the amount of the reduction and the amount received or receivable by the creditor company for the reduction. This is the amount of value shift that new Division 139 will address.

Threshold issues

2.31 A debt for the purposes of new Division 139 has not been defined but will instead take its ordinary meaning. As mentioned at paragraph 2.24, a debt would include part of a debt.

2.32 New Division 139 will only apply where the debt is owed between companies which are under common ownership at the forgiveness time. Two companies will be under common ownership where they are members of the same wholly-owned group or where the companies are ultimately owned by the same individuals in the same proportions (refer to subsection 138-15(2) of the ITAA 1997).

2.33 However, new Division 139 will not apply where the debtor company is a 100% subsidiary of the creditor company [subsection 139-10(2)] . In this situation, there would be no potential for an artificial loss or reduced gain to result from the value shift.

Consequences of Division 139 applying

2.34 Where the relevant conditions are met, adjustments to the cost base and reduced cost base of shares and debts in the creditor company and indirect interests in those shares and debts may be required. Adjustments may also be required to the cost base and reduced cost base of shares, and indirect interests in shares, in the debtor company. The cost base and reduced cost base adjustment mechanisms will be based (broadly) on those contained in Subdivision 138-E of the ITAA 1997.

2.35 Reductions to cost bases and reduced cost bases of direct interests in the creditor company are to be made as at the forgiveness time. [Subsection 139-15(1)]

2.36 Adjustments to cost bases and reduced cost bases of indirect interests in the creditor company and to direct and indirect interests in the debtor company are to be made as at the time of a CGT event applying to those interests [subsection 139-15(2)] . This will mean that these adjustments to the cost base or reduced cost base would be made at the time of calculating any capital gain or capital loss from the CGT event.

Direct interests in shares in creditor company

2.37 Where new Division 139 applies, and all of the shares in the creditor company at the forgiveness time are post-CGT shares, their cost base and reduced cost base will be reduced under new subsection 139-25(1). Where there are pre-CGT shares, or more than one class of share in the creditor company, new section 139-30 may apply. (Refer to paragraphs 2.41 and 2.42.)

2.38 The method of doing the reduction where the trigger event is CGT event C2 is as follows:

•

divide the market value of the share just before the forgiveness time by the sum of the market values of all the post-CGT shares in the creditor company. The result is the share reduction factor [subsection 139-25(2)] ;

•

reduce the market value of the surrendered amount by the capital proceeds the creditor company receives or is entitled to receive from the trigger event;

•

multiply this result by the share reduction factor;

•

the result is the maximum reduction amount ;

•

reduce the cost base and reduced cost base of the share to the extent possible by the maximum reduction amount [subsection 139-25(3)] . The cost base and reduced cost base cannot be reduced below nil.

2.39 Example 2.3 demonstrates the operation of new section 139-25 where the trigger event is a CGT event C2.

Example 2.3

Using the facts from Example 2.1, assume that each of the 200 shares on issue in Subco has a market value of $2. Applying new section 139-25, the share reduction factor would be 0.005 (that is, 2/400). This would be multiplied by the value shift of $100 to give a cost base and reduced cost base reduction of $0.50 (the maximum reduction amount ). Therefore, the cost base and reduced cost base of each share in Subco would be reduced to $0.50.

2. 40 Where new Division 139 applies, and the trigger event is something done which causes a substantial and permanent reduction in the value of the debt, the cost base and reduced cost base of any post-CGT shares held in the creditor company at the forgiveness time will be reduced as follows:

•

calculate the share reduction factor as outlined in paragraph 2.38;

•

reduce the amount of the substantial and permanent reduction in the value of the debt by the money and market value of any other property (if any) received or receivable by the creditor company for the reduction;

•

multiply this result by the share reduction factor;

•

the result is the maximum reduction amount ;

•

reduce the cost base and reduced cost base of the share to the extent possible by the maximum reduction amount . The cost base and reduced cost base cannot be reduced below nil.

Different calculation in certain circumstances

2. 41 However, a reduction is not required under new section 139-25 where:

•

at the forgiveness time:

-

there were 2 or more classes of shares owned in the creditor company; or

-

the taxpayer or another entity owned a share in the creditor company that was acquired before 20September1985 (pre-CGT); and

•

it would be unreasonable to reduce the cost base and reduced cost base of the share by as much as would be required under new section 139-25.

[Subsection 139-30(1)]

2.42 In this situation, the cost base and reduced cost base of the post-CGT share are reduced by a reasonable amount having regard to the circumstances in which the share was acquired and the extent to which its market value was reduced by the trigger event. [Subsection 139-30(2)]

2.43 Example 2.4 demonstrates when new section 139-30 could apply.

Example 2.4

Holdco capitalises Subco with $100 pre-CGT and receives 100 shares. Subco lends the $100 back to Holdco, also pre-CGT. Subsequently, Holdco subscribes another $100 to Subco post-CGT and receives another 100 shares.The loan is then forgiven and no consideration is given by Holdco. Assuming the market value of the loan was still equal to its face value, there has been a value shift of $100 from Subco to Holdco.

It is also assumed that, immediately prior to the forgiveness, the shares in Subco are worth $2.50 each and that immediately afterwards they are worth $2 each.

If new section 139-25 applied to this situation, the share reduction factor would be 0.01 ($2.50/250). Therefore, the cost base and reduced cost base of each post CGT share would be reduced by $1 (0.01 * 100). However, this result would be unreasonable because the market value of the pre-CGT shares has also been reduced by the value shift.

Applying new section 139-30, the cost base of each post-CGT share would be reduced by $0.50, being the amount by which the market value of each share was reduced by the value shift.

Direct interests in loans to creditor company

2.44 New section 139-35 deals with the reduction in the cost base and reduced cost base of loans to the creditor company. Where there are pre-CGT shares in, or more than one loan to, the creditor company, new section 139-40 may apply. (Refer to paragraphs 2.52 to 2.54.) New section 139-35 will apply where:

•

a loan is owed to the creditor company at the forgiveness time;

•

the loan was acquired post-CGT; and

•

either:

-

the value of the loan was reduced by the trigger event; or

-

the loan was not an arms length loan.

2. 45 Where these conditions are satisfied, any reductions to the cost base and reduced cost base of the loan must be calculated under section 139-35. However, reductions only occur where one of the following applies:

•

there are no post-CGT shares in the creditor company acquired before the forgiveness time;

•

the cost base or reduced cost base of one or more shares in the creditor company has been reduced to nil under section 139-25; and

•

the market value of all the post-CGT shares in the creditor company, just before the forgiveness time, is nil.

[Subsection 139-35(1)]

2.46 This section ensures that if the whole of the maximum reduction amount is not used to reduce the cost base and reduced cost base of shares under new section 139-25(i.e. the amount of cost base and reduced cost base is less than the maximum reduction amount ), then the excess will be used to reduce the cost base and reduced cost base of loans to the creditor company.

2.47 The first step in calculating any reduction required under new section 139-35 is to calculate the loan reduction factor . This is determined by dividing the market value of the loan just before the forgiveness time by the sum of the market values of all the loans (that were acquired post-CGT) to the creditor company just before the forgiveness time. [Subsection 139-35(2)]

2.48 Where there were no shares to which new section 139-25 could apply, or the market value of all the post-CGT shares in the creditor company just before the forgiveness time is nil, the cost base and reduced cost base of the loan are reduced in the same way as in new section 139-25 (discussed at paragraph 2.38) except that the loan reduction factor (rather than the share reduction factor ) is used. [Subsection 139-35(3)]

2.49 If new section 139-25 has operated to reduce the cost base of one or more shares in the creditor company to nil, and the maximum reduction amount exceeded the cost base of the share (i.e. before the reduction), the reduction in the cost base of the loan is determined as follows:

•

the excess for each share whose cost base has been reduced to nil is multiplied by the loan reduction factor [subsection 139-35(4)] ;

•

the sum of the amounts obtained is the reduction in the cost base of the loan [subsection 139-35(5)] .

2.50 If new section 139-25 has operated to reduce the reduced cost base of one or more shares in the creditor company to nil, and the maximum reduction amount exceeded the reduced cost base of the share (i.e. before the reduction), the reduction in the reduced cost base of the loan is determined as follows:

•

the excess for each share whose reduced cost base has been reduced to nil is multiplied by the loan reduction factor [subsection 139-35(6)] ;

•

the sum of the amounts obtained is the reduction in the reduced cost base of the loan [subsection 139-35(7)] .

2. 51 Example 2.5 demonstrates the operation of new section 139-35.

Example 2.5

Holdco capitalises Subco A with $100 post-CGT and receives 100 shares. Subco A then capitalises Subco B with $100. Subco A subsequently trades profitably. Subco A then lends $150 to Holdco and Subco B lends $70 to SubcoA. Subco A then forgives the debt to Holdco and no consideration is given for the forgiveness. At that time, the market value of each share in Subco A is assumed to be $2. Assuming the market value of the loan is equal to its face value, there is a value shift of $150 from Subco A to Holdco.

Under new section 139-25, the maximum reduction amount will be $1.50 ($150 * (2/200)). Since the cost base and reduced cost base of the shares in Subco A is $1, they will be reduced to nil. The excess amount of $0.50 per share will then be applied under new section 139-35.

The loan reduction factor will be one (70/70). New subsections 139-35(4) to 139-35(7) would then apply to reduce the cost base and reduced cost base of the loan from Subco B to Subco A by $50 (i.e. the excess amount of $0.50 per share * 100 shares).

Different calculation in certain circumstances

2. 52 However, the cost base or reduced cost base of a loan owned by a taxpayer is not reduced under new section 139-35 if:

•

at the forgiveness time:

-

there was a pre-CGT share held in the creditor company;

-

the taxpayer owned another loan to the creditor company; or

-

another loan to the creditor company was owned by a company that was a member of the same wholly-owned group or by an individual who was an ultimate owner of the creditor and debtor company; and

•

it would be unreasonable to reduce the loan by as much as would be required under section 139-35.

[Subsection 139-40(1)]

2.53 Where these conditions are met, the cost base and reduced cost base are reduced by a reasonable amount having regard to the circumstances in which the loan was acquired and the extent to which its market value was reduced by the trigger event. [Subsection 139-40(2)]

2.54 New section 139-40 could apply where all of the shares in a company were acquired pre-CGT and there was a post-CGT loan owed to the creditor company. In this case, if new section 139-35 were to apply, the whole of the maximum reduction amount would be applied to reduce the cost base of the loan. Under new section 139-40, any reduction in the market value of the loan can be taken into account in determining the reduction in the cost base and reduced cost base of the loan.

2.55 Example 2.6 demonstrates when new section 139-40 could apply.

Example 2.6

Modifying the facts in Example 2.5, assume the shares held by Holdco in Subco A were all acquired pre-CGT. Further, assume that the market value of the loan from Subco B to Subco A was not affected by the value shift.

In this situation, new section 139-25 would not operate to adjust the cost base and reduced cost base of shares in Subco A. If new section 139-35 applied, the full amount of the value shift of $150 would be offset against the cost base and reduced cost base of the loan from Subco B to Subco A. The cost base and reduced cost base would be reduced to nil, regardless of the fact that the value shift did not affect the market value of the loan.

Under new section 139-40, no adjustment would be required to the cost base and reduced cost base of the loan because the market value of the loan was not altered by the value shift.

Indirect interests in creditor company

2. 56 Under new section 139-45 the cost base and reduced cost base of a CGT asset must be reduced if:

•

because of owning the asset, a taxpayer has an indirect interest in a share in, or loan to, the creditor company;

•

the asset was owned at the forgiveness time;

•

a CGT event happens in relation to the asset;

•

the asset was acquired post-CGT; and

•

new Division 139 has applied to reduce the cost base or reduced cost base of one or more shares in, or loans to, the creditor company.

[Subsection 139-45(1)]

2.57 The amount of the reduction is such amount as is reasonable having regard to the reduction in the value of the CGT asset as a result of the trigger event and, in the case of cost base reductions, inflation measured by reference to the All Groups CPI Number. [Subsection 139-45(2)]

2.58 In regard to a taxpayer having an indirect interest in a share in, or loan to, the creditor company, the words indirect interest do not require an interest in a strict legal or technical sense. There is a relevant interest if it would be reasonable to conclude, by tracing the effect of the value shift through an interposed entity or interposed entities, that the CGT asset could be affected by a shift in value out of a share in, or loan to, the creditor company.

2.59 Example 2.7 demonstrates when new section 139-45 could apply.

Example 2.7

Holdco capitalises Subco A with $200 post-CGT. Subco A then capitalises Subco B and Subco B capitalises Subco C with $200 each. Subco C subsequently lends $50 to Subco A. The debt is then forgiven and no consideration is given for the forgiveness. Assuming the debt is worth its face value, there has been a value shift of $50 from Subco C to Subco A.

The effect of the value shift on Subco As shares in Subco B would be accounted for under new section 139-45 as Subco A has an indirect interest in the creditor company (Subco C). Assuming an adjustment has been done under new section 139-25 and the market value of Subco As shares in Subco B has decreased by the amount of the value shift, then the cost base and reduced cost base of Subco As shares in Subco B would be reduced by $50 (ignoring inflation) if a CGT event happens to the shares.

The effect of the value shift on Holdcos shares in Subco A would have to be determined under both new sections 139-45 and 139-50.There would be no adjustment to Holdcos shares in Subco A if the market value of the shares has not been affected by the value shift from Subco C to Subco A.

2.60 When calculating the reduction in the cost base of a CGT asset under new section 139-45, regard is to be had to inflation. An adjustment for inflation is necessary because the adjustment to the cost base is only made when a CGT event happens to the asset (refer to new subsection 139-15(2)). If an adjustment were not made for inflation, indexation would be available on the full amount of the cost base from the forgiveness time. By having regard to inflation, it achieves an analogous result to reducing the cost base of the asset at the forgiveness time.

2.61 Having regard to inflation effectively means that the reduction amount is indexed for inflation over the period from the forgiveness time until the CGT event happens to the asset. However, as a consequence of the amendments contained in Schedule 11 of this Bill, indexation of the reduction amount will only be required up to 30 September 1999 (when indexation is frozen).

Direct and indirect interests in debtor company

2.62 New section 139-50 requires that the cost base and reduced cost base of a CGT asset must be increased if:

•

the asset is a share in the debtor company or an asset that gives the taxpayer an indirect interest in a share in that company;

•

the asset was owned at the forgiveness time;

•

a CGT event happens in relation to the asset;

•

the asset was acquired post-CGT; and

•

new Division 139 has applied to reduce the cost base or reduced cost base of one or more shares in, or loans to, the creditor company.

[Subsection 139-50(1)]

2.63 The amount of the increase is such amount as is reasonable having regard to the increase in the value of the CGT asset as a result of the trigger event, the amount of any relevant reductions under new Division 139 and, in the case of cost base increases, inflation measured by reference to the All Groups CPI Number. [Subsection 139-50(2)] However, as mentioned in paragraph 2.61, indexation of the increased amount will only be required up to 30 September 1999.

2.64 As discussed at paragraph 2.58, the words indirect interest do not require an interest in a strict legal or technical sense. In this context, there is a relevant interest if it would be reasonable to conclude, by tracing the effect of the value shift through an interposed entity or interposed entities, that the CGT asset could be affected by a shift in value into a share in the debtor company.

2.65 Example 2.8 demonstrates when new section 139-50 may apply.

Example 2.8

Holdco capitalises Subco A with $100 post-CGT. Subco A in turn capitalises Subco B and Subco C with $50 each. Subco C subsequently lends $50 to Subco B. Subco C then forgives the loan and no consideration is given for the forgiveness. There has been a value shift of $50 from Subco C to Subco B (assuming the market value of the loan was equal to its face value).

The effect of the value shift on Subco As shares in Subco B would be accounted for under new section 139-50 as Subco A has a direct interest in the debtor company (Subco B). Assuming an adjustment has been done under new section 139-25 and the market value of Subco As shares in Subco B has increased by the amount of the value shift, then the cost base and reduced cost base of Subco As shares in Subco B would be increased by $50 (ignoring inflation).

The effect of the value shift on Holdcos shares in Subco A would have to be determined under both new sections 139-45 and 139-50. There would be no adjustment to Holdcos shares in Subco A if the market value of the shares has not been affected by the value shift from Subco C to Subco B.

Application and transitional provisions

2. 66 The amendments contained in this Bill will apply to trigger events that occur on or after 22 February 1999. [Item 5 of Schedule 2]

Consequential amendments

2.67 Item 1 of Schedule 2 to this Bill amends the note to subsection 116-30(1) of the ITAA 1997. Subsection 116-30(1) contains a market value substitution rule where no proceeds are received from a CGT event. As mentioned at paragraph 2.26, new section 139-20 of this Bill provides that in working out the capital proceeds from a CGT event covered by new Division 139, the market value substitution rule is to be ignored. Therefore, the note to subsection 116-30(1) will now provide that the market value substitution rule is ignored where section 138-30 or new section 139-20 apply.

2.68 Item 2 of Schedule 2 adds a note after section 138-15 of the ITAA1997. Section 138-15 is contained in Division 138 of the ITAA1997, which deals with value shifting between commonly owned companies. As new Division 139 now also deals with value shifting (involving the forgiveness of debts), the note will draw attention to newDivision 139 by providing that it also deals with cost base adjustments to interests in companies under common ownership.

2.69 Item 4 of Schedule 2 repeals paragraph 245-85(1)(c) of the CDF provisions (contained in the ITAA 1936) and inserts new paragraph 245-85(1)(c). The new paragraph will ensure that any cost base reductions made under Division 139 will not affect the application of the CDF provisions (also refer to paragraphs 2.10 to 2.15).

Chapter 3 - Excess deductions

Outline of Chapter

3.1 Unless an election is made to take immediate deductions, existing Division 330 of the ITAA 1997 (mining and quarrying) limits deductions for exploration and prospecting expenditure and allowable capital expenditure on mine development to the amount of available income. The excess deductions are carried forward for successive deduction in later years until fully absorbed.

3.2 This Chapter explains amendments that will end the quarantining arrangements for these excess deductions.

Context of Reform

3.3 The excess deductions rules were in place before the 1990 removal of the 7 year limit on the carry forward of non-primary production losses. The rules recognised that the mining sector might not be able to use early year losses fully within the 7 years.

3.4 In accordance with the Recommendations of the Review, the full cost of acquiring mining or quarrying rights and information will be available for write-off under new Division 40. The removal of deduction limits on the cost of acquiring mining or quarrying rights and information, the absence of limits on the deductibility of prior year losses, mean that there is no reason to retain the special excess deduction rules.

Detailed explanation of new law

3.5 Existing Subdivision 330-F of the ITAA 1997 contains the rules about how excess deductions arise in an income year and how they can be deducted in later income years. The basic rule is that, unless a contrary election is made, a taxpayer can only deduct an amount for exploration or prospecting expenditure and allowable capital expenditure up to the amount of available income. In later income years those excess amounts can be used to absorb surplus income provided that particular conditions are met.

3.6 Item 4 of Schedule 3 to this Bill inserts new section 330-335 which ensures that the deduction limits contained in sections 330-300 and 330-305 will not operate to restrict the amount of the allowable deduction in the 1999-2000 income year for expenditure on exploration and prospecting or allowable capital expenditure.

3.7 Item 4 of Schedule 3 also inserts new section 330-340. Subsection 330-340(1) is concerned with those taxpayers whose balancing date for the 1998-1999 income year has occurred before 21September1999. It ensures that excess amounts available to a taxpayer at 11.45 am AEST on 21September 1999 will be treated as an allowable deduction at that time for either exploration or prospecting expenditure or allowable capital expenditure. This will mean that those previously quarantined amounts are deductible in calculating taxable income for the 1999-2000 income year and may, in relevant circumstances, contribute to a tax loss for that year.

3.8 Subsection 330-340(2) is concerned with taxpayers whose balancing date for the 1998-1999 income year occurs after 21September1999. Those taxpayers will apply the existing rules for calculating excess deductions for the 1998-1999 income year. Their excess deductions will not be converted on 21 September 1999. Instead, the excess amounts calculated at the end of their 1998-1999 income year will be converted into deductions on the first day of their 1999-2000 income year.

