House of Representatives

Explanatory Memorandum

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

Chapter 8 - Direct value shifting - interests in companies and trusts

Outline of chapter

8.1 This chapter provides a detailed discussion of the operation of the DVS rules in Division 725. This chapter also explains amendments contained in Schedule 15 to this bill.

Context of reform

8.2 DVS rules were recommended in A Tax System Redesigned (see Recommendations 6.14 and 6.15) as part of the response to generalised value shifting on assets. The DVS rules outlined in this chapter relate to value shifts involving equity or loan interests in companies or trusts. A further DVS rule, dealing with the creation of rights over assets is discussed in Chapter 9.

8.3 The DVS rules discussed in this chapter implement fully the principles underlying Recommendations 6.14 and 6.15 of A Tax System Redesigned .

8.4 The DVS rules only apply to value shifts involving direct equity or loan interests in companies or trusts that are controlled. The DVS rules impact mainly on controllers and their associates who have interests in a controlled company or trust. If the company or trust is also closely-held, the rules may impact on active participants in a DVS scheme who have interests in the company or trust. All of these interest owners are affected owners for the DVS rules.

8.5 If value is shifted between affected owners interests, this Division results in a rearrangement of those interests adjustable values (e.g. cost bases) to prevent inappropriate losses or gains from later arising on realisation of the interests.

8.6 A taxing event may happen if value is shifted from an interest which has a pre-shift gain or profit to an interest of a different affected owner. This has the economic effect of a disposal.

8.7 Similarly, a taxing event may result if value is shifted within interests of the same affected owner and the shifted value cannot be later taxed at all, or taxed in the same way, on the increased value interest (or interest issued at a discount). This may occur, for example, if value is shifted from a post-CGT interest to a pre-CGT interest, or from trading stock to a post-CGT interest that is not trading stock.

8.8 Affected owners will now receive recognition for value shifted from pre-CGT interests to post-CGT interests. This is not a feature of existing Division 140 of the ITAA 1997 dealing with share value shifting.

8.9 Although it is not feasible to maintain pre-CGT status for the shifted value, regard is had to this amount in providing uplifts for increased value interests or interests issued at a discount. This implements Recommendation 6.15 of A Tax System Redesigned .

8.10 Consistent with Recommendation 6.14(iii), there is no taxing event crystallising a loss on a direct value shifting arrangement.

8.11 In many respects, the methodologies adopted in Division 725 are modelled on Division 140 of the ITAA 1997. However, there are significant differences in the scope and application of the new measures. These are summarised below in the new law to old law comparison.

Summary of new law

8.12 Division 725 applies to direct value shifts under schemes involving direct equity or loan interests in a target entity (company or trust) that is controlled.

8.13 A scheme does not have to have been entered into with a tax avoidance purpose for the Division to apply to it.

8.14 Specifically, a value shift under this Division relates to a thing or things done under a scheme involving equity or loan interests in the target entity that results in a decreased value interest and an increased value interest (or an interest issued at a discount to market value). An interest issued at a discount does not actually increase in value, but the effect of it is to cause a decrease in the value of other interests.

8.15 In a direct value shift, value is shifted between entity interests without a disposal occurring, although the economic effect achieved is similar if the value is shifted between different persons. If the value passes between interests held by the same person, at the very least the relationship between adjustable values and market values of the interests becomes distorted.

8.16 Only affected owners of impacted interests, at the time of the decrease or increase in market value, or issue, are impacted by the Division. Affected owners are mainly the controller of the entity, associates of the controller and, if the target entity is closely-held, active participants (if any) in relation to the scheme.

8.17 The consequences for an affected owner depend mainly on 2 factors:

•

from or to whom the value is shifted (e.g. from another affected owner, from the affected owners own interests or from a non-affected owner (e.g. a minority shareholder)); and

•

the tax character of the interests involved (i.e. whether they are held on capital account, or whether they are revenue assets or trading stock of the owner).

8.18 The consequences include a possible taxing event for a pre-shift gain or profit (no losses are taken to occur) and adjustable value (e.g. cost base) realignment.

8.19 In general, the following consequences can arise for particular types of value shift:

•

for shifts between interests held by the same affected owner - adjustable value realignment only unless value is shifted from post-CGT to pre-CGT interests or between interests of a different tax character (in these cases pre-shift gains may be taxed);

•

for shifts between interests held by different affected owners - adjustable value realignment (in some cases, pre-shift gains may be taxed); or

•

for shifts involving interests held by owners that are not affected owners - there are no consequences.

8.20 The Division does not apply to a direct value shift occurring wholly within a consolidated group where all of the affected interests will be subject to reconstruction under the consolidation rules.

8.21 There is also a de minimis exclusion. If the total value shift out of all down interests under the same scheme (whether the interests are held by affected owners or others) is less than $150,000 the Division will generally not apply.