3.9 Items 1 to 3 of Schedule 3 make consequential amendments to the ITAA 1997 to remove provisions that refer to the excess deduction rules for mining operations. These provisions will be redundant from the 1999-2000 income year onwards. Items 5 and 6 make similar consequential amendments to the ITAA 1936.

3.10 Item 7 of Schedule 3 applies the above changes to assessments for the 1999-2000 income year and later income years.

Chapter 4 - Preventing a deduction and a capital loss arising from a single economic loss

Outline of Chapter

4.1 Schedule 4 to this Bill inserts new subsections 110-55(9) and 110-60(7) into the ITAA 1997. These subsections will ensure that a taxpayer cannot claim a deduction and a capital loss for the same economic loss if a CGT event happens to a CGT asset (including an interest in a CGT asset of a partnership).

Context of Reform

4.2 Under the existing law, it is unclear whether a taxpayer can obtain both a capital loss and a deduction for a net loss incurred on the realisation of a revenue asset that is not trading stock. A revenue asset in this context is one for which the taxpayer would return a net profit as assessable income or obtain a deduction for a net loss. An example of such an asset is a share held by a financial institution where the share is not trading stock, but is treated by the institution as an asset on revenue or income account.

4.3 A capital gain or capital loss made under the CGT provisions for a revenue asset is not, unlike trading stock, directly disregarded. Rather, the capital gain or capital loss on the revenue asset may be reduced to take into account an amount already recognised as assessable income or as a deduction. This prevents double taxation of a gain or double relief for a loss. The issue discussed in this Chapter relates to possible double relief for a loss.

4.4 Broadly, the reduced cost base of an asset (which is used for calculating a capital loss when the asset is realised) does not include an amount to the extent to which the owner has deducted or can deduct it. Among other things, such an amount includes an amount paid in respect of acquiring the asset and an amount of capital expenditure to increase its value.

4.5 Under the current law, it is not clear that a deduction for a net loss on realisation of a revenue asset represents the deduction of such an amount so as to be excluded from reduced cost base, and hence from the calculation of a capital loss on disposal of the asset.

4.6 For example, it has been argued that because only the net loss arising on realisation is deductible (and the acquisition cost and other capital costs are not themselves directly deductible), the deduction for the net loss does not represent the deduction of such amounts for the purposes of calculating the reduced cost base of the asset. Thus, it is contended that a capital loss can be obtained for an amount effectively deducted as a net loss under the revenue provisions.

Example 4.1

A bank disposes of shares which it holds as revenue (non trading stock) assets. The shares were purchased on or after 20 September 1985 (post-CGT) for $100,000 and sold for $20,000. The bank cannot deduct the purchase price of the asset, but deducts the net loss ($80,000) realised on sale. The bank contends that it is also entitled to a capital loss of $80,000 representing the difference between the reduced cost bases of the shares ($100,000) and the capital proceeds on sale ($20,000).

4.7 A contrary view is that the deduction for a net loss under the revenue provisions is properly construed as a deduction of amounts paid in respect of acquiring the asset and other costs in respect of it, for the purposes of determining the reduced cost base of the asset. If this view is correct, this would mean that the bank in example 4.1 would be able to deduct the $80,000 net loss, but would not also make a capital loss for that amount.

4.8 Although the issue has not been judicially clarified, double relief for the one loss is clearly inappropriate. Clarification that double relief is not available is consistent with the policy approach to prevent loss duplication recommended in the Recommendations.

Summary of new law

4.9 The proposed amendments will ensure that the reduced cost base of a CGT asset (including an interest in a CGT asset of a partnership) will be reduced by any amount deducted (or would have been deducted but for the deferral rules proposed in item 15 of Schedule 4 of this Bill) as a result of the realisation of the asset.

4.10 However, no reduction will be made for an amount referable to some cost which could never have formed part of the assets reduced cost base. Further, no reduction will be required if, on a correct construction of the law, the amount is already excluded from the reduced cost base of the asset under another provision dealing with the reduced cost base of a CGT asset.

Detailed explanation of new law

4.11 New subsections 110-55(9) and 110-60(7) will ensure that the reduced cost base of a CGT asset (including an interest in a CGT asset of a partnership) will be reduced by an amount deducted (or that would have been deducted but for the deferral rules in Schedule 4 of this Bill) as a result of the realisation of the asset. [Items 2 and 3 of Schedule 4]

4.12 The reference to the entitys share of any amount that the partnership deducted or can deduct, or could have deducted except for Subdivision 170-D, is a reference to a partners individual interest in the net income or partnership loss relating to the deduction that the partnership has deducted, or can deduct, or could have deducted but for Subdivision 170-D. Ordinarily the partners share of that deduction will be the same as the partners interest in the overall net income or partnership loss, unless the partnership agreement suggests that a different proportion is appropriate.

4.13 The proposed subsections refer to a deduction which arises as a result of a CGT event that happens in relation to a CGT asset. Ordinarily, this CGT event will be a disposal of the CGT asset (CGT event A1). CGT events that do not trigger deductions for losses on revenue assets will not be relevant in this context.

4.14 Although strictly only a capital gain or capital loss is made as a result of the happening of a CGT event, the wording is intended to link together the revenue and CGT consequences of the realisation (e.g. a disposal) of a revenue asset, notwithstanding that the deduction and capital loss may arise at different times under the income and CGT provisions.

4.15 No reduction will be required for an amount which is relevant in calculating a net loss on realisation of a revenue asset, but which could never qualify as an element of an assets reduced cost base. This ensures that a capital loss is not inappropriately reduced by an amount of a deduction on realisation of the asset.

4.16 Further, no reduction of the reduced cost base will be required for an amount if, on a correct construction of the law, the amount is already excluded from the reduced cost base of the asset under another provision. This ensures that if a deduction for a loss on realisation of a revenue asset is, as a matter of law, a deduction of an amount otherwise qualifying as an element of reduced cost base, there will not be an inappropriate double reduction.

4.17 In limited cases, a capital loss and a deduction will still be appropriately obtained on the realisation of a revenue asset. This could occur, for example, if the reduced cost base of an asset exceeds its actual cost for the purposes of calculating a net loss on realisation (e.g. because of the operation of existing Subdivision 149-B of the ITAA 1997). However, under the new law, the same economic loss will not be recognised twice.

Application and transitional provisions

4.18 The proposed amendments will apply in respect of CGT events happening to CGT assets on or after 21October1999. [Subitem 19(1)]

4.19 This Bill specifically provides that the proposed amendments are to be disregarded in applying sections 110-55 and 110-60 of ITAA 1997,and subsections 160ZK(1) and 160ZK(3) of the ITAA 1936,to CGT events or disposals that happened before 21October1999. [Subitems 19(2) and 19(3)]

4.20 This means that the proposed amendments cannot, by inference, support a view under the current law that capital losses and deductions were available in respect of the same economic losses on the realisation of revenue assets.

Chapter 5 - Transfer or creation of assets by companies that are members of linked groups

Outline of Chapter

5. 1 Schedule 4 to this Bill inserts new Subdivision 170-D into the ITAA 1997. Subdivision 170-D will defer recognition of a capital loss or a deduction which would, apart from the Subdivision, be realised where there has been:

•

the transfer of a CGT asset between companies in the same linked group;

•

the creation of certain rights or options in a company in the same linked group as the creator company;

•

the transfer of a CGT asset to, or the creation of certain rights or options in, a trust (or an associate of the trust) connected with a member of a linked group; or

•

the transfer of a CGT asset to, or the creation of certain rights or options in, an individual (or an associate of the individual) connected with a member of a linked group.

5.2 The deferred capital loss or deduction will only become available to the company that has disposed of or created the asset where, broadly, that company, or the CGT asset involved, ceases to belong to the same linked group (together with connected entities and their associates).

5.3 Broadly, 2 companies are linked to each other if one of them has a controlling direct or indirect stake in the other or the same entity has a controlling stake in each of them.

Context of Reform

5.4 Loss duplication arises when a single economic loss is recognised by the taxation system more than once. This can occur because losses (realised or unrealised) in an entity are reflected in the value of interests (such as shares) in that entity.

5.5 Loss cascading, which is a form of loss duplication, occurs where a loss is artificially duplicated through a chain of companies so that multiple losses are allowed to the same group in respect of a single economic loss. This is facilitated by, among other things, the existence of asset roll-over concessions applying to wholly-owned groups of companies and the ability of groups of companies in general to realise losses (or deductions) by internal transactions.

5.6 For example, a loss may be cascaded where a loss asset (an asset carrying an unrealised loss) is disposed of within a wholly-owned company group. Where this occurs, Subdivision 126-B of the ITAA 1997 may allow a capital loss which would otherwise have been realised on the disposal to be claimed by the transferee when the asset is subsequently disposed of outside the group.

5.7 Subdivision 126-B may therefore effectively allow capital loss transfers between group companies without any of the anti-loss duplication cost base adjustment measures applying on the transfer of realised net capital losses. It may also allow non-residents (including controlled foreign companies) that are specifically prohibited from transferring net capital losses and tax losses to do so indirectly via loss asset transfers. This potentially allows an unrealised loss to be cascaded on interests held directly or indirectly in the transferor company.

Example 5.1

Company A capitalises Company B with $100. Company B purchases an asset for $100. The asset declines in value until it is worth $10. Company B transfers the asset to Company C, another wholly-owned subsidiary of Company A. Under Subdivision 126-B, the capital loss that Company B would make on the transfer of the asset is disregarded and the cost-base and reduced cost base of the asset is rolled-over to Company C. Company C now has an asset with an unrealised loss of $90. Company As equity in Company B is worth $10. Company A could sell Company B and realise a capital loss of $90. Company C can sell the loss asset and duplicate the loss.

5.8 Loss cascading is not limited to wholly-owned company groups. It can also occur within majority-owned groups, although the mechanism does not involve the roll-over of unrealised loss assets. For example, losses may be obtained on certain transfers of interests in loss entities within less than 100% owned groups where these losses duplicate losses later claimed in the entities themselves. The fact that there are currently no specific restrictions on companies realising losses and deductions on the transfer or creation of assets within majority-owned groups increases cascading opportunities for such groups.

5.9 The deficiencies in the existing law outlined above are to be addressed by ensuring that the transfer or creation of a loss asset by one company to, or in, another in a majority-owned or wholly-owned company group, or by a company in such a group to a connected individual or trust (or an associate of one of these), does not give rise to a capital loss or deduction that can be immediately utilised for tax purposes. The deferred capital loss or deduction will only become available to the company that has transferred or created the asset where, broadly, that company, or the CGT asset involved, ceases to belong to the same linked group (together with connected entities and their associates).

5.10 One of the effects of the proposed amendments is that wholly-owned company groups will have to use the tax loss and net capital loss transfer provisions if they want to group a net capital loss or tax loss. As a consequence, resident companies will not be able, by transferring loss assets, to bypass the anti-loss duplication measures proposed in this Bill (Schedule 5, Subdivision 170-C) for net capital loss and tax loss transfers. In addition, non-resident companies (including controlled foreign corporations) within wholly-owned groups will no longer be able to obtain effective net capital loss or tax loss transfer (which they are denied) via the transfer of an unrealised loss asset.

5.11 The new law will also ensure that balancing adjustment roll-over will not apply in a situation where Subdivision 170-D applies. In these cases, the deduction will be deferred to the transferor company. The new law will not impact on the roll-over of balancing adjustments where the adjustment would otherwise involve the inclusion of an amount in assessable income.

5.12 New Subdivision 170-D is consistent with the policy approach outlined in recommendation 6.11(b) of A Tax System Redesigned.

Summary of new law

5. 13 Broadly, Subdivision 170-D will apply where:

•

a company disposes of an asset to, or creates an asset in;

-

another company; or

-

a connected entity or its associate;

•

the company disposing of or creating the asset (the originating company) and the company receiving the asset (where relevant) are members of the same linked group; and

•

the disposal or creation of the asset would, apart from the operation of Subdivision 170-D, generate a capital loss or a deduction for the originating company.

5.14 Where these conditions are met, the capital loss or deduction that would otherwise be available on transfer will be deferred. [Section 170-250]

5.15 The deferred capital loss or deduction will only become available to the company that has disposed of or created the asset where, broadly, that company, or the CGT asset involved, ceases to belong to the same linked group (together with connected entities and their associates).

Detailed explanation of new law

When is a company required to defer recognition of a capital loss or deduction?

5.16 A company will be required to defer recognition of a capital loss or deduction that arises from a deferral event involving a company (the originating company) and another entity [paragraph 170-255(1)(a)] . Where a company is a partner in a partnership, and an event happens between the partnership and another entity, the company is involved in the event for the purposes of Subdivision 170-D.

5.17 Deferral of recognition means disregarding a capital loss or deduction that would, apart from the operation of Subdivision 170-D, become available on the happening of a specified deferral event. The capital loss or deduction that is disregarded is deferred until a further specified event happens. When that event happens, the capital loss or deduction is able to be utilised by the originating company.

5.18A deferral event happens if a prescribed CGT event (in paragraph 5.25) would have resulted in the originating company making a capital loss on the disposal of a CGT asset to the other entity, or the creation of a CGT asset in the other entity. However, where a capital loss is made but is disregarded, apart from Subdivision 170-D, then Subdivision 170-D will not apply. [Subparagraph 170-255(1)(b)(i)]

5.19 A deferral event also happens if the originating company would have become entitled to a deduction as a result of the disposal of a CGT asset to the other entity. [Subparagraph 170-255(1)(b)(ii)]

5.20 In addition, a deferral event happens if the originating company is a partner in a partnership and the partnership would have become entitled to a deduction as a result of the disposal of a CGT asset to the other entity. [Subparagraph 170-255(1)(b)(iii))]

5.21 A partners share of the deduction refers to a partners individual interest in the net income or partnership loss relating to the deduction that the partnership would have become entitled to as a result of the deferral event. Ordinarily the partners share of that deduction will be the same as the partners interest in the overall net income or partnership loss, unless the partnership agreement suggests that a different proportion is appropriate.

5.22 For example, assume there is a partnership loss of $1,000 of which $700 relates to a deduction that the partnership would have become entitled to as a result of the deferral event. If the partners individual interest in the partnership loss is 25%, then $175 of the deduction the partner would otherwise have made is disregarded.

5.23 Subdivision 170-D will not apply to the disposal of trading stock. This is because of the interaction of the conditions required for Subdivision 170-D to apply with the way that deductions and assessable income are accounted for under the trading stock provisions of the law, and because of the treatment of trading stock under the CGT provisions of the law.

5.24The originating company must be a member of a linked group at the time of the deferral event. In addition, the other entity must be either:

•

another company in the same linked group; or

•

a connected entity in relation to the originating company or an associate of the connected entity.

In the case of a partnership, the relevant entity will be a partner in the partnership.

5. 25 The CGT events which are relevant for the purposes of Subdivision 170-D are as follows:

•

CGT event A1 the originating company disposes of the asset to the other company, connected entity or an associate of the connected entity. Disposal occurs where ownership of the asset passes from the originating company to the other company, connected entity or its associate. [Subparagraph 170-255(1)(c)(i)]

•

CGT event B1 the originating company enters into an agreement with the other company, connected entity or associate of the connected entity by which the use and enjoyment of the asset passes to the other company, connected entity or associate. At the end of the agreement, title in the asset must pass to the other company, connected entity or associate of the connected entity. [Subparagraph170-255(1)(c)(i), subsection 170-255(2)]

•

CGT event D1 the originating company creates a contractual right or other legal or equitable right in the other company, connected entity or associate of the connected entity. [Subparagraph170-255(1)(c)(ii)]

•

CGT event D2 the originating company grants, renews or extends an option to the other company, connected entity or associate of the connected entity. [Subparagraph170-255(1)(c)(ii)]

•

CGT event D3 the originating company owns, or owns an interest in, a prospecting entitlement or mining entitlement and the originating company grants a right to the other company, connected entity or associate of the connected entity to receive income from operations carried on because of the entitlement. [Subparagraph170-255(1)(c)(ii)]

•

CGT event F1 the originating company grants, renews or extends a lease for the other company, connected entity or associate of the connected entity. [Subparagraph 170-255(1)(c)(ii)]

[Paragraph 170-255(1)(e)]

5. 26 In addition, Subdivision 170-D will only apply where one of the following is satisfied:

•

at the time of the deferral event, the originating company is a resident of Australia;

•

for CGT events A1, B1, or F1, the relevant asset had the necessary connection with Australia immediately before the deferral event;

•

for CGT event D1, the proceeds from the CGT event are, or would be, Australian sourced; or

•

for CGT event D2, the option had the necessary connection with Australia immediately after the deferral event.

[Paragraph 170-255(1)(d)]

5. 27 If the deferral event is CGT event D3, Subdivision 170-D will only apply where the originating company is a resident. This is because section 136-20 of the ITAA 1997 provides that a non-resident cannot make a capital gain or capital loss from CGT event D3.

Example 5.2

Bigco and Smallco are companies in the same linked group. Bigco owns a CGT asset with a cost base of $100 and a market value of $50. On 1 January 2000 Bigco sells the asset to Smallco for $50.

Subdivision 170-D requires that the capital loss of $50 which Bigco would otherwise make on the sale of the asset be deferred because both companies are members of the same linked group.

5. 28 To determine whether Subdivision 170-D applies, it will be necessary to identify a linked group and, if necessary, a connected entity of the originating company or an associate of the connected entity. The rules for determining whether a company forms part of a linked group, or whether an entity is connected with an originating company, are discussed in paragraphs 5.29 to 5.40.

What is a linked group?

5. 29 Two companies are linked to each other if one of them has a controlling stake in the other or the same entity has a controlling stake in each of them. [Subsection 170-260(2)]

What is a controlling stake in a company?

5. 30 An entity has a controlling stake in a company at a particular time if the entity either alone or with its associates has at least one of the following:

•

the ability to exercise, or control the exercise of, more than 50% of the voting power in the company (either directly or through an interposed entity or entities);

•

the right to receive (either directly or through an interposed entity or entities) for their own benefit more than 50% of any dividends that the company may pay; or

•

the right to receive (either directly or through an interposed entity or entities) for their own benefit more than 50% of any distribution of capital of the company.

[Subsection 170-260(3)]

5. 31 A wholly-owned group of companies will also be a linked group for the purposes of Subdivision 170-D.

Who may be an associate?

5. 32 For the purposes of Subdivision 170-D, associate takes its meaning from section 318 of ITAA 1936.

Rules for avoiding the double counting of interests

5. 33 There exists the potential for double-counting of an entitys interest because both direct and indirect interests of the entity and its associates are taken into account in determining whether a company forms part of a linked group. An entity is to ignore an indirect interest which has already been counted in determining a direct interest of the entity (or an associate). [Subsection 170-260(4)]

Example 5.3

Individual shareholder A holds 80% of all the shares in Company A and 60% of all the shares in Company B. Company A and Company B form a linked group because individual A has a controlling stake in each of them.

Example 5.4

Headco holds 80% of the shares in Subco-1. Subco-1 holds 51% of the shares in Subco-2. Headco, Subco-1 and Subco-2 form a linked group. Headco has a controlling stake in Subco-1. Headco also has a controlling stake in Subco-2, by virtue of Subco-1 (which is an associate of Headco).

Example 5.5

Trust A is a widely held fixed (unit) trust. The trustee of Trust A holds 100% of the shares in A-co and 60% of the shares in B-co. B-co holds 40% of the shares in C-co. The trustee of Trust A has a controlling stake in A-co and B-co. A-co and B-co are also both associates of the trustee of Trust A. The trustee of Trust A and its associates do not, however, have a controlling stake in C-co. Therefore the linked group is made up of A-co and B-co only.

Example 5.6

Headco holds 100% of the shares in A-co and 80% of the shares in B-co. A-co holds 30% of the shares in C-co. B-co holds 40% of the shares in C-co. Headco and A-co are linked as are Headco and B-co because Headco has a controlling stake in each of them. A-co and B-co are also linked. Headco can control (indirectly via A-co and B-co) 70% of the voting power of C-co.

Example 5.7

Company A owns 30% of Company B and 30% of Company C. Company B owns 70% of Company C. Company B forms part of the same linked group as Company C. Company As interest in Company C is calculated by aggregating Company As direct and indirect interests in C. Company As indirect interest in Company C is calculated by multiplying 30% by 70%. Company As indirect interest in Company C is 21%. Company As direct interest in Company C is 30%. Company As interest in Company C is the sum of Company As direct and indirect interests, Company As interest in Company C is 51%. Company C forms part of the same linked group as Company A.

Example 5.8

Company A has a controlling stake in Company B such that Company A and Company B form a linked group. Company B is also an associate of Company A. Company A and Company B also hold shares in Company C. It is assumed that Company C is not an associate of Company B.

Company A has a direct interest in Company C of 10% and an indirect interest of 15% (51% of 30%). Company B has a direct interest in Company C of 30%. The total of these interests is 55%.

However Company As indirect interest has already been counted in counting Company Bs interest. Therefore the indirect interest is disregarded. The aggregate interests of Company A in Company C is 40%. Company C does not form part of the linked group of which Company A and Company B are members.

What is a connected entity?

5.34 Capital losses and deductions will be deferred where a member of a linked group originating company disposes of a CGT asset to, or creates a CGT asset in (in the case of capital losses), a connected entity or its associate.

5.35 A connected entity in relation to an originating company at a particular time is:

•

a trustee of a connected trust (where the trustee is acting in its capacity as such); or

•

an individual who has a controlling stake in the originating company.

[Subsection 170-265(1)]

5.36 A connected trust can either be a fixed trust or a trust that is not a fixed trust. A trust is a fixed trust if persons have fixed entitlements to all of the income and corpus of the trust. [Item 4 of Schedule 10 - Section 995-1]

5.37 A fixed trust will be a connected trust at a particular time if one or more members of the linked group that the originating company belongs to, or those members and their associates, have between them the right to receive as beneficiaries more than 50% of any distribution of the income or the corpus of the trust. [Subparagraph 170-265(1)(a)(i)]

5.38 Where the trust is not a fixed trust, it will be a connected trust at a particular time if a member of the linked group, or an associate of the member, benefits or is capable of benefiting under the trust. [Subparagraph 170-265(1)(a)(ii)]

5.39 An individual has a controlling stake in a company at a particular time if the individual either alone or with its associates has at least one of the following:

•

the ability to exercise, or control the exercise of, more than 50% of the voting power in the company (either directly or through an interposed entity or entities);

•

the right to receive (either directly or through an interposed entity or entities) for their own benefit more than 50% of any dividends that the company may pay; or

•

the right to receive (either directly or through an interposed entity or entities) for their own benefit more than 50% of the distribution of capital of the company.

[Subsection 170-265(2)]

5.40 The double-counting rules discussed in paragraph 5.33 are of equal relevance in determining whether an individual has a controlling stake in a company. [Subsection 170-265(3)]

Example 5.9

Companies A, B and C form a linked group. Company A is an originating company. Company B is an object of a discretionary trust, Trust A. Trust A is a connected trust of Company A.

Example 5.10

Companies A, B and C form a linked group. Company C is an originating company. Company A holds 60% of the units in a unit trust. The unit trust is a connected trust of Company C.

When can an originating company utilise a deferred capital loss or deduction?

5.41 Where the originating company would have made a capital loss or become entitled to a deduction as a result of a deferral event in relation to a CGT asset, the capital loss or deduction which it would otherwise be entitled to is disregarded. Where the originating company is a partner in a partnership, and the partnership would have become entitled to a deduction as a result of a deferral event in relation to a CGT asset, the partners share of the deduction is disregarded. [Section 170-270]

5.42 The originating company can only later utilise the capital loss or deduction when, broadly, the CGT asset or the originating company are no longer part of the same linked group (including connected entities and their associates). This will happen in the following circumstances:

•

the CGT asset ceases to exist;

•

the asset, or a greater than 50% interest in it, is acquired by an entity that is not a member of the same linked group as the originating company, nor a connected entity or an associate of a connected entity. In the case of a partnership, the relevant entity will be a partner in the partnership;

•

the asset is owned by a company that is a member of the linked group and that company ceases to be a member of the linked group;

•

the originating company ceases to be a member of the linked group; or

•

the CGT asset was transferred to or created in a connected entity of the originating company, or an associate of the connected entity, and that entity ceases to be connected with the originating company, or the associate ceases to be an associate.

[Subsection 170-275(1)]

5.43 When one of these events occurs, the originating company is taken to have made a capital loss or deduction equal to the amount of the deferred capital loss or deduction. The capital loss or deduction will be taken to have been realised immediately before the relevant circumstance occurred. [Subsection 170-275(1)]

Example 5.11

Oldco and Newco are companies in the same linked group. Oldco has a revenue asset with a cost price of $200 and a market value of $100. On 1 December 1999 Oldco sells the asset to Newco for $100. On the sale of the asset Oldco realises a potential deduction of $100.

Oldco cannot utilise this deduction because Newco is part of the same linked group.

On 1 March 2000 Newco sells the asset to Ethel. Ethel is an individual unconnected with the group. On the sale of the asset to Ethel, Oldco can utilise the deferred deduction of $100.

Loss retains character in hands of the originating company

5. 44 If the CGT asset subject to the deferral event is a personal use asset or a collectable, then the capital loss which the originating company would have made retains its character as a loss made from a personal use asset or collectable when the capital loss subsequently becomes available for utilisation. [Subsection 170-275(2)]

Restriction on the realisation of a deferred capital loss or deduction

5. 45 Where a capital loss or deduction has become available to the originating company because of the occurrence of a new event in respect of a CGT asset (set out in section 170-275), and within 4 years after the happening of the new event the asset, or a greater than 50% interest in it, is acquired by:

•

an entity which is a connected entity (or an associate of the connected entity) in relation to the originating company at the time the asset is acquired by the connected entity (or associate); or

•

a company (including the originating company) that is a member of the same linked group as the originating company group at that time,

then the capital loss or deduction made at the time of the new event is taken not to have been made. [Subsections 170-280(1) and 170-280(2)]

5. 46 The capital loss or deduction becomes a deferred capital loss or deduction and is only capable of being utilised when one of the following circumstances happens:

•

the CGT asset ceases to exist;

•

the asset, or a greater than 50% interest in it, is acquired by an entity that is not a member of the same linked group as the originating company, nor a connected entity or an associate of a connected entity. In the case of a partnership, the relevant entity will be a partner in the partnership;

•

the asset is owned by a company that is a member of the linked group and that company ceases to be a member of the linked group;

•

the originating company ceases to be a member of the linked group; or

•

the CGT asset was transferred to or created in a connected entity of the originating company, or an associate of the connected entity, and that entity ceases to be connected with the originating company, or the associate ceases to be an associate. [Subsection 170-280(3)]

Application and transitional provisions

5. 47 The amendments made by Schedule 4 apply to deferral events happening on or after 21 October 1999. [Subitem 19(1) of Schedule 4]

Consequential amendments

Income Tax Assessment Act 1997

5.48 Item 1 of Schedule 4 makes a consequential amendment to Subdivision 41-A of the ITAA 1997. Subdivision 41-A contains common rule 1 for capital allowances (dealing with roll-over relief for related entities). The amendment will ensure that where Subdivision 170-D applies to a CGT event or disposal, Subdivision 41-A will not apply.

5.49 Items 4 to 13 of Schedule 4 make consequential amendments to Subdivision 126-B of the ITAA 1997. Subdivision 126-B deals with the roll-over of CGT assets between companies in the same wholly-owned group. Broadly, the amendments reflect that new Subdivision 170-D now deals with capital losses and deductions which would otherwise be realised where a CGT asset is disposed of or created within a wholly-owned group. Thus, Subdivision 126-B will generally no longer have application where Subdivision 170-D applies.

5.50 Item 4 repeals existing paragraph 126-55(1)(a) and inserts new paragraph 126-55(1)(a) and (aa). These paragraphs have the effect of confining roll-over under Subdivision 126-B to situations where:

•

the originating company would otherwise make a capital gain;

•

the originating company would otherwise make no capital loss and would not be entitled to a deduction; or

•

the originating company acquired the roll-over asset before 20September 1985.

5.51 Thus, Subdivision 126-B functions as a standard group roll-over provision allowing for the retention of pre-CGT status (including on lossassets otherwise subject to deferral) and for roll-over of gain assets. If the asset would (but for the new deferral rules) have generated a capital loss or a deduction then it cannot be rolled-over under Subdivision 126-B, unless it is a pre-CGT asset (in which case the only effect of the roll-over is to preserve that pre-CGT status).

5.52 Items 5 to 9 make amendments to Subdivision 126-B to omit references to capital losses and to omit provisions relevant only to capital losses. Again, the effect of these amendments is to confine roll-over under Subdivision 126-B to situations where the originating company would make a capital gain or no capital loss or deduction.

5.53 Items 10 to 13 make amendments to section 126-85 of Subdivision 126-B. Currently, section 126-85 allows capital gains and capital losses made by a holding company on the liquidation of its 100% subsidiary to be reduced in certain circumstances where the subsidiary rolls over assets to the holding company in the course of the subsidiarys liquidation. This is to ensure that the gain or loss attached to the roll-over asset is not duplicated on the disposal of the shares in the subsidiary.

5.54 As mentioned at paragraph 5.49, the introduction of Subdivision 170-D means that Subdivision 126-B will no longer apply to assets which would otherwise realise a capital loss. Therefore, it is now highly unlikely that a capital loss could be duplicated where a subsidiary in liquidation transfers a loss asset to the holding company. This is because Subdivision 170-D requires the loss to be deferred in the subsidiary company and not in the holding company.

5.55 In addition, although the capital loss may be realised in the subsidiary before it is dissolved, the transfer of that loss to another member in a wholly-owned group would trigger cost base adjustments affecting the holding companys shares in the subsidiary.

5.56 For these reasons, section 126-85 is amended to ensure that a capital loss on the holding companys shares is not reduced by the section.

5.57 In addition, the method statement in subsection 126-85(3) is amended to ensure that capital losses subject to the rules in Subdivision 170-D are counted in determining the extent of a reduction in a capital gain made by the holding company on cancellation of its shares in the subsidiary.

Income Tax Assessment Act 1936

5.58 Items 16-18 of Schedule 4 make consequential amendments to several provisions of the ITAA 1936.

5.59 Items 16 and 18 ensure that where Subdivision 170-D applies to a disposal, sections 73E and 124PA will not apply.

5.60 Item 17 ensures that, where demutualisation method 6 of the demutualisation of insurance company provisions (contained in Division 9AA) applies to the demutualisation of an entity, then roll-over relief under Subdivision 126-B, as in force prior to the amendments made by items 4 to 13 of Schedule 4, will be available.

Chapter 6 - Transfer of losses within wholly-owned groups of companies

Outline of Chapter

6.1 Schedule 5 to this Bill inserts new Subdivision 170-C into the ITAA 1997. Subdivision 170-C will prevent the duplication of a tax loss which has been transferred between wholly-owned group companies, where direct or indirect interests in the loss company are realised.

6.2 Where a tax loss is transferred:

•

cost base and reduced cost base reductions will be required to be made in certain circumstances to equity interests acquired on or after 20September 1985 (post-CGT) and held directly or indirectly in the loss company;

•

reduced cost base reductions will be required to be made in certain circumstances to debt interests acquired post-CGT and held directly or indirectly in the loss company; and

•

in some cases, cost base and reduced cost base increases to post-CGT interests held directly or indirectly in the income company will also be necessary.

6.3 New Subdivision 170-C will also contain provisions replacing the current cost base and reduced cost base adjustment regime where a net capital loss is transferred between companies in a wholly-owned group. The policy approach underlying the current law has been maintained.

Context of Reform

6.4 Loss duplication arises when a single economic loss is recognised by the taxation system more than once. This can occur because losses realised in an entity are reflected in the value of interests in that entity.

6.5 A form of loss duplication, called loss cascading, occurs where losses are artificially duplicated through a chain of companies. This is facilitated by the existence of loss transfer and asset roll-over concessions applying to wholly-owned company groups. Some forms of loss cascading are prevented under the existing law but others are not.

6.6 An example of where loss cascading is not prevented is where a group company, which has incurred a revenue loss (referred to as a tax loss) for a year of income, transfers the loss to another group company under Subdivision 170-A of the ITAA 1997. Subdivision 170-A allows the transfer of tax losses between companies in the same wholly-owned group. Broadly, the amount of loss that can be transferred under Subdivision 170-A is equal to the amount that can be used by the company receiving the loss in that year of income.

6.7 If the tax loss (transferred under Subdivision 170-A) also reduced the value of direct and indirect interests (e.g. shares) held in the loss company, the tax loss can be duplicated by the sale (or other realisation) of the direct or indirect interests held in the loss company. (Where the loss is wholly attributable to a tax incentive, duplication cannot occur).

Example 6.1

Holdco capitalises Incomeco and Lossco each with $100 post-CGT. Lossco subsequently makes a tax loss of $50. Lossco transfers the loss to Incomeco. Incomeco gives no consideration for the transfer of the tax loss. The loss that Lossco makes reduces the value of the shares held by Holdco in Lossco by $50.

If Holdco subsequently disposes of the shares in Lossco (CGT event A1) for $50, it would make a loss of $50 (being the difference between the $100 reduced cost base of the shares and $50). This loss is a duplicate of the $50 loss transferred to Incomeco.

6.8 Subdivision 170-B of the ITAA 1997 deals with the transfer of net capital losses within wholly-owned groups of companies. Broadly, the conditions for the transfer of a loss under Subdivision 170-B mirror those in Subdivision 170-A.

6.9 However, Subdivision 170-B prevents loss duplication where a net capital loss is transferred by requiring cost base and reduced cost base reductions to interests held directly or indirectly in the loss company. Section 170-175 of Subdivision 170-B requires appropriate reductions to the cost base and reduced cost base of direct and indirect share and debt interests in a loss company following the transfer of a net capital loss. Section 170-180 of Subdivision 170-B allows for increases to the cost base and reduced cost base of direct and indirect share and debt interests in the gain company to reflect any increase in their market value because of the transfer of the net capital loss.

Example 6.2

Using the facts in Example 6.1, if the loss transferred were a net capital loss, section 170-175 would require a reduction to the cost base and reduced cost base of the shares in Lossco of $50, being the amount of the loss transferred. In addition, section 170-180 would allow an increase to the cost base and reduced cost base of the shares in Incomeco of $18 ($50 * 36%), being the tax benefit of the amount of the loss transferred (in the absence of any consideration given by Incomeco for the transfer).

6.10 Subdivision 170-A does not contain provisions to prevent the duplication of a tax loss transferred. This Bill will remedy this by introducing a new Subdivision 170-C, which will require cost base and reduced cost base adjustments where a tax loss is transferred between companies in a wholly-owned group. New Subdivision 170-C will also replace the provisions in Subdivision 170-B that require cost base and reduced cost base adjustments where a net capital loss is transferred between companies in a wholly-owned group.

6.11 The cost base adjustment mechanisms contained in new Subdivision 170-C will be based on those currently contained in Subdivision 170-B. However, the new provisions will clarify the circumstances in which an adjustment should be made, the amount of the adjustment required and when the adjustment is to be made.

Summary of new law

6.12 New Subdivision 170-C will apply where a tax loss or net capital loss is transferred between companies in the same wholly-owned group. Where a loss is transferred:

•

cost base and reduced cost base reductions will be required to be made in certain circumstances to post-CGT equity interests held directly or indirectly in the loss company;

•

reduced cost base reductions will be required to be made in certain circumstances to post-CGT debt interests held directly or indirectly in the loss company; and

•

in some cases, cost base and reduced cost base increases to post-CGT interests held directly or indirectly in the income company or the gain company will also be necessary.

6. 13 New Subdivision 170-C specifies factors to be taken into account in determining whether a cost base and reduced cost base adjustment should be made and, if so, the appropriate amount. Subdivision 170-C also specifies when the adjustments are to be made.

Detailed explanation of new law

6.14 Item 12 of Schedule 5 to this Bill inserts new Subdivision 170-C into the ITAA 1997. New Subdivision 170-C prescribes cost base and reduced cost base adjustments for direct and indirect equity interests, and reduced cost base adjustments for direct and indirect debt interests, in companies in a wholly-owned group where a net capital loss or tax loss is transferred between them. [Section 170-201]

6.15 The main object of new Subdivision 170-C is to prevent the duplication of tax losses or net capital losses which are transferred between companies in the same wholly-owned group [section 170-205] . As mentioned at paragraph 6.4, this can occur because losses realised by an entity are reflected in the values of interests in that entity. Duplication can occur if a CGT event happens in relation to equity or debt interests held directly or indirectly in the loss company. Duplication can take the form of the making of a loss or the reduction of a capital gain that would otherwise have been made. However, duplication only occurs if the group obtains the benefit of an economic loss more than once.

6.16 The effect of new section 170-205 (and the relevant factors specified in this Bill) is that where there is no duplication of a transferred loss (e.g. because the loss transferred is wholly attributable to a tax incentive), then no reductions will be required under new Subdivision 170-C. This is the case whether the tax incentive creates a permanent difference or a timing difference for the purposes of tax effect accounting.

6.17 New Subdivision 170-C also provides for adjustments to increase the cost base and reduced cost base of equity and debt interests held directly or indirectly by a group company in the income or gain company. The adjustment reflects the increase in the market value of the interest because of the transfer of the loss. However, the adjustment is only made if the increase is still reflected in the market value of the interest when a CGT event happens in relation to it. [Section 170-205]

6.18 As mentioned at paragraph 6.10, new Subdivision 170-C deals with the transfer of both tax losses and net capital losses. The cost base and reduced cost base adjustment mechanisms are identical for both types of loss transfers.

Transfer of a tax loss

Direct interests in the loss company

6. 19 Reductions to the cost base and reduced cost base of a direct equity interest, and to the reduced cost base of a direct debt interest, in a loss company, where a tax loss is transferred, will be required where the following conditions are met:

•

an amount of a tax loss is transferred by a company to another company;

•

Subdivision 170-A applies to the transfer;

•

a company (the group company ) holds a share in the loss company or is owed a debt by the loss company in respect of a loan;

•

the group company acquired the share or debt post-CGT; and

•

throughout the deduction year, the group company is a member of the same wholly-owned group as the loss company (disregarding a period when either was not in existence).

[Subsection 170-210(1)]

6. 20 The reference to an amount of a tax loss or an amount of a net capital loss in new Subdivision 170-C ensures that where a company incurs a tax loss or net capital loss but is only able to transfer part of that loss under Subdivision 170-A or Subdivision 170-B, then new Subdivision 170-C will still apply to the transfer of that part of the tax loss or net capital loss.

Indirect interests in the loss company

6. 21 Reductions to the cost base and cost base of an indirect equity interest, and to the reduced cost base of an indirect debt interest, in a loss company, where a tax loss is transferred, will be required where the following conditions are met:

•

an amount of a tax loss is transferred by a company to another company;

•

Subdivision 170-A applies to the transfer;

•

a company (the group company ) holds a share in another company or is owed a debt by another company in respect of a loan;

•

the group company acquired the share or debt post-CGT;

•

the money that the group company paid for the share, or the borrowed money, has been applied (directly, or indirectly through one or more interposed entities):

-

in the other company or a third company acquiring shares in the loss company; or

-

in a borrowing by the loss company from the other company or from a third company; and

•

throughout the deduction year, the group company, the other company and the third company (if any) are all members of the same wholly-owned group as the loss company (disregarding, for a particular company, a period when it was not in existence).

[Subsection 170-210(2)]

Amount of reduction

6.22 The amount of the reduction to the cost base and reduced cost base of a share, or the reduced cost base of a debt, for the purposes of new subsections 170-210(1) and 170-210(2), is determined under new subsection 170-210(3).

6.23 The reduction will be an amount that is appropriate having regard to the following factors:

•

the group companys direct or indirect interest in the loss company;

•

the amount of the loss transferred (which is the maximum reduction to any interest);

•

the extent to which the loss reduced the market value of the share or debt;

•

any consideration received by the loss company for the loss transferred; and

•

whether, because of a dividend or dividends paid by the loss company, the consideration is no longer reflected wholly or partly in the market value of the share or debt when a CGT event happens in relation to it.