8.22 Diagram 8.1 outlines the coverage of the DVS rules.

Diagram 8.1: Map of the DVS rules

8.23 Diagram 8.2 explains how the DVS rules operate in practice.

Diagram 8.2: Flowchart of the DVS rules in practice

Example 8.1

Richard, a resident individual, wholly-owns and controls Richard Co, a resident private company, which he incorporated in 1986. Richard holds 2 ordinary shares each worth $1 million and each with a cost base of $0.1 million.

If Richard were to sell 50% of his shareholding (i.e. one share) to his brother Stan for $0.1 million, the CGT market value substitution rule in section 116-20 of the ITAA 1997 would apply so that a capital gain (ignoring indexation and the CGT discount) of $0.9 million would arise (i.e. $1 million sale proceeds less $0.1 million cost base).

However, if instead of selling a share to Stan, Richard were to cause Richard Co to issue 2 ordinary shares to Stan for $0.1 million each, Richard would not have disposed of anything, but would effectively shift $0.9 million in value to Stan without tax effect (but for the DVS rules).

Richards shares would now be worth 2 * ($2.2 million / 4) = $1.1 million and Stans shares, for which he paid $0.2 million, would also be worth $1.1 million.

(Note: if the shares had been issued to Stan for $1 million each, there would have been no value shift and no application of the Division).

Consequences - Richard

In broad terms, the Division deals with such a transaction by assessing a gain to Richard because he has shifted value out of a gain interest to an associate. The amount of the gain assessed is based on the value shifted from the shares less a pro-rata allocation of their adjustable values.

Richard shifted $900,000 value to Stan. This represents 45% of the pre-shift value of his interests ($2 million). That proportion of cost base of his shares is allowed as a reduction (i.e. 45% / $200,000 = $90,000). The gain is $810,000 ($900,000 - $90,000).

Consequences - Stan

Assuming Stans shares continue to reflect the shifted value, their cost base would be increased by the value shifted to them (i.e. $450,000 each), so the value would not, on later sale of the shares, be taxed again under the ordinary CGT rules. Each of Stans shares would now be worth $550,000 and each would have that amount as a cost base.

A similar result would have followed if Richard and Stan had both owned shares in the company from the time of incorporation, and a shift were achieved by varying the rights attaching to their shares.

A similar result would also have followed if, instead of a company, the entity were a unit trust and either units were issued at undervalue to an associate or unit rights were varied (assuming that a new trust does not result).

Detailed explanation of new law

8.24 This explanation of the DVS rules is in 4 parts:

•

object of the Division (paragraphs 8.25 to 8.27);

•

threshold conditions for a direct value shift (paragraphs 8.28 to 8.91);

•

interaction with other provisions (paragraphs 8.92 to 8.103); and

•

consequences of a direct value shift (paragraphs 8.104 to 8.198).

Object of Division 725

8.25 Oneobject of the Division is to prevent inappropriate losses arising on the realisation of equity or loan interests from which value has been shifted to other equity or loan interests in the same entity.

8.26 Anotherobject of the Division is to prevent inappropriate gains from arising on the realisation of equity interests in the same entity to which the value has been shifted.

8.27 The object is achieved by adjusting the adjustable values of interests owned by entities involved in the value shift to take account of the changes in market value attributable to it. In some cases, the value shift is treated as a partial realisation, from which an immediate gain (but not a loss) may result. [Schedule 15, item 1, section 725-45]

Threshold conditions for the application of Division 725

8.28 A direct value shift under a scheme involving equity or loan interests in a company or a trust (called the target entity), has consequences for an entity with such interests if:

•

the controlling entity test is satisfied;

•

there is a sufficient causal nexus between the thing or things done under the scheme and the value shift;

•

the entity is an affected owner of a down interest or an up interest or both;

•

the direct value shift will not be reversed; and

•

the de minimis exclusion does not apply (i.e. the shift involves a material decrease).

[Schedule 15, item 1, section 725-50]

Is there a direct value shift under a scheme involving equity or loan interests in an entity?

8.29 There is a direct value shift under a scheme involving equity or loan interests in a target entity if:

•

there is a decrease in market value of one or more equity or loan interests in the target entity that is reasonably attributable to one or more things done under the scheme and occurs at or after the time when that thing, or the first of those things, is done - called a down interest and the time the decrease happens is its decrease time ; and

•

one or more equity or loan interests in the target entity increases in market value or is issued at a discount, and the increase, or issue, is reasonably attributable to the thing, or one or more of those things done, and occurs at or after the time the thing, or first of those things, is done - called an up interest and the time the increase or issue happens is its increase time .

[Schedule 15, item 1, sections 725-145 and 725-155]

8.30 A more detailed discussion of these requirements follows in paragraphs 8.48 to 8.89.

8.31 If the decrease or increase or issue (as applicable) is only partly attributable to the scheme, the Division applies only to that extent. [Schedule 15, item 1, section 725-165]

8.32 Common examples of things that may result in a direct value shift include issuing shares or trust units at a discount, proposing to buy back shares at less than market value or varying share rights.