[Subsection 170-210(3)]

Example 6.3

Holdco capitalises Incomeco and Lossco each with $100 post-CGT. Lossco subsequently makes a tax loss of $70. Lossco transfers the loss to Incomeco. No consideration is given by Incomeco for the transfer. The loss that Lossco makes reduces the value of the shares held by Holdco in Lossco by $70. Holdco subsequently disposes of the shares in Lossco for $30 (CGT event A1) .

The reduction in the cost base and reduced cost base of the shares in Lossco under new subsection 170-210(1) would be equal to $70, being the amount of the loss transferred in this case. Therefore, Holdco would make no capital gain or capital loss on the disposal of the shares in Lossco as the cost base and reduced cost base of the shares in Lossco would be reduced to $30.

If the reduction to the cost base and reduced cost base of the shares in Lossco were less than $70, Holdco would make a capital loss on the disposal of the shares in Lossco. This loss would duplicate (partly or wholly) the amount of the loss transferred by Lossco to Incomeco.

Example 6.4

Holdco capitalises Incomeco and Lossco each with $100, $50 pre-CGT and $50 post-CGT. All shares are of the same class. Lossco subsequently makes a tax loss of $50. Lossco transfers the loss to Incomeco for no consideration. The loss that Lossco makes reduces the value of all the shares held by Holdco in Lossco by $50. Holdco subsequently disposes of the shares in Lossco for $50 (CGT eventA1).

The reduction in the cost base and reduced cost base of the post-CGT shares in Lossco under new subsection 170-210(1) would in this case be equal to $25, being the extent to which the loss transferred reduced the market value of the post-CGT shares.

Example 6.5

Lossco capitalises Incomeco and Subco with $50 each post-CGT. Subco also makes a loan of $30 to Lossco. Lossco subsequently makes a tax loss of $40. Lossco transfers the loss to Incomeco for no consideration.

Whether new section 170-210 will require reductions to the reduced cost base of the loan from Subco to Lossco will depend on whether the market value of the loan is affected by the loss. If its market value were not affected, then no reduction would be required. However, if the market value were affected, it would be appropriate to make reductions to prevent the duplication of the transferred loss.

6.24 In determining the extent to which the loss reduces the market value of the share or debt, the tax benefit associated with the loss is to be disregarded. Regard should only be had to how the loss impacts on the value of the share or debt when the loss is suffered.

6.25 As discussed at paragraph 6.16, it would not be appropriate to reduce the cost base and reduced cost base of equity interests, or the reduced cost base of debt interests, in a loss company where the loss transferred is not an economic loss (e.g. the loss is wholly attributable to a tax incentive ). This is because the object of new Subdivision 170-C is to prevent a group company duplicating a loss transferred.

6.26 New subsection 170-210(3) requires any consideration received by the loss company for the transfer of the loss to be taken into account in determining the amount of any adjustment. Consideration paid for the transfer of a tax or net capital loss is called a subvention payment. A subvention payment cannot exceed the commercial value of the loss. This is because only the amount of the payment up to the commercial value of the loss can be said to be consideration received by the loss company for the loss transferred. The commercial value of a loss is, at most, equal to the tax benefit of the loss (i.e. the amount of the loss multiplied by the applicable company tax rate) which is the amount of tax saved by the income company because of the transfer.

6.27 Example 6.6 illustrates how a subvention payment is taken into account in determining reductions under new subsection 170-210(3).

Example 6.6

Holdco capitalises Incomeco and Lossco each with $100 post-CGT. Lossco subsequently makes a tax loss of $100. Lossco transfers the loss to Incomeco in return for a subvention payment of $36. The loss that Lossco makes reduces the value of the shares held by Holdco in Lossco by $100. Holdco subsequently sells the shares in Lossco for their market value of $36.

The cost base and reduced cost base of the shares in Lossco would be reduced under new subsection 170-210(1) by $64 (so that it would now be $36), being the amount of loss of $100 less the subvention payment of $36. Therefore, Holdco would make no gain or loss on the disposal of the shares in Lossco.

If no cost base or reduced cost base reduction were made, a capital loss of $64 would be made on the sale of Holdcos shares in Lossco. That loss would duplicate $64 of the $100 tax loss transferred and utilised within the group. A cost base and reduced cost base reduction of $64 is appropriate even though a subvention payment has been made equal to the tax benefit of the loss transferred.

6.28 Consideration paid for a tax loss is not taken into account in determining reductions under new subsection 170-210(3) if, because of a dividend or dividends paid by the loss company, the consideration is no longer reflected wholly or partly in the market value of the share or debt when a CGT event happens in relation to it.

6.29 Consideration paid for a loss will be taken to be reflected wholly or partly in the market value of the share or debt at the time of the CGT event if it can be demonstrated that a dividend has not subsequently been paid by the loss company or if there is an amount of undistributed accounting profit in the loss companys accounts equal to the amount of the consideration. In the second case, there is no requirement to demonstrate that the profit represents the actual consideration, as long as the amount of consideration is present. If only part of the amount of consideration is present in the accounts, then only that part will be able to be taken into account in determining the adjustment to the cost base and reduced cost base of the share or debt.

Example 6.7

Using the facts from Example 6.6, the reduction in the cost base and reduced cost base of the shares in Lossco calculated under new subsection 170-210(3) would be equal to $64 (and not $100) only if Lossco had not paid a dividend to Holdco after the loss transfer or if Lossco had at least $36 undistributed accounting profits (from any source) recorded in its accounts. If Lossco had only $10 undistributed profits, a reduction of $90 would be required.

6.30 Any reduction is to be made immediately before a CGT event happens in relation to the share or debt and is to have effect from that time or the end of the year of income in which the loss was transferred (i.e. the deduction year), whichever is the earlier [subsection 170-210(4)] . The reduction will generally have effect from the end of the deduction year. This will ensure that indexation will only be available on the cost base of the share as reduced under new subsection 170-210(1) or 170-210(2). However, the reduction is made immediately before the CGT event so that regard can be had to whether any consideration paid for the loss is still reflected (wholly or partly) in the market value of the share or debt at that time.

6.31 New subsection 170-210(4) will also ensure that where a company is dissolved during the year of transfer, any reduction is made at, and will have effect from immediately before, the time of the dissolution.

Direct interests in the income company

6.32 Increases to the cost base and reduced cost base of a direct interest (share or debt) in an income company, to which a tax loss is transferred, will be required where the following conditions are met:

•

an amount of a tax loss is transferred by a company to another company;

•

Subdivision 170-A applies to the transfer;

•

a company (the group company ) holds a share in the income company or is owed a debt by the income company in respect of a loan;

•

the group company acquired the share or debt post-CGT; and

•

throughout the deduction year, the group company is a member of the same wholly-owned group as the income company (disregarding a period when either was not in existence).

[Subsection 170-215(1)]

Indirect interests in the income company

6. 33 Increases to the cost base and reduced cost base of an indirect interest in an income company, to which a tax loss is transferred, will be required where the following conditions are met:

•

an amount of a tax loss is transferred by a company to another company;

•

Subdivision 170-A applies to the transfer;

•

a company (the group company ) holds a share in another company or is owed a debt by another company in respect of a loan;

•

the group company acquired the share or debt post-CGT;

•

the money that the group company paid for the share, or the borrowed money, has been applied (directly, or indirectly through one or more interposed entities):

-

in the other company or a third company acquiring shares in the income company; or

-

in a borrowing by the income company from the other company or from a third company; and

•

throughout the deduction year, the group company, the other company and the third company (if any) are all members of the same wholly-owned group as the income company (disregarding, for a particular company, a period when it was not in existence).

[Subsection 170-215(2)]

Amount of increase

6.34 The amount of the increase to the cost base and reduced cost base of a share or debt, for the purposes of new subsections 170-215(1) and 170-215(2), is determined under new subsection 170-215(3).

6.35 The increase will be an amount that is appropriate having regard to the following factors:

•

the group companys direct or indirect interest in the income company;

•

the amount of the loss transferred; and

•

any consideration given by the income company for the loss transferred.

[Subsection 170-215(3)]

6.36 However, the increase cannot exceed the increase in the market value of the share or debt that results from the transfer of the loss [subsection 170-215(4)] . For example, if the income company makes a subvention payment for the transfer of the loss and the amount of the payment is equal to the commercial value of the loss transferred, then there would be no increase to the cost base and reduced cost base of the share or debt. Conversely, if no subvention payment were made for the transfer of the loss, then the increase would be limited to the increase in the market value of the share or debt because of the transfer of the loss.

Example 6.8

Holdco capitalises Incomeco and Lossco each with $50 post-CGT. Holdco also makes a loan of $50 to Lossco. Lossco then trades profitable for several years. Lossco subsequently makes a tax loss of $100 which it transfers to Incomeco in return for a $36 subvention payment.

Assuming that the market value of the loan was unaffected by the loss, the loss reduced the value of the shares by $100 and the subvention payment increased the value of the shares by $36, the reduction in the cost base and reduced cost base of the shares in Lossco under new subsection 170-210(1) would be equal to a maximum of $50, reducing them to nil.

If on the other hand Lossco had not increased in value before the loss was transferred, the loss reduced the market value of the shares and loan by $50 each, and the subvention payment restored $36 value in the loan, the cost base and reduced cost base of the shares would be reduced by $50 and the reduced cost base of the loan by $14.

There would be no increase in the cost base and reduced cost base of the shares in Incomeco under new subsection 170-215(1) because the amount of consideration for the tax loss is equal to its commercial value ($36). Therefore, the market value of Incomecos shares is not increased by the loss transfer.

6.37 Any increase to the cost base and reduced cost base of a share or debt is to be made immediately before a CGT event happens in relation to the share or debt and is to have effect from that time or the end of the deduction year, whichever is the earlier [subsection 170-215(5)] . The increase will generally have effect from the end of the deduction year. This will ensure that indexation will be available on the cost base of the share or debt as increased under new subsection 170-215(1) or 170-215(2).

6.38 New subsection 170-215(5) will also ensure that where a company is dissolved during the year of transfer, any increase is made at, and will have effect from immediately before, the time of the dissolution.

6.39 No increase is to be made to the cost base and reduced cost base of a share or debt to the extent to which, because of a dividend or dividends paid by the income company, the increase in the market value of the share or debt that resulted from the transfer of the loss is no longer in existence at the time when a CGT event happens in relation to the share or debt. [Subsection 170-215(6)]

6.40 The operation of new subsection 170-215(6) means that any adjustments required under new subsections 170-215(1) and 170-215(2) can only be made at the time immediately before the CGT event (as required by new subsection 170-215(5)). This is so regard can be had to whether the increase in the market value that resulted from the transfer of the loss still exists (wholly or partly) at the time of the CGT event.

6.41 The increase in the market value that resulted from the transfer of the loss will be taken to be still in existence at the time of the CGT event if it can be demonstrated that a dividend has not been paid by the income company since the transfer or if there is an amount of undistributed profits in the income companys accounts at the time of the CGT event equal to the market value increase. If only part of the amount of market value increase is represented, then only that part will be able to be used to increase the cost base and reduced cost base of the share or debt.

Transfer of a net capital loss

6. 42 As mentioned at paragraph 6.10, the cost base and reduced cost base adjustment mechanism for the transfer of net capital losses is identical to the mechanism for the transfer of tax losses. Therefore, the previous discussion of the tax loss transfer provisions in paragraphs 6.19 to 6.41 is of equal relevance to the net capital loss transfer provisions outlined in paragraphs 6.43 to 6.54.

Direct interests in the loss company

6. 43 Where a net capital loss is transferred, reductions will be required to the cost base and reduced cost base of a direct equity interest, or the reduced cost base of a direct debt interest, in a loss company where the following conditions are met:

•

an amount of a net capital loss is transferred by a company to another company;

•

Subdivision 170-B applies to the transfer;

•

a company (the group company ) holds a share in the loss company or is owed a debt by the loss company in respect of a loan;

•

the group company acquired the share or debt post-CGT; and

•

throughout the year of income in which the loss was transferred (the application year), the group company is a member of the same wholly-owned group as the loss company (disregarding a period when either was not in existence).

[Subsection 170-220(1)]

Indirect interests in the loss company

6. 44 Where a net capital loss is transferred, reductions will be required to the cost base and reduced cost base of an indirect equity interest, or the reduced cost base of an indirect debt interest, in a loss company where the following conditions are met:

•

an amount of a net capital loss is transferred by a company to another company;

•

Subdivision 170-B applies to the transfer;

•

a company (the group company ) holds a share in another company or is owed a debt by another company in respect of a loan;

•

the group company acquired the share or debt post-CGT;

•

the money that the group company paid for the share, or the borrowed money, has been applied (directly, or indirectly through one or more interposed entities):

-

in the other company or a third company acquiring shares in the loss company; or

-

in a borrowing by the loss company from the other company or from a third company; and

•

throughout the application year, the group company, the other company and the third company (if any) are all members of the same wholly-owned group as the loss company (disregarding, for a particular company, a period when it was not in existence).

[Subsection 170-220(2)]

Amount of reduction

6.45 The amount of the reduction to the cost base and reduced cost base of a share, or the reduced cost base of a debt, for the purposes of new subsections 170-220(1) and 170-220(2) is determined under new subsection 170-220(3).

6.46 The reduction will be an amount that is appropriate having regard to the following factors:

•

the group companys direct or indirect interest in the loss company;

•

the amount of the loss transferred;

•

the extent to which the loss reduced the market value of the share or debt;

•

any consideration received by the loss company for the loss transferred; and

•

whether, because of a dividend or dividends paid by the loss company, the consideration is no longer reflected wholly or partly in the market value of the share or debt when a CGT event happens to it.

[Subsection 170-220(3)]

6.47 Any reduction is to be made immediately before a CGT event happens in relation to the share or debt and is to have effect from that time or the end of the application year, whichever is the earlier. [Subsection 170-220(4)]

Direct interests in the gain company

6. 48 Where a net capital loss is transferred, increases will be required to the cost base and reduced cost base of a direct interest (share or debt) in a gain company where the following conditions are met:

•

an amount of a net capital loss is transferred by a company to another company;

•

Subdivision 170-B applies to the transfer;

•

a company (the group company ) holds a share in the gain company or is owed a debt by the gain company in respect of a loan;

•

the group company acquired the share or debt post-CGT; and

•

throughout the application year, the group company is a member of the same wholly-owned group as the gain company (disregarding a period when either was not in existence).

[Subsection 170-225(1)]

Indirect interests in the gain company

6. 49 Where a net capital loss is transferred, increases will be required to the cost base and reduced cost base of an indirect interest in a gain company where the following conditions are met:

•

an amount of a net capital loss is transferred by a company to another company;

•

Subdivision 170-B applies to the transfer;

•

a company (the group company ) holds a share in another company or is owed a debt by another company in respect of a loan;

•

the group company acquired the share or debt post-CGT;

•

the money that the group company paid for the share, or the borrowed money, has been applied (directly, or indirectly through one or more interposed entities):

-

in the other company or a third company acquiring shares in the gain company; or

-

in a borrowing by the gain company from the other company or from a third company; and

•

throughout the application year, the group company, the other company and the third company (if any) are all members of the same wholly-owned group as the gain company (disregarding, for a particular company, a period when it was not in existence).

[Subsection 170-225(2)]

Amount of increase

6.50 The amount of the increase to the cost base and reduced cost base of a share or debt, for the purposes of new subsections 170-225(1) and 170-225(2) is determined under new subsection 170-225(3).

6.51 The increase will be an amount that is appropriate having regard to the following factors:

•

the group companys direct or indirect interest in the gain company;

•

the amount of the loss transferred; and

•

any consideration given by the gain company for the loss transferred.

[Subsection 170-225(3)]

6.52 However, the increase cannot exceed the increase in the market value of the share or debt that results from the transfer of the loss. [Subsection 170-225(4)]

6.53 Any increase is to be made immediately before a CGT event happens in relation to the share or debt and is to have effect from that time or the end of the application year, whichever is the earlier. [Subsection 170-225(5)]

6.54 No increase is to be made to the cost base and reduced cost base of a share or debt to the extent to which, because of a dividend or dividends paid by the gain company, the increase in the market value of the share or debt that resulted from the transfer of the loss is no longer in existence at the time when a CGT event happens in relation to the share or debt. [Subsection 170-225(6)]

Additional Examples

Example 6.9

Holdco capitalises Subco A with $100 post-CGT. Subco A then capitalises Subco B with $50. Subco B subsequently makes a net capital loss (tax loss) of $50. Subco B transfers the loss to Subco A in return for a subvention payment of $18. The loss that Subco B made reduces the value of the shares held by Subco A in Subco B by $50.

The cost base and reduced cost base of the shares held by Subco A in Subco B would be reduced by $32. This is calculated as the amount of the loss transferred ($50) less the amount of the subvention payment ($18). This would prevent the loss of $50 being duplicated on the sale of the shares in Subco B.

On the facts above, it would not be appropriate to make an adjustment to the cost base and reduced cost base of the shares held by Holdco in Subco A. This is because there would be no duplication of the $50 transferred loss if the shares in Subco A were sold. In addition, the commercial value of the loss transferred to Subco A is equal to the subvention payment made for the loss.

If prior to Holdco selling Subco A, the capital gain (assessable income) sheltered by the transferred loss is paid as a dividend to Holdco (net of the subvention payment), it would be appropriate to reduce the cost base and reduced cost base of the shares held by Holdco in Subco A by $32. This is to prevent a $32 capital loss being realised on the sale of the shares in Subco A, which would duplicate part of the $50 transferred loss.

Example 6.10

Holdco capitalises Subco A with $100 post-CGT. Subco A then capitalises Subco B with $50. Subco A subsequently makes a net capital loss (tax loss) of $50. Subco A transfers the loss to Subco B in return for a subvention payment of $18. Holdco immediately sells Subco A.

On the facts above, it would not be appropriate to make an adjustment to the cost base and reduced cost base of the shares held by Holdco in Subco A. This is because there would be no duplication of the $50 transferred loss if the shares in Subco A were sold.

There would be no adjustment to the cost base and reduced cost base of the shares held by Subco A in Subco B. This is because the commercial value of the loss transferred is equal to the subvention payment made for the loss.

Example 6.11

Holdco capitalises Subco A with $100 post-CGT. Subco A then capitalises Subco B with $100. Subco B subsequently makes a net capital loss (tax loss) of $50. Subco B transfers the loss to Holdco in return for a subvention payment of $18. The loss that Subco B made reduces the value of the shares held by Holdco in Subco A, and the shares held by Subco A in Subco B, by $50.

The cost base and reduced cost base of the shares held by Subco A in Subco B would be reduced by $32. This is calculated as the amount of the loss transferred ($50) less the amount of the subvention payment ($18). This reduction would prevent the loss of $50 being duplicated on the sale of the shares in Subco B. For the same reasons, the cost base and reduced cost base of the shares held by Holdco in Subco A would also be reduced by $32.

Example 6.12

Holdco capitalises Subco A with $100 post-CGT. Subco A then capitalises Subco B with $100. Holdco subsequently makes a net capital loss (tax loss) of $50. Holdco transfers the loss to Subco B in return for a subvention payment of $18.

There would be no increasing adjustment to the cost base and reduced cost base of the shares held by Subco A in Subco B. This is because there has been no change to the market value of the shares owned by Subco A, since the commercial value of the loss transferred is equal to the subvention payment made for the loss. For the same reasons, there would be no adjustment to the cost base and reduced cost base of the shares held by Holdco in Subco A.

Application and transitional provisions

6. 55 The provisions will apply where losses are transferred under written agreements made on or after 22February 1999. In addition, for tax loss transfers, the provisions will only apply to CGT events happening in relation to shares or debts on or after 22 February 1999.

Consequential amendments

Income Tax Assessment Act 1997

6.56 Item 1 of Schedule 5 to this Bill repeals section 112-95 of the ITAA 1997 and inserts new section 112-95. Division 112 of the ITAA1997 contains modifications to the cost base and reduced cost base of a CGT asset. Section 112-95 contains a section finding table for modifications where there has been a transfer of a net capital loss within a wholly-owned group of companies.

6.57 However, Schedule 5 to this Bill introduces new Subdivision 170-C, which also deals with the transfer of a tax loss within a wholly-owned group of companies. Therefore, new section 112-95 contains a section finding table for modifications where there has been a transfer of a tax loss or a net capital loss. The section finding table refers to the provisions of new Subdivision 170-C.

6.58 Items 2 to 11 of Schedule 5 make consequential amendments to Subdivisions 170-A and 170-B of the ITAA 1997.

6.59 Items 2 and 3 insert notes into section 170-25 of Subdivision 170-A. Section 170-25 deals with the tax treatment of consideration paid for the transfer of a tax loss. The inserted notes provide that consideration paid for the transfer of a tax loss may affect how new sections 170-210 and 170-215 modify the cost base of direct and indirect interests in the loss company and income company.

6.60 Items 4 and 8 repeal subsections 170-105(4), 170-145(2), 170-145(3) and 170-145(4) of Subdivision 170-B. These provisions currently place a cap on the amount of net capital loss that can be transferred under Subdivision 170-B. The cap is equal to the unindexed amount of the cost bases of post-CGT equity and debt held directly by other companies in the wholly-owned group in the loss company.

6.61 The purpose of the cap was to prevent the loss company transferring an amount of net capital loss greater than the group had actually suffered, measured by reference to the amount of direct group investment in the loss company. The commercial debt forgiveness provisions now require compensating adjustments in most cases where a loss company is relieved of its obligations in respect of external debts so the overall aim of the cap is effectively achieved in another way. For this reason, and in light of the clarifications contained in this Bill for the cost base and reduced cost base regime for transferred net capital losses, the provisions implementing the cap will be repealed.

6.62 Item 5 inserts new subsection 170-105(8) into Subdivision 170-B. This provision will ensure that, in applying the provisions of Subdivision 170-B to net capital losses transferred under written agreements made before 22 February 1999, the net capital loss transfer provisions in new Subdivision 170-C are to be disregarded.

6.63 Items 6 and 7 amend the notes contained in section 170-125 of Subdivision 170-B. Section 170-125 deals with the tax treatment of consideration paid for the transfer of a net capital loss. The notes in the section currently make reference to section 170-175. However, as this section is being repealed (refer to item 10), the reference in the notes will be amended to refer to new section 170-220 and new section 170-225.

6.64 Items 9 and 11 are minor amendments to reflect that sections 170-175 and 170-180 of Subdivision 170-B will be repealed and a new Subdivision 170-B introduced.

6.65 Item 10 repeals sections 170-175 and 170-180 of Subdivision 170-B. These provisions currently deal with cost base adjustments where a net capital loss is transferred within a wholly-owned company group. As the cost base adjustments are now dealt with in new Subdivision 170-C, these provisions will be repealed. However, cost base and reduced cost base adjustments required by these provisions in respect of net capital losses transferred before the commencement of new Subdivision 170-C must still be made.

6.66 Items 13 and 14 of Schedule 5 make consequential amendments to the IT(TP) Act 1997.

6.67 Item 13 of Schedule 5 repeals sections 170-175 and 170-180 of the IT(TP)Act 1997. This reflects the amendments made by item 10. Item 14 amends the IT (TP) Act 1997 by reintroducing the sections repealed in item 13 as new section 170-220 and 170-225. This reflects the introduction of new Subdivision 170-C.

Income Tax Assessment Act 1936

6.68 Item 15 of Schedule 5 inserts new subsection 160ZP(16) into the ITAA 1936. This provision has the same operation as the provision introduced by item 5 (discussed at paragraph 6.62) except that item 15 deals with the net capital loss transfer provisions contained in the ITAA1936.

Financial Corporations (Transfer of Assets and Liabilities) Act 1993

6.69 The object of the FCA 1993 is to facilitate the transfer of assets and liabilities from certain subsidiaries of a particular foreign corporation to that foreign corporation or other subsidiaries, in certain circumstances.

6.70 Items 16 to 19 of Schedule 5 introduce consequential amendments to the FCA 1993. These amendments generally reflect other amendments introduced by Schedule 5.

6.71 Item 16 ensures that the tax loss transfer provisions contained in the FCA 1993 are the same as those contained in the ITAA 1997. Items 17 and 18 replicate the amendments made by items 6 and 7 of Schedule 5 (discussed at paragraphs 6.63). Item 19 replicates the amendment made by item 8 of Schedule 5 (discussed at paragraph 6.60).

Chapter 7 - The continuity of ownership test

Outline of Chapter

7.1 Schedule 6 to this Bill amends the ITAA 1997 to remove defects in the existing continuity of ownership test applying to companies prior and current year tax losses and net capital losses and bad debts. The Schedule will also apply the amended continuity of ownership test to companies with unrealised net losses.

7.2 This Chapter discusses the operation of the continuity of ownership test in relation to both realised and unrealised losses. (Chapter 8 discusses the treatment of companies with unrealised net losses when the test is failed.)

7.3 The continuity of ownership test will now only be satisfied if:

•

there is no substantial change in proportionate shareholding within a group of continuing owners; and

•

majority ownership is maintained throughout a period from the time a loss was incurred to the time the loss is claimed.

Context of Reform

7.4 This Bill aims to reduce the scope for loss duplication by restricting the availability of a companys realised losses (i.e. tax losses, and net capital losses) and unrealised losses (i.e. losses on assets the company is yet to dispose of). Where there has been a substantial change in the companys ownership or control, the losses are allowed only if the same business test is satisfied. Broadly, the same business test is satisfied if the nature of a companys business carried on when the losses are claimed is unchanged compared to the business carried on immediately before the change.

7.5 Broadly, loss duplication arises because losses that a company realises on its assets are reflected in the value of equity interests in the company. The losses are also reflected in the value of any indirect interests in the company. Where a substantial proportion of the equity interest in the company has been disposed of, the losses subsequently allowed to be claimed by the company, are predominantly duplicates of losses already allowed on the sale of equity interests.

7.6 The current law requires continuity of majority ownership of a company before the company can recoup a tax loss or net capital loss, or claim a deduction for a bad debt. However, the law fails to register a change in majority ownership when this occurs through a change in proportionate shareholding within a group of continuing owners. For example, the test does not recognise a change in ownership of a company when, in a company that is 99% owned by person A and 1% owned by person B, A sells more than half of its shares to B.

7.7 Further, the test under the existing law is satisfied if the majority ownership in the year a loss was incurred is the same as in the year the loss is sought to be claimed. Thus, it does not require continuous ownership in the intervening period. This allows majority ownership to be reinstated after disposal of a majority of the shares (carrying a majority of the relevant power or rights) in the intervening period between the loss year and the claim year. This results in loss duplication, as the loss would have been reflected in the price the owners received on disposal of their shares.

7.8 The proposed changes are consistent with the Reviews recommendation 6.9(a).

Summary of new law

7.9 Schedule 6 amends the continuity of ownership test in ITAA 1997 applying to companies losses, whether realised or unrealised.

7.10 Broadly, the continuity of ownership test will be satisfied if:

•

there is no substantial change in proportionate shareholding within a group of continuing owners; and

•

majority ownership by individuals is maintained throughout the period from the time a loss is incurred to the time the loss is claimed.

7.11 The amendments apply the amended continuity of ownership test to a companys:

•

tax losses, net capital losses and bad debt deductions claimed in relation to an income year ending after 21 September 1999 [item 16] ; and

•

unrealised net losses, where the test is failed after 11.45 am AEST on 21 September 1999 [item 6, paragraph 165-115A(1)(a)] .

Detailed explanation of new law

7. 12 Schedule 6 amends ITAA 1997 to remove defects in the existing continuity of ownership test applying to companies prior and current year tax losses and net capital losses and bad debts. The Schedule will also apply the amended continuity of ownership test to companies with unrealised net losses.

What are the changes to the continuity of ownership test applying in relation to losses currently subject to the test?

7.13 A company may be prevented from deducting a tax loss, a net capital loss or a deduction for a bad debt unless it satisfies the continuity of ownership test and the same control in the company is maintained throughout the ownership test period [item 1, section 165-5; item 5, section 165-93; item 7, section 165-117] . Where a company has failed to maintain continuity of ownership or control, a loss or deduction will only be available if the same business test is satisfied.

7.14 The term ownership test period has been changed. The new term has different meanings depending on the nature of the losses a company seeks to claim. The alternative meanings are:

•

in relation to a tax loss or a net capital loss - the start of the loss year to the end of the income year (claim year) in which the loss is deducted against taxable income (including a net capital gain) [item 2, subsection 165-12(1)] ; and

•

in relation to a bad debt deduction from the day on which the debt was incurred to the end of the claim year [item 9, subsection 165-123(1)] .

7.15 A company will only satisfy the amended ownership test where during the whole of the ownership test period:

•

the same persons beneficially owned the same shares that when taken together carried more than 50% of the voting power in the company;

•

the same persons beneficially owned the same shares that when taken together carried the rights to more than 50% of the companys dividends; and

•

the same persons beneficially owned the same shares that when taken together carried the rights to more than 50% of any capital distributions made by the company.

[Item 2, subsections 165-12(2), (3) and (4); item 9, subsections 165-123(2), (3) and (4); item 11, subsection 165-165(1)]

Who has more than 50% of a power or right?

7.16 There are 2 tests for determining who has more than 50% of the voting power in a company the primary test and the alternative test. The relevant test in a particular case depends on the ownership structure of the company. Similarly, there are two tests for determining at a particular time, who owns shares that carry rights to more than 50% of the companys dividends or any capital distributions made by the company.

7.17 Effectively, the primary tests are applicable to a company that at the beginning of the ownership test period, was beneficially owned by persons other than companies [item 2, subsection 165-12(5); item 9, subsection 165-123(5)] .

7.18 The alternative tests, however, are applicable to a company that was at the beginning of the ownership test period, beneficially owned by individuals through interposed companies [item 2, subsections 165-12(5) and (6); item 9, subsections 165-123(5) and (6)] . This amendment reflects the amended definition of ownership test period. Under the existing law, the alternative test is to be used where a loss company is owned through an interposed company at any time during the loss year or the year in which the loss is claimed.

The primary tests

7.19 The primary tests in the existing law have been amended so that they operate to determine who owns more than 50% of a power or a right at a particular time. The existing tests make the determination in respect of the ownership test period. [Item 11, subsection 165-150(1), subsection 165-155(1) and subsection 165-160(1)]

7.20 The amendments enable the application of the primary tests in support of the continuity of ownership test for companies with unrealised losses (discussed at paragraphs 7.27 to 7.33). The amendments do not affect the overall operation of the continuity of ownership tests applying to tax losses and net capital losses (contained in section 165-12 of ITAA 1997) and bad debt deductions (contained in section 165-123 of ITAA 1997).

The alternative tests

7.21 The alternative tests in the existing law have been amended. Under an amended alternative test, the persons who have more than 50% of the voting power in a company are the individuals who beneficially own between them, directly or indirectly, shares in the company carrying more than 50% of the voting power in the company. [Item 11, subsection 165-150(2)]

7.22 Under the amended test, indirect equity interests in the company will be treated as carrying the relevant proportion of the voting power carried by the shares held directly or indirectly by the interposed entity in the company at all times during the ownership test period.

Example 7.1

Garry holds, shares in an interposed company carrying 30% of the voting power in the interposed company. The interposed company holds shares carrying 60% of the voting power in a loss company.

Garry is treated as having an indirect equity interest carrying 18% (i.e.30% * 60%) of the voting power in the loss company.

7.23 The other alternative tests apply similarly in working out the identity of the persons who held the shares that carried the rights to more than 50% of the companys dividends or capital distributions. [Item 11, subsection 165-155(2) and subsection 165-160(2)]

How will the changes affect the control test?

7. 24 The current control test will be amended as a consequence of the changes made to the continuity of ownership test. The amendment will require that the control of the voting power in a company be maintained by the same persons throughout the ownership test period in order for the company to be able to claim a loss or deduction. The current law does not require continuity during any intervening period, for example between a loss year and a claim year. A company failing to meet the continuity requirement will be subject to the same business test on its tax loss, net capital loss or bad debt deductions. [Item 4, paragraph 165-15(1)(a); item 10, paragraph 165-129(1)(a)]

How will the changes affect the same business test?

7.25 The provision containing the conditions for applying the same business test will be amended as a consequence of the changes made to the continuity of ownership test. The amendment will effectively redefine the continuity period as a period that starts at the beginning of the ownership test period, and ends when at least one of the conditions in section 165-12 ceases to be satisfied. [Item 3, subsection 165-13(2)]

7.26 Broadly, a company seeking to claim a loss after having failed the continuity of ownership test must carry on the same business in the claim year as it carried on immediately before the end of the continuity period, as redefined.

How will the continuity of ownership test apply in relation to a companys unrealised losses?

7.27 A company that has failed the continuity of ownership test or has experienced a change in its control may, in some circumstances, be prevented from claiming a loss on an asset owned at the time of failure or change [item 6, subsection 165-115A(1)] . An example would be where, at the time of change, there was an overall unrealised loss (having regard to all of the assets of the company) that exceeded the loss on the particular asset. In these circumstances, a loss or deduction on such an asset will only be available if the same business test is satisfied. (Chapter 8 of this Explanatory Memorandum contains a detailed discussion of the treatment of a companys assets in certain circumstances where the company has failed the continuity of ownership test or experienced a change of control.)

7.28 This Bill extends the application of the amended continuity of ownership test to companies with unrealised net losses. This Chapter discusses how the continuity of ownership test will apply to companies in these circumstances.

Changeover time

7.29 A changeover time occurs when the company either fails the continuity of ownership test or experiences a change in the control of the companys voting power [item 6, subsection 165-115C(1) and section 165-115D] . A changeover time occurs whether or not the company has an unrealised net loss at the time.

7.30 For a company to be allowed to carry forward its unrealised losses, the ownership of and control in a company must be maintained throughout the period from one changeover time to another. Where a company has not experienced a changeover time, then ownership and control must be maintained from the commencement of these measures on 21September1999. The reference time is the time at which the ownership profile is tested for comparison purposes to determine whether or not there is a subsequent changeover time. [Item 6, subsections 165-115C(1) and (4)]

Continuity of ownership

7.31 A company fails the continuity of ownership test at a particular time when:

•

the persons who beneficially owned shares at the reference time that when taken together carried more than 50% of the voting power in the company, stopped beneficially owning those shares; or

•

the persons who beneficially owned shares at the reference time that when taken together carried the rights to more than 50% of the companys dividends, stopped beneficially owning those shares; or

•

the persons who beneficially owned shares at the reference time that when taken together carried the rights to more than 50% of any capital distributions made by the company, stopped beneficially owning those shares.

[Item 6, subsections 165-115C(1); item 11, subsection 165-165(1)]

7.32 The rules supporting the continuity of ownership test apply for unrealised losses in the same way that they do to realised losses. For instance, there are 2 tests for determining at a particular time, who has more than 50% of a companys voting power, or rights to dividends or capital distributions the primary test and the alternative test. The relevant test, as for realised losses, depends on the ownership structure of a company. [Item 6, subsections 165-115C(2) and (3)]

7.33 The primary tests and the alternative tests are the same tests as those applying to a companys realised losses.

General rules affecting the operation of the tests

7.34 The current law contains general rules that affect the operation of a test. These rules apply not only to tax losses, net capital losses and bad debt deductions (dealt with by current rules) but also to unrealised losses (dealt with under new Subdivision 165-CC). Various provisions have been amended to reflect the changes made to the continuity of ownership test. The changes are discussed at paragraphs 7.35 to 7.44

Exactly the same shares at all times

7. 35 When applying a test, a persons share in a company may be counted only if the person owns the same share throughout the relevant period [item 11, subsection 165-165(1)] . As reflected in the current law, a public company is taken to have satisfied the test if it is reasonable to assume that the test is satisfied [item 11, subsection 165-165(1)] .

Share splits and share consolidations

7.36 Notwithstanding the rule, a persons share (original share) may continue to be counted if the share is split into several shares and the person continues to beneficially own all of the split shares. For the purposes of establishing whether the required voting power or dividend or capital rights have been maintained, the power or rights that attached to the original share and that continue to be carried by the split shares will be counted. [Item 11, paragraph 165-165(2)(a)]

7.37 Where a persons original share in a company is consolidated with other shares in the company that the person beneficially owns, the person will be treated as continuing to own the original share as long as the person continues to beneficially own the consolidated share. Effectively, to qualify as a consolidated share for these rules, the powers and rights carried by the consolidated share must be the sum of all the powers and rights carried by the individual shares that have been consolidated. [Item 11, paragraph 165-165(2)(b)]

Arrangements affecting the beneficial ownership of shares in a company

7.38 Notwithstanding a persons legal or beneficial ownership of shares in a company, the Commissioner may, in certain conditions outlined in the current law, ignore a persons beneficial ownership of the shares at a particular time. The reference in the current law to the ownership test period has been removed to enable this provision to also apply to companies with unrealised net losses. [Item 12, subsection 165-180(1)]

7.39 For the Commissioner to be able to apply the provision, a condition in the current law is that there must be an arrangement entered into before or during a year in which a loss is claimed. The provision reflects the test in the law where a company was only required to maintain continuity of majority ownership throughout the loss year and the claim year but not during any intervening period.

7.40 The provision may now be invoked where an arrangement (with the necessary features) is entered into at any time. The amendment reflects the new requirement under the continuity of ownership test to maintain majority interest throughout the test period. [Item 13, subsection 165-180(2)]

Changes to rights attaching to shares

7.41 The existing section 165-185 and section 165-190 of ITAA 1997 are concerned with ensuring that the continuity of ownership test is failed where there has effectively been a substantial change in the rights attaching to shares that occurred as a result of an arrangement made during the claim year.

7.42 To reflect the change to the continuity of ownership test requiring a continuous period of majority ownership, the test will now be failed where there has effectively been a substantial change in the rights occurring because of an arrangement made at any time during the ownership test period. [Item 14, subsection 165-185(1) and subsection 165-190(1)]

7.43 In addition, new provisions will ensure that the continuity of ownership test is failed in relation to a companys unrealised losses where there has effectively been a substantial change in the rights attaching to shares. The provision may be invoked where a change in the rights occurred as a result of an arrangement entered into at any time. [Item 14, subsection 165-185(2) and subsection 165-190(2)]

Redeemable shares

7. 44 Section 165-195 of ITAA 1997 disregards certain redeemable shares in applying the continuity of ownership test. The provision has been amended so that it operates to disregard the relevant redeemable shares beneficially owned by a person at a particular time. The existing provision which effectively refers to shares beneficially owned during the claim year is inconsistent with the application of these general rules to companies with unrealised losses. The amendment does not affect the overall operation of the continuity of ownership test applying to tax losses, net capital losses and bad debts. [Item 15, subsection 165-195(1)]

Application provisions

7. 45 The measures will apply differently to the following two groups of losses:

•

tax losses, net capital losses and bad debt deductions; and

•

unrealised net losses.

7. 46 While the measures are new in the context of unrealised losses, they amend current tests in relation to tax losses, net capital losses and bad debt deductions.

Tax losses, net capital losses and bad debt deductions

7.47 The measures will apply to tax losses, net capital losses and bad debt deductions claimed in relation to an income year ending after the measures were announced on 21 September 1999 [item 16] .

7.48 A company could effectively be denied either a tax loss or a net capital loss of an income year before the announcement if the company experienced a substantial change in its ownership or control during the period between the loss year and the claim year. This could occur even if the change in ownership or control happened before the announcement.

7.49 The measures will not apply to a loss or a deduction claimed in an income year that ended on or before 21 September 1999.

Unrealised losses

7.50 The measures will apply to a companys unrealised net losses where there is a substantial change in the companys ownership or control after the announcement of the measure at 11.45 am AEST on 21September1999 [item 6, paragraph 165-115A(1)(a) and paragraph 165-115A(2)(a)] .