Nature of a direct value shift

8.33 A direct value shift has 2 aspects:

•

the decrease in market value of the down interests and the increase in market value of the up interests (or interests issued at a discount to market value) [Schedule 15, item 1, subsection 725-160(2)] ;and

•

that Division 725 assumes, and proceeds on the basis that, the direct value shift is from each of the down interests to each of the up interests [Schedule 15, item 1, subsection 725-160(3)] .

8.34 The assumption in the second dot point is important because it avoids entities having to actually determine as a matter of fact , the precise amount of value shifted from one interest to another interest . Grouping tests for interests make such calculations more straightforward, especially in a scheme involving many interests, and affected owners.

Controlling entity test and active participant test

8.35 Broadly, the Division has no application to a direct value shift under a scheme unless an entity controls (for value shifting purposes) the target entity at some time during the scheme period (from the time the scheme is entered into until it has been carried out). [Schedule 15, item 1, section 725-55]

8.36 It is not necessary for the entity to still be the controller of the target entity when any decrease in market value of an interest actually occurs.

8.37 There may also be more than one controller of a target entity during the course of the scheme.

8.38 The control concept is discussed in more detail in Chapter 11.

Affected owners

8.39 Only affected owners of down and up interests under the shift are potentially impacted by the Division.

8.40 An entity is an affected owner of a down interest if it owns the interest at the decrease time and either:

•

the entity is the controller or an associate of the controller at some time during or after the scheme period; or

•

the target entity is closely-held at some time during the scheme period and the entity is an active participant in the scheme.

[Schedule 15, item 1, section 725-80]

8.41 An entity is an affected owner of an up interest if the entity owns the interest at the time it increases in value or is issued to the entity at a discount and:

•

there is at least one affected owner of a down interest; and

•

either or both of the following are satisfied:

-

the entity is the controller, or an associate of the controller at some time during or after the scheme period, or an associate of an associate of the controller during or after the scheme period where the second mentioned associate was an affected owner of down interests; or

-

the target entity is closely-held at some time during the scheme period and the entity is an active participant in the scheme.

[Schedule 15, item 1, section 725-85]

8.42 An entity is an active participant if the target entity is closely-held and it has actively participated in or directly facilitated the entering into or carrying out of the scheme, and it owns a down or up interest at the decrease or increase time (as relevant) or has an interest issued to it at a discount. [Schedule 15, item 1, subsection 725-65(2)]

8.43 Chapter 11 contains a detailed discussion of affected owners.

Reversals

8.44 There is an exception that provides special relief from the requirement to calculate gains and make adjustments where a value shift reverses.

8.45 A direct value shift will not have consequences under Division 725 if it is more likely than not that there will be a reversal within 4 years. The reversal must occur under the terms of the same scheme. [Schedule 15, item 1, subsection 725-90(1)]

8.46 The concept of reversal is based on the state of affairs that arises because of the thing, or things, done under the scheme to which the decrease in value of equity or loan interests is reasonably attributable. It must be the case that without the state of affairs the direct value shift would not have happened. A reversal happens where the state of affairs ceases to exist. [Schedule 15, item 1, subsection 725-90(1)]

8.47 The state of affairs can include the effects and consequences of the things done, as well as the circumstances brought about by those things. A state of affairs can cease to exist partially or gradually over a period of time. If the state of affairs has not fully ceased to exist by the end of the 4 year period, the exception will stop applying. [Schedule 15, item 1, subsection 725-90(2)]

8.48 The exception will also stop applying if the state of affairs exists when a down or up interest of an affected owner is realised within the 4 year period. If the exception stops applying it is as if it had never applied. [Schedule 15, item 1, subsections 725-90(2) and (3)]

8.49 A direct value shift that happens when the reversal occurs will also have no consequences under Division 725. [Schedule 15, item 1, section 725-95]

Example 8.2

Two classes of shares are on issue in Collar Co (A Class and B Class).

Under a scheme, special voting rights are attached to the A Class shares. As a result, the market value of the A Class shares increases, and the market value of the B Class shares decreases. Under the terms of the scheme, the special voting rights will cease to apply after 2 years.

The consequences under Division 725 will not apply to the direct value shift that happens when the special voting rights are attached (from B Class shares to A Class shares).

The consequences under Division 725 will not apply to the direct value shift that happens when the special rights cease to apply (from A Class shares to B Class shares).

8.50 The exclusion will cease to apply (and is treated as never having applied) if, before the reversal happens, a realisation event happens to down interests or up interests of an affected owner, or the 4 year period expires. Where this happens, the consequences under Division 725 are applied from the earlier time when the direct value shift happened. This may result in an assessment for an earlier income year having to be amended. [Schedule 15, item 1, subsection 725-90(1)]

Scheme and related issues

8.51 Division 725 requires the existence of a scheme to trigger its operation. It must be the case that:

•

there is a thing, or things, done under the scheme;

•

the thing must be done by certain entities; and

•

the scheme must involve equity or loan interests in an entity.

Scheme

8.52 Scheme is very broadly defined in the tax law. It is defined in subsection 995-1(1) of the ITAA 1997 as encompassing:

•

any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings; and

•

any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

8.53 A tax avoidance purpose in respect of a scheme is not required for the application of Division 725. It is the effect of the scheme, and the effect of things done under the scheme, that are relevant.

8.54 What acts or omissions constitute a scheme is a question of fact. A series of events or transactions may form part of one scheme. This ensures that even if, for instance, a share value shift proceeds over a long period, each decrease in value of a share may be attributed to a single scheme.

8.55 If variations occur to things agreed to under a scheme, such variations will ordinarily amount to a new scheme, except where the variations were clearly contemplated by, and consistent with, the earlier scheme.

Example 8.3

A finalised scheme to issue shares at undervalue by 5%, is later varied by the parties so that the shares are to be issued at undervalue by 30%. These constitute 2 separate schemes.

What is a thing done?

8.56 A thing done takes its ordinary meaning. A thing done could, in limited circumstances, include a thing omitted to be done. For example, it could include failing to use the option of a casting vote in an otherwise tied ballot. However, something omitted to be done would not include inadvertent omissions and oversights.

8.57 References to a thing done under a scheme include (but are not limited to) things such as the issuing of new interests at a discount, the buying back of existing interests or the changing of the various rights attached to interests.

Who must do the thing or things?

8.58 The thing or things must be done by:

•

the target entity itself;

•

by a controller of the target entity or by an associate of the controller at some time during or after (but not before) the scheme period; or

•

by an active participant in the scheme.

The thing or things can be done either alone or with others. [Schedule 15, item 1, subsection 725-65(1)]

The scheme must involve equity or loan interests in the target entity

8.59 The DVS rules require that the thing or things must be done under a scheme that involves equity or loan interests in an entity. This requires there to be a direct connection between the thing or things done under the scheme and the equity or loan interest or interests in the entity.

8.60 A thing done under a scheme that causes an asset of an entity to change in value, which is reflected in the value of interests in the entity, is not sufficient to involve the interest. A purely incidental value shift, for example, a value shift resulting from particular investments undertaken by the entity, will not trigger Division 725.

Equity or loan interest in an entity

8.61 The DVS rules apply only to direct interests in target entities and not to interests held through other entities in the target entity. Direct interests are referred to as equity or loan interests. The DVS rules apply to interests held on capital account (the most usual case) but also have implications for interests held as trading stock or as revenue assets.

Primary or secondary interests

8.62 An equity or loan interest in an entity can be a primary interest, or a secondary interest, in the entity [Schedule 15, item 1, subsection 727-520(1)] . A primary interest in an entity can be a primary equity interest or a primary loan interest in an entity [Schedule 15, item 1, subsection 727-520(2)] .

8.63 A primary equity interest in a company is a share in the company or an interest as joint owner of a share. [Schedule 15, item 1, subsection 727-520(3), item 1 in the table]

8.64 A primary equity interest in a trust is an interest in the trust income or trust capital, or any other interest in the trust or an interest as a joint owner in one of these interests. [Schedule 15, item 1, subsection 727-520(3), item 2 in the table]

8.65 A primary loan interest in an entity is a loan to the entity or an interest as a joint owner in one of these interests. [Schedule 15, item 1, subsection 727-520(4)]

Secondary interests

8.66 A secondary interest is a right or option to acquire an existing primary interest in an entity, for example, a share or a loan, or to have the entity issue these type of interests. It does not apply to a put option, as this is not an option to acquire an interest. [Schedule 15, item 1, subsections 727-520(5) to (7)]

Relevant trust interests

8.67 While an interest in a trust includes any other interest in the trust apart from an interest in the trust income and capital, in practical terms the DVS rules can only apply in relation to a trust interest:

•

that is capable of being acquired and disposed of;

•

that is quantifiable; and

•

in which the rights attaching to it are defined with particularity in the terms of the deed of settlement.

8.68 The trust interest must also be capable of having a market value.

8.69 An interest in a non-fixed trust which merely entitles the holder to have the trust estate properly administered and to be considered by the trustee in exercising a power of appointment to distribute income or capital of the trust is not the type of interest to which Division 725 has any practical application. This is because such an interest cannot decrease or increase in market value.

8.70 However, Division 725 is capable of having practical application to the extent that an interest in a non-fixed trust has value capable of being measured and quantified (e.g. but not limited to, an interest in a trust that is fixed in respect of either income or capital).