7.51 An existing company will be affected by these measures for the first time only if its ownership or control substantially changes by reference to its ownership or control profile at 11.45 am AEST on 21September1999. After that time, the measures will apply where there are substantial changes by reference to the last change time.

7.52 The measures will apply to a newly incorporated company where the ownership or control in the company substantially changes by reference to the ownership and control profile on incorporation [item 6, paragraph 165-115A(1)(a) and paragraph 165-115A(2)(b)] .

Chapter 8 - Applying the same business test to unrealised losses

Outline of Chapter

8.1 Schedule 6 to this Bill inserts Subdivision 165-CC into the ITAA 1997. The Subdivision will limit the extent of unrealised loss duplication by applying the same business test to company losses where there has been a substantial change in the companys ownership or control. By adopting this approach, Subdivision 165-CC will align the taxation treatment of unrealised losses with that of realised losses. [Item 6, Schedule 6]

8.2 This Chapter discusses the treatment of companies with unrealised net losses where there has been a substantial change in the companies ownership or control (Chapter 7 of the Explanatory Memorandum discusses the rules for determining whether there has been a substantial change in a companys ownership or control).

8.3 A company will be required to determine the extent of its unrealised net loss as at the time of a change in its ownership or control. The same business test will then be applied, to the extent of the companys unrealised net loss, to any losses subsequently arising in respect of the disposal of the assets owned by the company at the time of the change in ownership or control. [Subdivision 165-CC]

Context of Reform

8.4 Schedule 6 to this Bill addresses the deficiency in the current law regarding unrealised losses by aligning their treatment with that of realised losses. [Subdivision 165-CC]

8.5 Loss duplication arises where a single economic loss is recognised by the taxation system more than once. This can occur because losses realised in a company are reflected in the value of interests in that company.

8.6 Where a company has undergone a change in ownership or control, the current law reduces the scope for duplicating a tax loss or net capital loss carried forward by the company at the time of the change. This is achieved by denying the losses wherever the company has not carried on the same business throughout the income year in which a deduction for the loss is claimed, as it carried on immediately before the change.

8.7 The current law, however, has no application where a company has unrealised deductions or unrealised capital losses at the time of a change in its ownership or control. This deficiency in the law allows a company to duplicate a loss by deferring the realisation of the loss until after a change in ownership. In these circumstances, the company will then be able to claim the loss without having to satisfy the same business test.

Example 8.1

Georgina and Lee capitalise Investco with $100. Georgina owns 60% of the shares in Investco and Lee owns the remaining 40% of the shares. Investco acquires an asset for $100 but the investment is poor and the value of the asset falls to nil. Georgina and Lee sell all of their shares in Investco to Clare while Investcocontinues to hold the asset with an unrealised loss of $100. Georgina and Lee would incur capital losses of $60 and $40, respectively, on the sale of their shares. Investco could subsequently sell the asset and realise a duplicate loss of $100.

8.8 Subdivision 165-CC is designed to remedy the deficiency in the current law and is consistent with the policy approach proposed in recommendation 6.10 of A Tax System Redesigned.

Summary of new law

8.9 The new law will address the deficiency in the current law regarding unrealised losses by disallowing a certain amount of deductions and capital losses arising in relation to the disposal of assets held by a company at the time of a change in its ownership, unless the company satisfies the same business test.

8.10 The new law will apply to a company only where the company:

•

undergoes a substantial change of ownership or control after 11:45 am AEST on 21 September 1999; and

•

has an unrealised net loss in respect of the assets that it owned at the time of the change.

8.11 The new law provides tests for establishing whether or not a company with unrealised losses has undergone a substantial change in ownership or control. Chapter 7 of the Explanatory Memorandum contains a discussion of this aspect of the Bill.

8.12 Once a substantial change of ownership or control has been established, the new law will require the company to work out the amount of its unrealised net loss. Broadly, a companys unrealised net loss is the amount of the loss that the company would make if it were to sell all of its assets at market value on the day of the change.

8.13 The new law provides that, up to the amount of the companys unrealised net loss, deductions and capital losses subsequently arising on the disposal of assets held at the time of a change in its ownership or control may be claimed only where the company satisfies the same business test.

Detailed explanation of new law

8.14 Subdivision 165-CC prescribes the conditions under which tax losses and capital losses arising in relation to CGT events that occur in respect of CGT assets held by a company at the time of a change in its ownership will be disallowed. [Section 165-115]

8.15 The object of the new law is to reduce the scope for the duplication of any unrealised losses owned by a company at the time of a change in its ownership or control. Duplication is reduced by applying the same business test to the companys pool of unrealised losses held at the time of the change. Generally those losses are duplicates of losses previously claimed at the equity level by the former owners of the company.

8.16 Losses arising in respect of CGT events that occur in relation to CGT assets held at the time of a change in a companys ownership or control will be allowed only where the company satisfies the same business test. The test will be applied only to the extent that the amount of losses subsequently realised does not exceed the amount of the unrealised net loss calculated by the company as at the time of the change in ownership or control.

Criteria for applying the provisions

8. 17 Subdivision 165-CC will apply to a company in circumstances where the company undergoes a change in ownership or control after the commencement time and has an unrealised net loss in respect of the assets owned by the company at the time of the change. [Paragraphs 165-115A(1)(a) and (b)]

Definitions

8. 18 The commencement time for a company is taken to be the later of:

•

11:45 am AEST on 21 September 1999; and

•

the time that the company came into existence.

[Paragraph 165-115A(2)]

8. 19 The time at which a company undergoes a change in ownership or control is referred to as the changeover time . [Subsections 165-115C(1) and 165-115D(1)]

Assets held at more than one changeover time

8. 20 Where a company owns an asset over a period including more than one changeover time, Subdivision 165-CC will apply in respect of that asset only in relation to the latest changeover time [subsection 165-115A(3)] . Consequently, a relevant capital loss or deduction subsequently arising in relation to a CGT asset, to the extent that it does not exceed the unrealised net loss calculated as at the most recent changeover time, will be claimable by the company subject to satisfying the same business test.

Changes in ownership and control

8.21 In order to determine whether or not to apply Subdivision 165-CC, a company must ascertain whether or not it has undergone a change in ownership or control.

8.22 There are tests for determining whether or not a company has undergone a change in ownership or control [sections 165-115C and 165-115D] . For discussion of the operation of those provisions, refer to Chapter7 of this Explanatory Memorandum.

What happens if a company makes a capital loss or is entitled to a deduction in respect of a CGT asset held at a changeover time?

Capital losses and deductions subject to these provisions

8.23 A capital loss realised as a result of a CGT event that occurs in respect of a CGT asset owned by a company at a changeover time will be subject to Subdivision 165-CC . [Paragraph 165-115A(1)(c)]

8.24 Deductions such as balancing adjustments on depreciable assets owned by a company at a changeover time will also be subject to Subdivision 165-CC. [Paragraph 165-115A(1)(c)]

Same business test to be applied

8.25 Subsequent to a change in its ownership, a company may realise a capital loss or, but for Subdivision 165-CC, become entitled to a deduction as a result of a CGT event that occurs in relation to an asset owned by the company at changeover time. Subject to an upper limit, such a realised capital loss or entitlement to a deduction will be disallowed unless the company satisfies the same business test. [Subsection 165-115B(4)]

8.26 The upper limit referred to in paragraph 8.25 is the amount of the companys residual unrealised net loss. The extent to which the same business test applies to a realised capital loss or an entitlement to a deduction (but for Subdivision 165-CC) resulting from a CGT event occurring in respect of a CGT asset owned at changeover time, will depend on whether or not the amount of the capital loss or deduction exceeds the amount of the companys residual unrealised net loss.

Where a capital loss or deduction does not exceed the residual unrealised net loss

8.27 In the event that a realised capital loss does not exceed the residual unrealised net loss, the entire amount of the capital loss will be taken to have been a net capital loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(1)(a)] . Additionally, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]

8.28 Consequently, by virtue of existing sections 165-10 and 165-13 of the ITAA 1997 (as it applies because of existing section 165-96), the company will not be able to apply the net capital loss unless it satisfies the requirements of the same business test. In effect, the company will be required to carry on the same business in the claim year as it carried on immediately before the changeover time. [Subsection 165-115B(4)]

8.29 In the same way, if the company becomes entitled to a deduction (but for Subdivision 165-CC) which does not exceed the residual unrealised net loss, the deduction is taken to have been a tax loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(1)(b)] . As in the case of a realised capital loss discussed in paragraph 8.27, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]

8.30 As a consequence the operation of existing sections 165-10 and 165-13 of the ITAA 1997, the company will not be able to deduct the tax loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]

Where a capital loss or deduction exceeds the residual unrealised net loss

8.31 In the event that a realised capital loss exceeds the residual unrealised net loss, the capital loss (to the extent that it does not exceed the residual unrealised net loss) will be taken to have been a net capital loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(2)(a)] . Additionally, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]

8.32 Consequently, by virtue of existing sections 165-10 and 165-13 of the ITAA 1997 (as it applies because of section 165-96), the company will not be able to apply the net capital loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]

8.33 Similarly, if the company becomes entitled to a deduction (but for Subdivision 165-CC) which exceeds the residual unrealised net loss, the deduction (to the extent that it does not exceed the residual unrealised net loss) is taken to have been a tax loss of the company for the income year immediately preceding the income year in which the changeover time occurred [paragraph 165-115B(2)(b)] . As in the case of a realised capital loss discussed in paragraph 8.31, the company will be taken to have failed to satisfy the continuity of ownership requirements of subsections 165-12(2), (3) and (4) at the changeover time. [Subsection 165-115B(3)]

8.34 As a consequence of the operation of existing sections 165-10 and 165-13 of the ITAA 1997, the company will not be able to deduct the tax loss unless it satisfies the requirements of the same business test. [Subsection 165-115B(4)]

8.35 Any amount of a capital loss or deduction in excess of the companys residual unrealised net loss will be claimable by the company without the requirement to satisfy the same business test. Such an excess can be thought of as an additional loss suffered by the company after the changeover time. In relation to bad debts, however, any amount of a bad debt deduction in excess of the companys residual unrealised net loss will be subject to the existing rules for deducting bad debts . [Item 8, section 165-119]

Capital losses and deductions to be quarantined

8.36 Any capital loss treated by Subdivision 165-CC as a net capital loss for the income year immediately preceding the income year in which the changeover time occurred, cannot be applied against capital gains made before the time of the occurrence of the CGT event that resulted in the capital loss. [Subsection 165-115B(5)]

8.37 Similarly, a deduction treated by Subdivision 165-CC as a tax loss for the income year immediately preceding the income year in which the changeover time occurred, cannot be deducted from assessable income derived before the time of the occurrence of the CGT event that resulted in the deduction. [Subsection 165-115B(6)]

Calculation of residual unrealised net loss

8.38 As previously discussed, a company that undergoes a change in ownership or control will be required to calculate its residual unrealised net loss in order to determine the extent to which the same business test will be applied.

8.39 A companys residual unrealised net loss at the time of a CGT event that results in the company making a capital loss, or resulted in the company becoming entitled to a deduction, in respect of a CGT asset owned by the company at a changeover time, is equal to the amount of the companys unrealised net loss calculated as at the most recent changeover time, less any previous capital losses or deductions. [Subsection 165-115B(8)]

8.40 An explanation of the meaning of Previous capital losses or deductions is provided in subsection 165-115B(8). Where a company subsequently accrues capital losses or entitlements to deductions (but for Subdivision 165-CC) in respect of CGT assets held by the company at the changeover time, the amount of the residual unrealised net loss is successively reduced by the amount of each capital loss or deduction. Once the amount of the residual unrealised net loss is reduced to zero, any subsequent capital losses and deductions resulting from subsequent CGT events will be claimable by the company without having to satisfy the same business test. [Subsection 165-115B(8)]

8.41 Capital losses and deductions arising in relation to CGT events that occur in respect of CGT assets owned by a company at a changeover time will be subjected to the same business test generally in the order in which the CGT events occurred. [Subsection 165-115B(7)]

Calculation of unrealised net loss

8.42 In order to work out its residual unrealised net loss, a company must first calculate its unrealised net loss as at the changeover time. A companys unrealised net loss in respect of assets owned at changeover time is equal to the excess of its unrealised gross loss over its unrealised gross gain, where:

•

the companys unrealised gross loss is the sum of its unrealised capital loss and its unrealised revenue loss; and

•

the companys unrealised gross gain is the sum of its unrealised capital gain and its unrealised revenue gain.

[Section 165-115E]

8.43 The companys unrealised capital loss is the sum of all of its notional capital losses in respect of assets owned at changeover time. [Section 165-115E]

8.44 The companys unrealised capital gain is the sum of all of its notional capital gains in respect of assets owned at changeover time. [Section 165-115E]

8.45 The companys unrealised revenue loss is the sum of all of its notional revenue losses in respect of assets owned at changeover time. [Section 165-115E]

8.46 The companys unrealised revenue gain is the sum of all of its notional revenue gains in respect of assets owned at changeover time. [Section 165-115E]

Treatment of multiple changeover times

8.47 A company must calculate its unrealised net loss each time that it experiences a changeover time. The unrealised net loss at a particular changeover time is relevant only in respect of assets owned by the company at that time. Where one of those assets is subsequently sold, only the unrealised net loss calculated as at the most recent changeover time is relevant to that particular asset sale. [Paragraph 165-115A(1)(b)]

Calculation of notional losses and gains

8.48 For the purposes of calculating its notional gains and losses, a company is taken, at a changeover time, to have notionally disposed of all of the assets that it owned at that changeover time at market value. [Subsection 165-115F(2)]

8.49 In respect of the notional disposal of each asset held at a changeover time:

•

if the company would make a capital gain in respect of the disposal of an asset then the company will be considered to have a notional capital gain equal to the amount of the capital gain;

•

if the company would make a capital loss in respect of the disposal of an asset then the company will be considered to have a notional capital loss equal to the amount of the capital loss;

•

if the company would include an amount (other than a capital gain) in its assessable income in respect of the disposal of an asset then the company will be considered to have a notional revenue gain equal to the amount included; or

•

if the company would be entitled to a deduction in respect of the disposal of an asset then the company will be considered to have a notional revenue loss equal to the amount of the deduction.

[Subsection 165-115F(3)]

Example 8.2

Margaret, an Australian resident individual, owns 100% of the shares in Assetco, a private company. On the 30 June 2000, Margaret sells her entire interest in Assetco to another company, Holdco. Margaret holds no equity interests in Holdco.

Details of the assets owned by Assetco at the changeover time are provided in the following table:

In accordance with Subdivision 165-CC, Assetco must work out any notional gains or losses on assets held at the changeover time, in the manner specified by section 165-115F, so as to calculate its unrealised net loss (if any).

The notional gains and losses on the assets held by Assetco at the changeover time are provided in the following table:

In accordance with section 165-115E, Assetco must calculate its unrealised net loss in the following manner:

Thus, at the changeover time, Assetco has an unrealised net loss of $1.4 million.

Treatment of trading stock

8.50 A company may have a notional revenue loss or a notional revenue gain in respect of an item of trading stock.

8.51 A company will have a notional revenue loss in respect of an item of trading stock on hand at a changeover time equal to any excess of the tax value of the item determined by the company, over its market value. [Paragraph 165-115F(4)(a)]

8.52 Similarly, a company will have a notional revenue gain in respect of an item of trading stock on hand at a changeover time equal to any excess of the market value of the item over its tax value determined by the company. [Paragraph 165-115F(4)(b)]

8.53 The tax value of an item of trading stock determined by the company is the items latest valuation under Division 70. If there is no valuation under that Division for an item of trading stock, then the tax value is its cost at changeover time. [Subsection 165-115F(4)]

Example 8.3

Assemblyco, a small Australian resident manufacturing company experiences a substantial change in ownership on 1 July 2000. At the changeover time, Assemblyco owns several items of trading stock with the following valuations:

For each item of stock listed in the table above, the notional revenue loss or gain is determined by comparing the items market value as at the changeover time with the tax value determined by Assemblyco in the manner discussed in paragraph 8.53.

Where there are many units of a particular item of stock, the notional revenue gain or loss for that particular type of item is simply the sum of the individual notional revenue gains or losses for each item.

Example 8.4

Industrialco, a June-balancing Australian resident company, undergoes a substantial change of ownership on 1 December 2000. At the changeover time, Industrialco owns the following three assets:

•

shares in an Australian listed public company;

•

a commercial property; and

•

an item of depreciable plant

As at the changeover time, Industrialco calculates the following values:

As highlighted by the table above, Industrialco has an unrealised net loss of $130,000 at the changeover time.

Suppose that Industrialco disposes of the commercial property on 1March 2001 and realises a capital loss of $115,000. At that time, the residual unrealised net loss equals the unrealised net loss of $130,000.

Given that the residual unrealised net loss exceeds the amount of the capital loss realised by Industrialcoon disposal of the commercial property, the entire amount of the realised capital loss, as discussed in paragraph 8.27, will be taken to be a net capital loss for the 1999-2000 income year, and Industrialcowill be taken to have failed to satisfy the requirements of the continuity of ownership test. [Section 165-12]

Consequently, as discussed in paragraph 8.28, Industrialco will not be able to apply the net capital loss unless it satisfies the requirements of the same business test.

Suppose also that Industrialco disposes of the item of depreciable plant on 1 September 2001 and realises a balancing deduction of $40,000. At the time of the disposal, the residual unrealised net loss is $15,000 the result of subtracting the previous capital loss of $115,000 from the unrealised net loss calculated at the changeover time of $130,000.

As discussed in paragraphs 8.33 to 8.35, the consequences for the deduction under Subdivision 165-CC are:

•

the amount of the deduction up to the amount of the residual unrealised net loss ($15,000) will be taken to be a tax loss for the 1999-2000 income year;

•

Industrialco will be taken to have failed to satisfy the requirements of the continuity of ownership test in regard to the loss;

•

the tax loss will only be deductible if Industrialco satisfies the requirements of the same business test; and

•

the excess of the deduction over the residual unrealised net loss will be deductible by Industrialco without having to satisfy the requirements of the same business test.

In the event that Industrialco makes a capital loss on the disposal of the shares owned at the changeover time, the entire amount of that capital loss will be allowed to be applied without having to satisfy the same business test, because the residual unrealised net loss will have already been reduced to zero.

Application and transitional provisions

8.54 Subdivision 165-CC will apply to any company that:

•

undergoes a changeover time after 11:45 am AEST on 21September 1999; and

•

has an unrealised net loss in respect of the assets owned at the time of the change.

[Paragraphs 165-115A(1)(a) and (b)]

8. 55 Following the application of Subdivision 165-CC to a company for the first time, the measures will subsequently apply on each occasion where there are substantial changes in the ownership profile of the company compared to its profile as at its last changeover time.

Chapter 9 - Deducting prepayments

Outline of Chapter

9.1 This Chapter explains changes to the income tax treatment of prepayments. The 13 month rule, which allows immediate deductions of prepayments for things to be done within 13 months, will be removed and the deduction spread over the period the prepayment covers.

9.2 These changes only apply to taxpayers in business and only if they are not small business taxpayers. They generally cover prepayments incurred after 11.45 am AEST on 21 September 1999. They are in Schedule 7 of the Bill and alter Subdivision H of Division 3 of Part III of the ITAA 1936.

Context of Reform

What is the current treatment of prepayments?

9.3 Existing section 82KZM of the ITAA 1936 provides special treatment for some prepayments that are allowable deductions under the general deductions provision.

9.4 The prepayment is an allowable deduction in the income year in which it is incurred if it is for something that is to be done wholly within 13 months.

9.5 However, if the prepayment is for more than 13 months, the allowable deduction is spread over the whole period over which the thing is to be done (to a maximum of 10 years).

Why is the prepayments rule being changed?

9.6 The current treatment is inconsistent with accounting practice, which brings prepayments to account as assets at years end. It also creates an inconsistent treatment between people making, and those receiving, the prepayments because the recipients usually only bring to account as income the part of a prepayment attributable to that year.

9.7 The Review considered the tax deferral advantages given by the 13 month rule to be unwarranted for medium and large businesses. Therefore, it recommended that the rule be altered.