Decrease in market value and related issues

8.71 There must be a material decrease in the market value of at least one equity or loan interest for the Division to apply. Equity or loan interests in an entity that have decreased in market value as a result of something done under a scheme are referred to as down interests . [Schedule 15, item 1, subsection 725-155(1)]

8.72 The decrease in market value of the down interests must be reasonably attributable to the thing or things done under the scheme and happen after the thing or first of the things. [Schedule 15, item 1, paragraph 725-145(1)(b)]

Decrease in market value must be material

8.73 A down interest will be regarded as having sustained a material decrease in market value if the sum of all of the decreases of the market value of that and all other down interests, arising from direct value shifts occurring under a single scheme, is at least $150,000. [Schedule 15, item 1, section 725-70]

Example 8.4

There are 50 A class shares in Alpha Co with a market value of $100,000 each, and 20 B class shares with a market value of $5,000 each. The controller of Alpha Co owns all the A class shares. An associate of the controller owns 10 of the B class shares, and an unrelated entity owns the other 10 shares.

If the controller causes Alpha Co to vary the share rights attaching to the A and B class shares, and shifts 10% of the A class value to the B class shares, the Division applies because the overall value shifted would have been $500,000 (i.e. 10% * 50 * $100,000).

8.74 The materiality requirement is designed to reduce the cost of complying with the value shifting provisions. It ensures that the provisions are not triggered by relatively small shifts of value.

8.75 The new law adopts a more practical threshold than does Division 140, especially given the difficulty of determining whether a 5% shift has occurred in respect of a particular interest.

8.76 Under a particular scheme there may be a series of direct value shifts reducing the market value of a down interest. In such a case, the sum of all the decreases is used to determine whether there is a material decrease in the market value of the interest. If, for instance, a value shift takes place in 2 stages so that initially there is a decrease in the market value of an interest and then, at some time later, a further decrease in the market value of the same interest, both are taken into account.

8.77 Unlike Division 140 there is no materiality requirement for increased value shares in Division 725. The rationale for this is that, provided the Division has been triggered in respect of a material decrease, taxpayers should be able to calculate any uplift (even a small one) to which they are entitled. There is, however, no obligation upon them to do so (e.g. if the costs of determining the appropriate amount would exceed any tax reduction obtained).

8.78 There is also a rule that ensures that the $150,000 threshold cannot be accessed inappropriately. In particular, the threshold will not apply if 2 or more direct value shifts happened under different schemes, and it is reasonable to conclude that the sole or main reason for this was to access the benefit of the threshold. [Schedule 15, item 1, subsection 725-70(2)]

Decrease must be reasonably attributable to the thing or things done under the scheme

8.79 The decrease in the market value of an interest must be reasonably attributable to the thing or things done under the scheme. This is an objective test and may be met even though the decrease was not intended. A similar nexus must exist between the thing or things done under the scheme and the increase in value (or issue at a discount) of other interests. Purely coincidental decreases and increases will not trigger the share value shifting provisions.

8.80 If the decrease (and/or increase) in market value of an interest was caused partly by doing something under the scheme and partly by some unconnected event (such as market forces), the DVS rules apply only to that part of the decrease (or increase or discount issue) that was caused by the thing done under the scheme. [Schedule 15, item 1, section 725-165]

Can there be a decrease in market value of an interest that is later extinguished under the terms of the scheme?

8.81 There can be a decrease in market value of an interest that is extinguished under the terms of the scheme. The legislation requires that at the time, or after the thing is done, interests decrease in value. In the case of a proposed cancellation or ending of an interest, the decrease in market value would generally occur at the time of the proposal, rather than when the interest ended, or it may occur immediately before the interest ends.

Does the decrease have to be permanent or everlasting?

8.82 The decrease need not be permanent or everlasting. The DVS rules may apply to certain temporary shifts in value, although a special rule is proposed to apply where a value shift reverses under the terms of the same scheme that gave rise to it.

8.83 For example, the issue of a dividend access share may, depending on factual circumstances and the particular rights attaching to the access share, cause a temporary reduction in value of other shares in the entity. The reduction in value might in certain cases persist until losses in another entity are used up, at which time, dividend flows return to normal. A temporary decrease of this kind may be sufficient to activate Division 725, however the special rule discussed previously in paragraphs 8.44 to 8.50 may apply.

Increase in market value or issue of an interest at a discount and related issues

8.84 Any equity or loan interests in an entity that are issued at a discount, and any equity or loan interests in the entity that increase in market value are referred to as up interests . [Schedule 15, item 1, subsection 725-155(2)]

8.85 The increase in market value of an up interest (or the interest issued at a discount) must be reasonably attributable to the thing or things done under the scheme in respect of which the decrease in value of the down interest was reasonably attributable. The increase must happen after the thing or first of the things is done. [Schedule 15, item 1, subsections 725-145(2) and (3)]

When is an interest issued at a discount?

8.86 An issue of an interest at a discount is, broadly speaking, the issue of the interest at a discount to market value. That is, the money or market value of property that is the payment for the interest is less than the market value of the interest at the time it is issued. Such an interest is not an increased value interest as such, because it commences with the value greater than what was paid for it. However, in a DVS context, it is analogous to an increased value interest, because it embodies the value shifted from a down interest.

Equity issued at a discount

8.87 An equity interest is issued at a discount if its market value when it is issued is greater than the payment received by the issuing entity. The payment received can include property. [Schedule 15, item 1, subsections 725-150(1) and (2)]

Example 8.5

A share is issued in return for a payment of $10. The share is worth $30 at the time of issue. The share is issued at a discount, with the discount being in this case $20.

Issue of loan interest at a discount

8.88 Broadly, the same principle that applies for an equity interest issued at a discount applies for an issue of a loan interest at a discount. A loan interest issued at a discount is one that at the time of issue has a market value greater than its face value. This would not be expected to occur frequently, but it could occur if, for example, the agreed rate of interest payable on the loan was more than the market rate for a loan of that type.

What about an interest issued at overvalue - that is, for a payment of more than its market value at the time of issue?

8.89 The issue of an interest for more than its market value at the time of issue does not cause a direct value shift to occur, because it does not cause the decrease in value of another interest. Note that in such cases, the adjustable value for the acquired interest may not be equal to the amount of the payment actually made (e.g. if the interest is not acquired in an arms length dealing).

Increase or discount issue reasonably attributable to the thing or things done under the scheme

8.90 The increase in market value of an interest or discount issue must be either reasonably attributable to the thing or things done under the scheme in respect of which the decrease was reasonably attributable, or it must be that thing or things.

8.91 In the case of a discount issue, the issue itself will often be the thing done under the scheme that causes the decrease. However, if the discount issue is announced, the announcement, rather than the actual issue, may be the thing in respect of which the decrease is more reasonably attributable. This will depend on the facts and when the change in market value occurs.

Interaction with other provisions

8.92 Issues arise as to the interaction of the DVS rules with other provisions in the ITAA 1936 and the ITAA 1997.

Part IVA of the ITAA 1936

8.93 Part IVA of the ITAA 1936, containing the general anti-avoidance provisions of the taxation law, is not precluded from applying to a scheme within the meaning of the DVS rules. However, the more specific rules, to the extent they do apply, would ordinarily apply in preference to Part IVA.

Share buy-back provisions: Division 16K of Part III of the ITAA 1936

8.94 In certain circumstances the DVS rules could apply to the off-market buy-back of a share at less than market value. This would happen, for example, if the shares to be bought back are shares of the controller of the company, and the decrease in value of those shares as a result of the proposed buy-back at less than market value causes an increase in value of an associates shares.

8.95 Under subsection 159GZZZQ(2) of Division 16K of Part III of the ITAA 1936, the deeming of market value (based on what would be the market value of the shares if the buy-back had not been proposed and did not occur) would increase the purchase price to the market value of the share for the purposes of the buy-back provisions. This would ensure that any gain reflected in the value shifted to the associates share would be realised under the ordinary CGT provisions. Therefore, it would be unnecessary for the DVS rules to determine the consequences in respect of the decreased value share.

8.96 To prevent double taxation if the market value rule applies to a share buy-back which resulted in a decrease in value of the shares to be bought back, the adjustable values of those shares are not reduced and there are no taxing events generating gains for them.

8.97 The value shifting provisions allow uplifts in relation to the value shifted. Uplifts to the adjustable values of shares reflect the increase in value of the shares because of the off-market buy-back. Under Division 140 of the ITAA 1997 no uplifts are available in these circumstances. [Schedule 15, item 1, section 725-230]

Interaction with the bonus interest provisions

8.98 In broad terms, the DVS rules will apply normally where bonus equities (e.g. bonus shares and bonus units) are issued at a discount to an entity in relation to original equities owned by it. However, certain of the outcomes from applying the DVS rules will be varied to take account of the effect of other provisions that deal with the issue of bonus equities. These other provisions are section 6BA of the ITAA 1936 and Subdivision 130-A of the ITAA 1997 (bonus equity provisions).

8.99 Outcomes for the original and bonus equities of an entity under the DVS rules will be varied to the extent that the direct value shift is between such equities. The effect of the DVS rules will be varied where:

•

Subdivision 130-A applies, none of the bonus equities are a dividend or otherwise assessable and:

-

the original equities were acquired post-CGT; or

-

the original equities were acquired pre-CGT and the entity was required to, and did, pay an amount for the bonus equities; and

•

section 6BA applies and the bonus shares:

-

were issued for no consideration and are not a dividend; or

-

are a dividend rebatable under section 46 or 46A.

[Schedule 15, item 1, section 725-225]

8.100 The outcomes in such cases are shown in Table 8.1.

Table 8.1

8.101 This treatment recognises that the bonus equity provisions deal with the effect of bonus issues and it is inappropriate to allow the DVS rules to also apply. For example, in cases covered by the second of the items in the first dot point in paragraph 8.99, it would be inappropriate to allow further uplifts under the DVS rules as the cost bases of such interests have been marked to market value under the bonus equity provisions. Further rules will be included in a later bill to deal with direct value shifts between the original and bonus equities of different affected owners.