Summary of new law

9.8 The new law will remove immediate deductibility for prepayments for the supply of assets or services incurred in carrying on a business, except by small business taxpayers. Instead, the law will spread the deduction over the period for which the assets or services are to be provided. This is the same as the current treatment of prepayments for periods of over 13 months.

9.9 The new law applies to prepayments incurred after 11.45 am AEST on 21 September 1999, except for those incurred pursuant to some contractual obligations existing at that time.

9.10 Because some taxpayers will have made plans based on the 13month rule, there will be transitional arrangements to ensure that they are not unduly disadvantaged by the new treatment. The transitional measure will phase in the initial impact of this measure over a period of 5years.

Comparison of key features of new law and current law

Detailed explanation of new law

9.11 Business prepayments, other than those by small business taxpayers, for things to be done within 13 months will no longer be immediately deductible. Instead, the deduction will be spread over the period for which the assets or services are to be provided. This is consistent with the current treatment of prepayments for periods over 13months.

9.12 The change applies to prepayments incurred on or after 11.45 am AEST on 21 September 1999, unless they were made pursuant to certain existing contractual obligations.

The existing treatment is preserved for some expenditure

9.13 Section 82KZM of the ITAA 1936 is being modified to limit its application. The modifications will preserve the existing treatment in these situations:

•

business expenditure by small business taxpayers;

•

non-business expenditure;

•

prepayments pursuant to an existing prepayment obligation.

[Items 3 and 4, Schedule 7, paragraph 82KZM(1)(aa)]

What is a small business taxpayer?

9. 14 In broad terms, a small business taxpayer is someone who has an average annual group turnover of less than $1 million from business supplies. The small business taxpayer test is set out in item 22 of Schedule 2 to the New Business Tax System (Capital Allowances) Bill 1999 (refer to Chapter 3 of the Explanatory Memorandum to that Bill). The Bill inserts, into the prepayments rules, a definition of small business taxpayer which refers to that test. [Item 2, Schedule 7, definition of small business taxpayer inserted into subsection 82KZL(1)]

What existing prepayment obligations are covered?

9. 15 The exception for existing prepayment obligations (called pre-RBT obligations ) is designed to avoid penalising taxpayers who have already committed themselves to making a prepayment. There are certain conditions that need to be met for an obligation to be a pre-RBT obligation:

•

the taxpayer must be bound by a contract made before 11.45am AEST on 21 September 1999;

•

the contract must require the payment in advance of the supply of services or assets; and

•

the prepayment must not be avoidable at the discretion of the taxpayer.

[Item 1, Schedule 7, definition of pre-RBT obligation inserted into subsection 82KZL(1)]

The new treatment for business expenditure

How are the new provisions structured?

9. 16 The new rules for prepaid business expenditure (other than that incurred by small business taxpayers) are organised into 4 sections. In broad terms, new section 82KZMA sets out when the new treatment will apply while new section 82KZMD explains how the deduction for prepaid expenditure is to be spread over the period to which the prepayment relates. New sections 82KZMB and 82KZMC set out the rules for prepayments, incurred in the transitional period, for things to be done wholly within 13 months.^[F1] [Item 5, Schedule 7, sections 82KZMA, 82KZMB, 82KZMC and 82KZMD]

When does the new treatment apply?

9. 17 The new treatment applies to expenditure meeting the following requirements, except where that expenditure is incurred by a small business taxpayer. The expenditure must be:

•

deductible under the general deductions provision (section 8-1 of the ITAA 1997);

•

incurred in carrying on a business; and

•

incurred under an agreement in return for the doing of a thing that is not to be done wholly within the income year in which the expenditure was incurred.

[Subsections 82KZMA(1), (2) and (3)]

9. 18 However, some prepayments are excluded from the new treatment, as they are under the existing section 82KZM. These prepayments will continue to be immediately deductible regardless of the period they are for:

•

prepayments that are less than $1,000; and

•

prepayments that are required to be paid by law or court order.

[Subsection 82KZMA(4)]

9. 19 Expenditure incurred under a pre-RBT obligation is not covered by the new treatment [subsection 82KZMA(5)] . Such expenditure continues to get the existing treatment (refer to paragraphs 9.13 and 9.15).

How is the deduction for prepayments spread over the service period?

9. 20 The fraction of the amount subject to the new treatment that taxpayers can deduct in an income year is worked out by dividing the number of days the prepayment covers in the income year by the total number of days it covers [subsections 82KZMB(3), 82KZMC(5) and 82KZMD(2)] . The formula illustrates this:

current year deduction = expenditure * (number of days the prepayment covers in the current income year / total number of days the prepayment covers)


(The period the prepayment covers is called the eligible service period in the legislation.)

Example 9.1

Garden Goods Ltd, who is not a small business taxpayer, signs a contract on 17 June 2006 for supply of garden gnomes for twelve months from 1 January 2007 to 31 December 2007. It pays $365,000 for the gnomes on the date it signs the contract.

•

In the income year 1 July 2005 to 30 June 2006, Garden Goods Ltd cannot claim any deduction for the garden gnomes.

•

In the income year 1 July 2006 to 30 June 2007, Garden Goods Ltd has used 181 days of the 365 day period covered by the contract. It can claim a deduction for $181,000 - that is:- 181/365 * $365,000.

•

In the income year 1 July 2007 to 30 June 2008, Garden Goods Ltd can claim the rest of the payment as a deduction; $184,000.

Prepayments are still subject to the commercial debt forgiveness rules

9. 21 The provisions operate subject to Division 245 of Schedule 2C of the ITAA 1936, which deals with forgiveness of commercial debts [paragraph 82KZMA(6)(b)] . Broadly speaking, this means a taxpayer who has a commercial debt that is forgiven may have to reduce some of their deductions, including those for prepayments covered by the rules discussed in this Chapter.

Application and transitional provisions

Transitional provisions

9.22 The transitional rules are intended to alleviate the effect of the new prepayments treatment. They do that by, in effect, spreading over 5years the increase in tax that comes from denying an immediate deduction for prepayments incurred in the first year of the change. Taxpayers only obtain the full transitional effect if they have even, or increasing, prepayments in those years. If their prepayments decline, the increase will be spread over a shorter period.

9.23 Prepayments incurred before 11.45 am AEST on 21September1999 will not be subject to the new treatment of prepayments, nor will those made afterwards pursuant to a contractual obligation that meets certain requirements existing at that time (refer to paragraphs 9.13 and 9.15).

Transitional treatment of expenditure incurred in the first year of change

9.24 Other prepayments incurred in the income year that includes 21September 1999 (usually 1999-2000^[F2]), that would previously have fallen within the 13 month rule, will be eligible for transitional treatment [subsection 82KZMB(1)] . That treatment isolates the part of the prepayment that relates to future years (usually 2000-2001 and 2001-2002). The part so isolated is called the later year amount [subsection 82KZMB(6)] . The treatment allows a deduction for 80% of that part in the current income year [subsections 82KZMB(2) and (5)] . The remaining 20% will be deductible in the next year (usually 2000-2001) [subsections 82KZMB(4) and (5)] .

Example 9.2

Jimco makes a $36,600 prepayment for the 2000 calendar year on 1January 2000. Jimco uses the standard income year, so it can deduct the $18,200 attributable to the 1999-2000 year immediately that is: 182/366 * $36,600. It can also deduct 80% of the remainder ($14,720) in the 1999-2000 year, because of the transitional rule. It can deduct the remaining $3,680 in 2000-2001.

Transitional treatment of expenditure incurred in the next 3 years of change

9. 25 Similar transitional deductions are available for prepayments incurred in the next 3 years (usually 2000-2001, 2001-2002 and 2002-2003) but with different percentages. Table 9.2 sets out the percentages for each of the transitional years [subsections 82KZMB(2), (4) and (5)] .

Cap on amount eligible for transitional treatment

9.26 There is a cap on the amount of a taxpayers future years expenditure that is eligible for the transitional rule in the years including 21 September 2000, 2001 and 2002. That cap is the total amount that was eligible for the transitional treatment for that taxpayer in the year including 21 September 1999. [Section 82KZMC]

9.27 If the amount that would otherwise be eligible in those later years does exceed the cap, the excess is deductible proportionately over the years the prepayment covers after the year it was incurred (refer to paragraph 9.20). [Subsections 82KZMC(4) and (5)]

9.28 The cap is a limit on the total amount eligible for transitional treatment in those later years. However, taxpayers are free to choose how much of the amount of each particular expenditure that would otherwise be eligible for that treatment will contribute to that total [subsections 82KZMC(2) and (3)] . To maximise the benefit, taxpayers would usually want to choose to make up the capped amount for the transitional treatment from the longest term prepayments.

Example 9.3: Transitional treatment for prepayments

Clock Ltd, who is not a small business taxpayer, buys broken Swiss clocks and restores them. In order to make sure it can receive the clocks, its makes prepayments for 12 months in each of the transitional income years. This table sets out details of the prepayments and the amounts Clock Ltd can deduct in each income year.^[F3]

Application provisions

9.29 The prepayments changes apply to prepayments incurred after 11:45 am AEST on 21 September 1999. [Subitem 12(1), Schedule 7]

9.30 Once the transitional changes have expired, in the income year starting after 21 September 2002, the transitional provisions will automatically be removed from the ITAA 1936. Section 82KZMD will then be the operational provision for business prepayments made by someone who is not a small business taxpayer. [Items 6, 7, 8, 9 and subitem 12(2), Schedule7; clause 2]

Commencement

9.31 The prepayments changes will only commence once Subdivision960-Q of the ITAA 1997 commences. This is because subdivision 960-Q defines small business taxpayer. [Clause 2]

Consequential amendments

9. 32 References in the ITAA 1936 and the ITAA 1997 are being altered to reflect the changes to section numbering caused by the new prepayments treatment. [Items 10 and 11 of Schedule 7]

Chapter 10 - Limiting indexation of cost bases of CGT assets

Outline of Chapter

10. 1 Schedule 8 to this Bill amends the ITAA 1997 to prevent indexation of the cost base of CGT assets acquired after 11.45 am AEST on 21 September 1999 (the start time). It also freezes the indexation amount of the cost base of CGT assets acquired at or before the start time and disposed of after that time.

Context of Reform

10. 2 Australia is one of the few countries that allows indexation of an assets cost base. Removing indexation will simplify the law and reduce compliance costs. An alternative relief is provided to individuals, trusts and complying superannuation entities with the introduction of the CGT discount (refer to Chapter 11 of this Explanatory Memorandum).

Summary of new law

10. 3 Indexation of the cost base is not available for assets acquired after the start time. For CGT events happening after the start time to CGT assets acquired at or before that time, an individual, complying superannuation entity or trust may choose either to claim indexation of the cost base in calculating the capital gain or the CGT discount. If the taxpayer chooses to claim the indexation option, indexation is frozen at 30September 1999.

Comparison of key features of new law and current law

10.4 The current law allows an entity who has owned a CGT asset for at least 12 months to adjust the cost base of the asset for inflation in calculating a capital gain made when a CGT event happens to that asset.

10.5 The new law does not allow any indexation for a CGT asset acquired after the start time. It also freezes indexation at the end of the September 1999 quarter in calculating the cost base of a CGT asset acquired at or before the start time.

Detailed explanation of new law

10.6 Indexation is the increase made to the cost base of a CGT asset to take account of inflation. The cost base can only be indexed if the asset has been owned for at least 12 months. Each element of the cost base (other than the third element, e.g. interest, rates and taxes) is increased by an indexation factor. The indexation factor is an amount equal to the CPI figure for the quarter of the year in which the CGT event happened to the asset, divided by the CPI figure for the quarter of the year in which the expenditure was incurred.

10.7 If a CGT event happens to a CGT asset acquired after the start time, the calculation of the capital gain cannot include any indexation of any of the elements of the cost base of the CGT asset. [Item 3, section 114-1]

10.8 For an asset owned at the start time and disposed of after that time, indexation of elements of the cost base at that time will be calculated for the period from the date the expenditure was incurred, up to the end of the September 1999 quarter. Indexation will then be frozen. [Item 6, subsection 960-275(2); item 8, subsection 960-275(3)]

Example 10.1

Penny purchased a parcel of shares in February 1999. She sold them in March 2000. Because she owned the shares for more than 12 months Penny can choose to calculate her gain using frozen indexation. If she makes this choice she indexes the cost base of her shares using the index factor for the September 1999 quarter. Indexation is available because her total period of ownership of the asset is at least 12 months, even though the indexation period is less than 12 months.

10. 9 If an individual, complying superannuation entity or trust owns a CGT asset at the start time and incurs further expenditure in relation to that asset after that time, indexation of that part of the cost base will not be available. [Item 5, subsection 114-10(1), Schedule 10, item 1]

Example 10.2

Aaron purchased a property for $180,000 in May 1986. In October 1999 he made capital improvements for a cost of $20,000. In July 2000 Aaron sells the property for $270,000.

Aaron may use either the frozen indexation option or the CGT discount to calculate the capital gain made on sale of the property. If he uses the frozen indexation option he can index the $180,000 purchase price up until 30 September 1999. The $20,000 cannot be indexed.

10.10 If a taxpayer is an entity other than an individual, complying superannuation entity or trust, indexation of the cost base of a CGT asset remains available, frozen at 30 September 1999, providing the entity acquired the asset at or before the start time and owned the asset for at least 12 months.

10.11 Minor changes are made to the guide to capital gains and losses in Division 100. These changes reflect the freezing of indexation at the end of the September 1999 quarter. [Items 1 and 2, subsection 100-40(2)]

10.12 The following notes reflect the change to freeze indexation. Note1 is amended and Note 4 is added to section 114-1 [item 4] . An additional note is added to subsection 960-275(2) [item 7] . An additional note is added to subsection 960-275(3) [item 9] .

Application and transitional provisions

10. 13 The amendments made by this Schedule apply to the calculation of the cost base of an asset for a CGT event occurring after the start time. [Item 10]

Chapter 11 - Concessions for capital gains by individuals and some other entities

Outline of Chapter

11. 1 Schedule 9 to this Bill amends the ITAA 1997 to provide a CGT discount to individuals, complying superannuation entities and trusts. This concession will allow individuals and trusts to exclude one-half of certain capital gains made on CGT assets from their assessable incomes. Complying superannuation entities will be able to exclude one third of those capital gains.

Context of Reform

11.2 These amendments to the ITAA 1997 will provide a broad form of CGT relief that has only a limited relationship to the period of holding of the asset. They will enable an individual, complying superannuation entity or trust to choose to include a set percentage of their capital gain, rather than claiming indexation of the cost base of the asset.

11.3 These amendments give effect to the Recommendations of the Review.

Summary of new law

11.4 After 11.45 am AEST on 21 September 1999 (the start time), an individual, complying superannuation entity or trust that acquires a CGT asset and makes a capital gain from a CGT event happening to that CGT asset will receive a discount on the capital gain, providing the CGT asset was owned by the taxpayer for at least 12 months.

11.5 For assets acquired at or before the start time, and disposed of after the start time, the taxpayer can choose whether to claim the CGT discount or to include an indexation adjustment in calculating the cost base of the asset.

11.6 Capital losses may be applied in the order chosen by the taxpayer. If the taxpayer chooses the CGT discount, capital losses will be applied against capital gains before applying the CGT discount. If the taxpayer chooses the indexation option, capital losses will be applied after calculating the capital gain using the indexed cost base of the CGT asset, with indexation frozen at 30 September 1999. Revenue losses will continue to be offset against net capital gains.

11.7 A beneficiary of a trust receiving a distribution from the trust that is attributable wholly or partly to a discount capital gain of the trust (because the trustee has claimed the CGT discount in calculating the net income of the trust) will need to gross up the distribution before applying any capital losses. The beneficiary will then apply the appropriate CGT discount (depending on whether the beneficiary is an individual, trust, or complying superannuation entity) to any remaining discount capital gains.

Comparison of key features of new law and current law

11.8 The current law allows taxpayers to calculate capital gains on the happening of a CGT event to a CGT asset with an indexation component, based on the period of ownership of the asset.

11.9 The new law will remove that indexation component for CGT assets acquired after the start time, and replace it with the CGT discount. For a CGT asset acquired at or before the start time, the taxpayer may choose to claim the indexation component, frozen at 30 September 1999 in calculating a capital gain on a CGT event happening to the asset, or the taxpayer may choose to claim the CGT discount.

Detailed explanation of new law

Application to individuals

11.10 If an individual makes a capital gain from a CGT event happening after the start time to a CGT asset acquired after that time, the individual will be taxed on one-half of the gain, without any indexation applying to the cost base. The CGT asset must have been acquired by the taxpayer at least 12 months before the CGT event that caused the capital gain. [Item 13, sections 115-5, 115-10, 115-15 and 115-20]

11.11 The gain before the CGT discount is applied is defined as the discount capital gain . The CGT discount is determined by the discount percentage. [Schedule 10, items 2 and 3, subsection 995-1(1)]

Example 11.1

Sarah acquires listed public company shares in November 1999, for $15 each. She sells the shares in December 2000 for $27 each. She must include in assessable income a discounted gain of $6 for each share, being half of the realised nominal gain of $12.

11.12 If an individual makes a capital gain from a CGT event happening after the start time to a CGT asset acquired at or before that time and owned for at least 12 months, the individual may choose to include in his or her taxable capital gain:

•

one-half of the capital gain without any indexation of the cost base; or

•

the whole of the gain between the realised price of the asset and its cost base, including indexation frozen at 30September 1999.

[Item 11, subsection 110-25(8), item 12, section 114-5, and Item 13, subsection 115-25(1)]

Example 11.2

Sandra acquired shares in a listed public company in 1995 for $20 each, and sells these shares in May 2000 for $38 each. At the date of sale, the frozen indexation amount would increase the cost base to $22, based on indexation frozen at 30 September 1999. Sandra may choose to calculate the capital gain for each share in either of the following ways:

•

the excess of disposal proceeds ($38) over indexed cost base ($22), giving a capital gain of $16; or,

•

half of the realised nominal gain, being the excess of the capital proceeds ($38) over the cost base without any indexation ($20), the nominal gain being $18 and half of that gain being $9.

Given this outcome, Sandra chooses to claim the CGT discount.

Example 11.3

Amy acquired listed public company shares in May 1999, for $11 each and sells these shares in April 2000 for $27 each. At the date of sale she has not owned the asset for at least 12 months and is therefore not able to choose either the CGT discount or the frozen indexation options. Amy must include in her assessable income a net capital gain based on $16 for each share.

Example 11.4

John purchased 3,000 shares in Mineral Co. NL for $900 on 2February 1990. The par value of each share was 50 cents partly paid to 30 cents. On 15 April 2000, the company made a call of 20 cents per share. John paid the call, $600, on 22 April 2000.

John sold his shares in July 2000. Because he acquired the shares prior to the start time he has the choice of using either the frozen indexation option or the CGT discount option in calculating the capital gain. If John chose the frozen indexation option, only the $900 is indexed. The cost base would include this indexed amount plus the $600.

John cannot choose the frozen indexation option for part of his cost base and the CGT discount option for another part of his cost base.

Application to complying superannuation entities

11.13 If a complying superannuation entity makes a capital gain from a CGT event happening after the start time to a CGT asset acquired after that time, the complying superannuation entity will be taxed on two-thirds of the gain, without any indexation applying to the cost base. The CGT asset must have been acquired by the complying superannuation entity at least 12 months before the CGT event that caused the capital gain. [Item 13, sections 115-5, 115-10, 115-15 and 115-20]

11.14 After the start time, if a complying superannuation entity makes a capital gain from a CGT event happening to a CGT asset it acquired at or before that time and owned for at least 12 months, it may choose to include in its assessable income:

•

two-thirds of the capital gain calculated without any indexation of the cost base; or

•

the whole of the capital gain calculated with the indexed cost base as frozen at 30 September 1999.

[Item 11, subsection 110-25(8), item 12, section 114-5, and item 13, subsection 115-25(1)]

11.15 A complying superannuation entity is a:

•

complying superannuation fund;

•

complying approved deposit fund; or

•

pooled superannuation trust.