8.102 In all other cases, not covered in paragraphs 8.99 or 8.101, the DVS rules and bonus equity provisions will apply together. For example, if the bonus equity is a dividend, Subdivision 130-A includes the amount of the dividend in the cost base of the bonus equity. The cost base of the bonus equity when issued is then taken to be the payment the issuing entity receives for the issue of the bonus equity (except if the issuing entity is a corporate unit trust or public trading trust), for the purpose of working out if the bonus equity was issued at a discount. If this payment is less than the market value of the bonus equity when issued it will be an equity interest issued at a discount in terms of the DVS rules. The DVS rules can then apply if the other requirements of those rules are met. [Schedule 15, item 1, section 725-150]

8.103 A similar analysis flows where section 6BA applies to bonus shares that are dividends. If Subdivision 130-A and section 6BA apply to the same bonus share, the greater of the cost base and consideration worked out under those provisions is used to work out if the bonus equity was issued at a discount. [Schedule 15, item 1, subsections 725-150(4) and (5)]

Consequences of a direct value shift

Flow of value shifts

8.104 Earlier it was noted that DVS rules proceed on the basis that there is a direct value shift between each down interest and each up interest under a direct value shift. [Schedule 15, item 1, subsection 725-160(3)]

8.105 This is shown in Diagram 8.3.

Diagram 8.3: Flow of value shifts

8.106 The direct value shift from a down interest to one of a number of up interests is taken to be a fraction of the value shifted (i.e. decrease in market value) from the down interest under the scheme. The fraction is the market value increase of the up interest because of the direct value shift over the total increase in market value of all up interests under the scheme. [Schedule 15, item 1, subsection 725-160(3)]

Which shifts in value between interests are affected?

8.107 Diagram 8.3 shows the shifts in value that can occur. Of these shifts in value, the DVS rules are concerned only with shifts between down and up interests that are owned by affected owners. That is, the provisions do not deal with value shifted to or from entities that are not affected owners ( third parties in the diagram). [Schedule 15, item 1, section 725-250, items 9 and 10 in the table and section 725-335, items 10 and 11 in the table]

8.108 Entities that are not affected owners are not likely to have been actively involved in the direct value shift, or associated with entities controlling the target entity during the period of the scheme. It is not appropriate for value shifts to, or from, the interests of non-affected owners to be covered by the DVS rules.

8.109 Table 8.2 sets out direct value shifts that are covered by the DVS rules. [Schedule 15, item 1, sections 725-250 and 725-335]

Table 8.2: Shifts in value covered by the DVS rules

8.110 Items 1 to 5 and 9 represent all of the direct value shifts that can occur involving a controller. The 3 cases are direct value shifts:

•

between a down and up interest of the controller (item 1);

•

from a down interest of the controller to an up interest of an associate of the controller, to an associate of an associate of the controller, or to an active participant (items 2 to 4); and

•

to an up interest of the controller from a down interest of an associate of the controller or from an active participant (items 5 and 9).

8.111 These 3 shifts of value are covered by the DVS rules and will be considered later. The positions of associates of a controller and active participants, viewed from their own perspectives, are similar to that of the controller.

8.112 The consequences for down and up interests of affected owners depend upon a number of factors. The 2 main factors are:

•

the owners of the interests that the value shifts between; and

•

the character or tax character (e.g. asset held on capital account, trading stock or revenue asset) of the interests.

Diagram 8.4: Treatment of interests under the DVS rules

What happens to the interests of affected owners that are involved in a DVS scheme?

8.113 The DVS rules change the adjustable values of each down interest and up interest of affected owners to take account of the market value decreases and increases that happen under the scheme. Without such changes, inappropriate losses and gains can be made when these interests are realised.

Example 8.6

Ken holds the 4 shares on issue in Cart Co on capital account. Ken acquired them post-CGT. Two shares are class A and the others are class B. Ken causes Cart Co to vary the rights of the A class shares so that their market value decreases. The market value of the B class shares increase because of what Ken and Cart Co did.

The relevant attributes of each share are:

Type of share	Adjustable value (cost base/ reduced cost base)	Market value before the rights changed	Market value after the rights changed
Class A share	$100	$150	$50
Class B share	$200	$250	$350

If Ken were to sell one of his A class shares in Cart Co after the value shift, he would make a capital loss of $50. This is inappropriate because there is no economic loss of $50 to Ken. The value has been shifted to other interests held by Ken.

On the other hand, if Ken sold one B class share, he would make a capital gain of $150. Of this gain, $50 does not represent an economic gain. This again is inappropriate.

From an economic point of view, an appropriate result is only possible if the matching gains and losses occurred at the same time. This will often not be the case under a realisation-based tax system. The DVS rules deal with value shifts such as these.