[Schedule 10, item 1, subsection 995-1(1)]

Application to trusts

11.16 If a trust makes a capital gain from a CGT event happening after the start time to a CGT asset acquired after that time, the net income of the trust will include one-half of the gain, without any indexation applying to the cost base. The CGT asset must have been acquired by the trust at least 12 months before the CGT event that caused the capital gain. [Item 13, sections 115-5, 115-10, 115-15 and 115-20]

11.17 If a trust makes a capital gain from a CGT event happening to a CGT asset it acquired at or before that time and it has owned the asset for at least 12 months, the trustee of the trust may choose the CGT discount or frozen indexation option. [Item 11, subsection 110-25(8), Item 12, section 114-5, and Item 13, subsection 115-25(1)]

11.18 The net income of the trust will include the discounted capital gain or indexation gain depending on the trustees choice. The beneficiary will need to know what proportion of their entitlement to the net income of the trust is attributable to capital gains, and what proportion of that capital gain amount is attributable to a discounted capital gain. [Item 13, Subdivision 115-C]

11.19 The beneficiary of a trust must gross up that part of their share of the net income of the trust that is attributable to a discounted capital gain by applying a gross up factor of 100%. This amount is treated as a capital gain of the beneficiary for the purposes of calculating the net capital gain for the year. This gross up factor allows the beneficiary to appropriately apply any capital losses against the trust capital gain before applying the CGT discount that is appropriate for that beneficiary. [Item 13, sections 115-210 and 115-215]

11.20 No discount is allowed for a trustee assessed under subsection 98(3) or section 99A of the ITAA 1936. [Item 13, sections 115-220 and 115-225]

11.21 That part of the beneficiarys share of the net income of the trust that is treated as a capital gain is deducted from their assessable income for the income year. This ensures that the capital gains component is not taxed twice. [Item 13, subsection 115-215(5), item 31]

Example 11.5

A fixed trust makes a capital gain of $1,000 as a result of an A1 event happening to a CGT asset that the trustee has owned for more than 12months. In calculating the net income under section 95 of the ITAA 1936 the trustee chooses to claim the CGT discount, resulting in a net income for the trust of $2,500, including the discounted capital gain of $500. There is one beneficiary, a company, that is presently entitled to the net income of the trust. The company will gross up the discounted capital gain component to $1,000. The company is not eligible to apply the CGT discount to that grossed up capital gain. This means that the company will include in its assessable income for the year the net trust distribution of $2,000, and the capital gain amount of $1,000.

Application to companies

11.22 The CGT discount is not available to a company.

11.23 If a company acquires an asset after the start time indexation of its cost base is not available.

11.24 If a company acquired an asset at or before the start time indexation of its cost base, frozen at 30 September 1999 is used to calculate a capital gain, providing the asset was owned for at least 12months at the time the CGT event happens.

The 12 month holding requirement

11.25 To qualify for the CGT discount, a CGT asset must have been owned by the taxpayer for at least 12 months at the time of the CGT event happening. [Item 13, subsection 115-25(1) and (2)]

11.26 In some cases, a taxpayer who acquires an asset within 12 months of the CGT event happening to that asset will be eligible for the CGT discount for any capital gain arising from the CGT event. Certain assets acquired under the same asset or replacement asset roll-over provisions (e.g. Divisions 122, 123 and 124) or under the rules applying to deceased persons (Division 128) will be treated as having been owned by the taxpayer for at least 12 months if the collective period of ownership is at least 12 months. This effective ownership rule is only for the purposes of claiming the CGT discount. [Item 13, section 115-30]

11.27 Certain CGT events do not qualify for the CGT discount. If a capital gain is made from a CGT event that creates a new asset, the 12month ownership rule cannot be satisfied and the taxpayer is not eligible for the CGT discount. [Item 13, subsection 115-25(3)]

11.28 Table 11.2 sets out those CGT events that do not qualify for the CGT discount.

11.29 If a taxpayer makes a capital gain from a CGT event happening to a CGT asset acquired by the taxpayer more than 12 months before the CGT event, under an agreement entered into witin that 12 month period, the capital gain does not qualify for the CGT discount [item 13, section 115-40] . This rule will prevent taxpayers inappropriately taking advantage of the CGT discount by seeking to extend artificially the period of ownership of the asset that produces the capital gain.

11.30 The CGT discount is not available for capital gains arising from certain CGT events happening to equity interests in a company or trust if more than half of the assets of the underlying company or trust were acquired within the 12 month period before the sale of the equity interests in the company or trust. This measure will compare the sum of the cost bases of assets acquired by the company or trust within 12 months of the CGT event happening to the equity interest, to the total of the cost bases of the company or trust at the time of the CGT event. [Item 13, section 115-45]

11.31 The rule outlined in paragraph 11.29 will not apply to capital gains from CGT events happening to:

•

shares in a company with at least 300 members; or

•

interests in a fixed trust with at least 300 beneficiaries,

unless the concentrated ownership rules apply (refer to paragraph 11.26). [Item 13, subsections 115-50(1) and (2), Schedule 10, item 4]

11.32 In determining whether the company or trust satisfies these requirements, any concentrated ownership is taken into account. Concentrated ownership occurs if:

•

one or up to 20 individuals own, directly or indirectly, shares with fixed entitlements to at least 75% of the income or capital, or at least 75% of the voting rights in the company; or

•

one or up to 20 individuals own, directly or indirectly, interests in the trust with fixed entitlements to at least 75% of the income or capital, or at least 75% of the voting rights in the trust (if any).

[Item 13, subsections 115-50(3) and (4)]

11.33 For the purposes of these tests, one individual together with associates, and any nominees of the individual or their associates will be counted as one individual. [Item 13, subsections 115-50(5)]

11.34 The tests also consider whether there is any potential for rights attaching to the shares or interests in the trust to be varied or abrogated. It does not matter whether or not the rights attaching to any of the shares or interests are actually varied or abrogated. [Item 13, subsection 115-50(6) to (8)]

How to apply other exemptions

11.35 Certain CGT events require a taxpayer to disregard a capital gain or loss (e.g. if the CGT event happens to a CGT asset acquired by the taxpayer before 20 September 1985). In other cases certain exemption provisions apply to reduce or disregard the capital gain or loss arising from a CGT event. In calculating the capital gain that is subject to discount, the taxpayer takes these general exemption provisions into account before applying any available capital losses, and before applying any discount. [Item 3, subsection 102-5(1), step 1, note 2)

Example 11.6

Lauren purchased a beach front house in 1990 for $140,000. After renting the house out as a holiday home for 3 years, Lauren moved into the house in 1993 and it became her principal place of residence for the next 7 years until she sells it in 2000 for capital proceeds of $260,000. Lauren has prior year net capital losses of $4,000 and current year capital losses of $6,000 and she chooses to apply the CGT discount to the capital gain. In calculating the net capital gain made on the house, Lauren will apply the partial main residence exemption first to reduce the capital gain received on disposal of the holiday house. $120,000 * 7/10 (partial main residence exemption) = $36,000

$120,000 * 7/10(partial main residence exemption) = $36,000


Lauren will then apply her capital losses to this amount.

Lauren can then apply her CGT discount to calculate her net capital gain.

$26,000 * 1/2 = $13,000


Applying capital losses

11. 36 A taxpayer may choose to apply capital losses against capital gains in any order [item 3, subsection 102-5(1), step 1). In most cases the best outcome will be achieved if capital losses are applied against capital gains in the following order:

•

to capital gains that have received neither indexation of the cost base nor the CGT discount (i.e. assets owned for less than 12months) and to capital gains calculated with the assets indexed cost base; and

•

to capital gains which have received the CGT discount.

11.37 If the taxpayer chooses to claim the frozen indexation option, capital losses will be applied against the capital gain arising after deducting the cost base, including any indexed elements, from the capital proceeds. If the taxpayer does not choose the indexation option, or it is not available, the capital gain is calculated by deducting the cost base, excluding indexation, from the capital proceeds for the CGT event. Capital losses will be applied against the capital gain before it is reduced by the CGT discount. [Item 3, subsection 102-5(1), step 1]

11.38 Net capital losses from previous income years must be applied in the order in which they were made. Subject to this rule, the taxpayer can choose to apply any prior year net capital losses against capital gains for the income year in any order. Any prior year net capital losses will be applied against the current year capital gains before applying the CGT discount. [Item 3, subsection 102-5(1), step 2)

11.39 If a capital gain remains after applying all available capital losses, the remaining capital gain is either:

•

fully included in assessable income as a net capital gain without further reduction (if the taxpayer has claimed the frozen indexation option, or if the CGT discount is not available for the CGT asset); or

•

reduced by the appropriate CGT discount and included as a net capital gain (if the taxpayer chose the CGT discount).

[Item 3, subsection 102-5(1)]

Example 11.7

Sharon acquires shares in a listed public company in June 1992, and units in a listed unit trust in May 1996. She has a net capital loss of $12,000 in the 1998-1999 income year, and incurs a further capital loss of $6,000 in August 1999.

Sharon sells the shares in July 1999 and makes a capital gain of $4,000 (Sharon chooses to calculate this capital gain using her indexed cost base). She also sells the units during February 2000, and makes a capital gain of $22,000 (Sharon chooses to calculate this capital gain using the CGT discount).

Sharon may choose to apply her capital losses in any order, but she must apply the losses against discount gains prior to reduction. Sharon chooses to apply the $6,000 current year capital loss firstly against the $4,000 gain realised in July 1999, leaving a current year capital loss balance of $2,000. Sharon will then apply the remaining $2,000 current year capital loss and the prior year net capital loss of $12,000 against the discount gain of $22,000. This results in a nominal gain after losses of $8,000.

This nominal gain is then reduced by the CGT discount of one-half applicable to individuals, leaving a net capital gain of $4,000 for the 1999-2000 income year.

11. 40 A beneficiary of a trust may apply capital losses to both personal capital gains and trust capital gains. That part of the beneficarys share of the net income of the trust that is attributable to discounted capital gains (capital gains calculated by the trustee using the CGT discount of one-half) will be grossed up prior to applying the capital losses of the beneficiary. The balance of discount capital gains (if any) will then be reduced according to the appropriate CGT discount for that beneficiary. [Item 13, subsections 115-215)

Example 11.8

A fixed trust makes a capital gain of $1,000 following the disposal of a CGT asset owned for at least 12 months. In calculating the capital gain the trustee of the trust chooses the CGT discount, leaving a net income in terms of section 95 of the ITAA 1936 of $500. There is a single beneficiary who is an individual and who is presently entitled to the net income of the trust. The beneficiary also has personal current year capital losses available of $400. In calculating his net capital gain for the year, the beneficary must gross up the trust gain to $1,000 before applying his personal capital losses of $400, leaving a discount capital gain of $600, with a net capital gain of $300 after the CGT discount has been applied.

Example 11.9

A fixed trust makes a capital gain of $900 following a CGT event A1, and a separate capital gain of $1,000 (after claiming indexation) from a CGT event C1. The trustee of the trust chooses the CGT discount for the A1 gain of $900 leaving a net income in terms of section 95 of the ITAA 1936 of $450, and chooses the frozen indexation option for the C1 gain.

There is a single beneficiary who is a complying superannuation fund and who is presently entitled to the net income of the trust. This fund has prior year capital losses of $700 available. The fund grosses up the part of the net income of $450 that is attributable to the discount gain (no gross up of the part of the net income that is attributable to the $1,000 indexed gain is necessary). The fund has a choice of applying its capital losses firstly to either the $900 grossed up discount gain or to the $1,000 indexed gain. The fund chooses to apply its capital losses to the $1,000 indexed gain, leaving a capital gain of $300. The discount capital gain of $900 is then reduced by one-third, resulting in a discounted capital gain of $600. The fund then adds together the $300 indexed gain and the $600 discounted gain to get a net capital gain of $900 which it includes in its assessable income for the year.

Applying revenue losses

11. 41 Consistent with the current law, revenue losses will continue to be applied against net capital gains.

Example 11.10

In Example 11.9, if the fund had a prior year revenue loss of $500, that loss would be claimed as a deduction for the 1999-2000 income year. If the $900 net capital gain were the only amount of assessable income, the taxable income of the fund would be $400.

Distribution by a trustee of excluded gain amounts

11.42 A distribution by the trustee of the amount of capital gain that is excluded from the net income of the trust because the trustee claimed the CGT discount may be a non-assessable amount for the purposes of section 104-70 of the ITAA 1997. If the non-assessable amount is distributed to an individual beneficiary who has received the benefit of the CGT discount (in calculating the capital gain that he includes in his net capital gain), section 104-70 will reduce the cost base of the individual beneficiarys interest in the trust. Once the cost base of the beneficiarys interest in the trust is reduced to nil a capital gain may arise (CGT event E4). This capital gain may also qualify for the CGT discount.

11.43 In order to prevent an element of double taxation of a beneficiary of a trust who receives such a non-assessable amount, and who is a company or a complying superannuation entity, there will be no cost base adjustment under section 104-70 for that part of the trust capital gain which is excluded from the calculation of the net income of the trust because the trustee claimed the CGT discount. [Item 5, and item 6, subsection 104-70(7A)]

Example 11.11

In Example 11.5, the company included in its assessable income a net capital gain of $1,000 being the grossed up amount of the share of the net income of the trust that was attributable to the discounted gain. The net income of the trust does not include that part of the capital gain that represents the CGT discount. If the trustee later decides to distribute that excluded amount to the company beneficiary, there will be no adjustment under section 104-70 of the cost base of the companys interest in the trust.

11.44 On distribution of the excluded gain amount by the trustee, there will also be no cost base adjustments under section 104-70 to the extent to which the beneficiary of the trust has applied personal capital losses against the grossed up trust capital gain. The beneficiary will need to identify which capital gains he has chosen to apply against his capital losses, particularly if the excluded gain amount is distributed in a later year of income than that in which the grossed up trust gain was assessed.

Example 11.12

In Example 11.8, the beneficiary applied personal capital losses of $400 against the grossed up trust discounted capital gain of $1000 (twice that part of the net income of the trust that was attributable to a discounted capital gain). On distribution by the trustee to that beneficiary of the excluded gain amount, $200 of the distribution of $500 has effectively been offset against capital losses. No cost base adjustment under section 104-70 will apply to that part of the distribution. The remaining $300 will be applied to reduce the cost base of the beneficiarys interest in the fixed trust.

Application and transitional provisions

11.45 The amendments to Divisions 100, 102, 104, 109 and new 115 of the ITAA 1997, apply to assessments for the income year including 21September 1999 and later years. The amendments to the cost base and indexation provisions apply to the calculation of the cost base of a CGT asset for a CGT event happening after the start time. [Item 14]

11.46 The amendment of section 6AD of the ITAA 1936 applies for income years commencing on or after 1 July 2000. [Item 21]

11.47 The consequential amendments to the ITAA 1997 apply to assessments for the income year including 21 September 1999 and later years [item 30] . The additional signposting for section 12-5 of the ITAA 1997 applies to assessments for the income year including 21 September 1999 and later years [item 32] .

Consequential amendments

11.48 Minor changes are made to the Guide to capital gains and losses in Division 100 of the ITAA 1997 to reflect these changes, and to introduce an outline of the CGT discount in Division 102. [Item 1 and 2]

11.49 The changes to the method statement in subsection 102-5(1) to give effect to the choice of CGT discount require consequential changes to paragraph 6AD(4)(e) of the ITAA 1936 to ensure that that provision continues to apply to capital gains and losses from a CGT event. [Item 15]

11.50 Further consequential changes have been made to insert notes referring to the application of Subdivision 115-C at the end of a number of provisions in Division 6 of Part III of the ITAA 1936 [items 16 to 20] . The introduction of the concept of complying superannuation entity has also required consequential changes to a number of provisions in Parts 3-1 and 3-3 of the ITAA 1997 to ensure consistency of terminology [items 22 to 29] .

Chapter 12 - Regulation Impact Statement

Policy objective

12.1 The measures contained in this Bill are part of the Governments broad-ranging reforms which will give Australia a New Business Tax System. These reforms are based on the Recommendations of the Review that the Government established to consider reforms to Australias business tax system.

12.2 The Government established the Review to consult on its plan to comprehensively reform the business income tax system (as outlined in ANTS). The Review made 280 recommendations to Government towards achieving a more simple, stable and durable business tax system (as set out in the Recommendations).

12.3 The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs, and improved savings as well as providing a sustainable revenue base so the Government can continue to deliver services for the community. An important feature of the New Business Tax System is the CGT reforms which aim to encourage greater investment by Australians and to improve the international competitiveness of Australian business.

12.4 The New Business Tax System promotes that end by providing a basis for more robust investment decisions. This is achieved by:

•

using consistent and clearly articulated principles, for example;

-

taxing business entities and investments on the basis of their economic substance or equivalence rather than their legal form; and

-

aligning the tax value of business investments more closely with their commercial value, using accounting principles where appropriate;

•

improving simplicity and transparency;

•

reducing the costs of compliance through principled tax laws that are easier to understand and comply with; and

•

providing fairer, more equitable outcomes, and less scope for tax avoidance.

12.5 Each of the measures in this Bill is consistent with the objectives and approaches discussed above. For example:

•

tightening the prepayment rule is consistent with moving the tax value of prepayments closer to their commercial value and aligning them with accounting principles;

•

the integrity measures (i.e. lease assignments, and creation and use of losses) are consistent with providing fairer and more equitable outcomes, and less scope for tax avoidance; and

•

the CGT reforms are consistent with a simpler and more transparent system; how capital gains are worked out becomes easier to understand and apply (i.e. a discount).

Implementation options

12. 6 The Reviews recommendations, including those on which the measures of this Bill are based, have been the subject of extensive consultation. Discussion of each measure, including the options for implementation, are to be found in the Reviews A Platform for Consultation (APFC) and A Tax System Redesigned (ATSR). Table 12.1 shows where each of the measures in this Bill (or the principles underlying the measure) is discussed.

Table 12.1: Options for implementing the measures in this Bill

Assessment of impacts

Impact group identification

12.7 The Review has considered the impacts of the recommended New Business Tax System in A Tax System Redesigned (refer to pages 28-34). There the focus was on the economy as a whole, business, small business and investors. The Review concluded that there would be net gains to business, Government and the community generally.

12.8 Most of the measures in this Bill specifically impact on a taxpayer that conducts a type of transaction or event as shown in Table12.2.

Table 12.2: Taxpayers affected by the measures in this Bill

Analysis of costs and benefits

Compliance costs

12.9 The New Business Tax System will reduce compliance costs as it will provide a more consistent and easily understood business tax system.

•

Tightening the prepayment rule means that properly prepared accounts will now contain the information necessary for income tax purposes.

•

The integrity measures that clarify how the law operates on the use and recognition of losses for tax purposes will harmonise disparate regimes making all of the regimes easier to comply with.

•

Taxpayers will no longer need to work out an assets indexed cost base for assets acquired after 21 September 1999; a calculation which can be quite complex and time consuming.

12. 10 Where measures may increase compliance costs for some taxpayers, they also provide taxpayers with greater flexibility in managing their affairs or preserve the integrity of the tax system.

Administration costs

12. 11 The costs of implementing the measures in this Bill are not expected to give rise to any significant increase in administration costs.

Government revenue

12. 12 The revenue impact of each measure is dealt with in the general outline for this Explanatory Memorandum.

Economic benefits

12. 13 The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings.

Consultation

12.14 The consultation process commenced with the release of the ANTS in August 1998. The Government established the Review in August 1998 and since that time the Review has published 4 documents on business tax reform, in particular A Platform for Consultation and A Tax System Redesigned in which the Review canvassed options and issues and sought public comment.

12.15 Also during this period, the Review has held numerous public seminars and focus group meetings with stakeholders in the taxation system. It received and analysed 376 submissions from the public on reform options. Further details are contained in paragraphs 12 to 16 of the Overview of A Tax System Redesigned.

12.16 In analysing options, the published documents frequently referred to, and often were guided by, views expressed during the consultation process.

Conclusion and recommended option

12. 17 The measures contained in this Bill should be adopted to support a more efficient, innovative and internationally competitive Australian business sector, ensure a sound revenue base, reduce compliance costs and establish a simpler and sounder tax system.