Changes to adjustable values

8.114 Changes are made to the adjustable values of interests regardless of when the affected owner acquired them. That is, the adjustable values of interests acquired before, on, or after 20 September 1985 are changed. The adjustable values of pre-CGT interests are adjusted because they may be relevant in some other places in the ITAA 1997(e.g. section 165-115F in Subdivision 165-CC requires notional capital gains and losses to be calculated for all CGT assets, or in section 115-45 of the capital gains provisions). [Schedule 15, item 1, subsection 725-240(7)]

8.115 Increases are made to the adjustable values of up interests that are primary or secondary loan interests. It would rarely occur that the market value of a loan would exceed its face value as a result of a value shifting scheme. But it is possible, for example, if a scheme involves increasing the interest rate on a loan to well above what would be a market rate for an equivalent loan. It is also conceivable that there could be an increase in the market value of a loan if the loan was worth less than face value immediately before the shift.

Taxing events

8.116 Taxing events that generate a gain can arise where value is shifted out of certain affected owners down interests under a direct value shift. Such taxing events happen to each down interest individually. [Schedule 15, item 1, section 104-240, paragraphs 725-310(1)(c) and 725-320(1)(c)]

Relevance of who owns the interests

8.117 The ownership of down interests and up interests is relevant in determining the consequences for those interests under the DVS rules.

8.118 A direct value shift between a down interest and an up interest of the same character (asset held on capital account, trading stock or revenue asset), and owned by the same affected owner, is generally treated in a different way from a shift from that owners down interest to an up interest of another affected owner. A shift in value between the same affected owners interests that have different characteristics (e.g. revenue asset down interest to a trading stock up interest) is also treated differently.

What cases receive disposal and roll-over treatment?

8.119 If value is shifted between down interests and up interests of the same character, and these are owned by the same affected owner, roll-over treatment (i.e. effectively transfer of some adjustable value) happens. Changes are made to the adjustable values of the owners interests and there are no taxing events generating a gain. Roll-over treatment ensures that inappropriate gains or losses do not arise when these interests are later realised.

8.120 Roll-over treatment is appropriate as the affected owner maintains ownership of the value shifted (which keeps its character) from its down interest to its up interest. The decrease and increase in the market values (or discounts given) of the affected owners interests in the target entity reflect the direct value shift and the interests adjustable values are changed correspondingly.

8.121 Effective disposal treatment applies to all direct value shifts between down interests and up interests that do not receive roll-over treatment. The most common examples are where:

•

value shifts between a down interest and an up interest owned by an affected owner, and the interests have different characteristics;

•

a down interest is owned by an affected owner and value is shifted to an up interest of another affected owner; or

•

an up interest is owned by an affected owner and value is shifted to that interest from another affected owners down interest.

8.122 Disposal treatment changes the adjustable values of relevant interests in a similar way to roll-over treatment, except that uplifts may be higher to reflect the fact that value has already been taxed. In addition, taxing events generating a gain can happen. No losses are deemed to arise as a result of a direct value shift.

When roll-over treatment does not apply?

8.123 There are a number of situations where roll-over treatment does not apply to direct value shifts between down and up interests that are owned by the same affected owner.

8.124 One of these situations is where an affected owner owns down and up interests of different characters (e.g. some shares are held as capital assets and some are held as trading stock) and value is shifted between them.

8.125 In these cases, the character of the value shifted can be changed (e.g. revenue gains can be converted to discounted capital gains). It is appropriate to bring to account any gains on the transfer ( disposal treatment). [Schedule 15, item 1, section 725-245, items 2 and 3 in the table and section 725-335, items 2 and 4 in the table]

What is disposal treatment?

8.126 How reductions are made to the adjustable values of down interests under the disposal treatment depends on whether there is a pre-shift gain or loss on the down interest. [Schedule 15, item 1, subsection 725-210(1)]

8.127 A down interest has a pre-shift gain if its market value is greater than its adjustable value, immediately before the decrease time. Similarly, there is a pre-shift loss if the market value of the down interest is the same as, or less than, its adjustable value immediately before the decrease time. [Schedule 15, item 1, subsections 725-210(2) and (3)]

8.128 It is necessary to work out if there is a pre-shift gain or loss on an interest using both its cost base and reduced cost base as the adjustable value. This is so that appropriate reductions can be worked out for the cost base and reduced cost base adjustable values of a down interest. For example, if the pre-shift market value of the down interest is less than the cost base of the interest, but greater than its reduced cost base, there will be a pre-shift loss relevant to the cost base and a pre-shift gain for reduced cost base [Schedule 15, item 1, paragraphs 725-240(6)(c) and (d)] . If the interest is trading stock or a revenue asset, the relevant adjustable values for these attributes must also be used [Schedule 15, item 1, sections 725-315 and 725-325] .

8.129 Disposal treatment ensures that the adjustable value of a down interest with a pre-shift gain is reduced by reference to the proportion of the pre-value shift adjustable value of the down interest that relates to the value shifted from the down interest to an up interest. The amount of the reduction can be thought of as the adjustable value that would have been used in calculating a gain or loss on a direct value shift from a down interest to an up interest if the shift in value were a taxing event at the decrease time. [Schedule 15, item 1, section 725-365, step 3 in the method statement]

8.130 The value shifted from the down interest to the up interest is the proportion of the decrease in market value of the down interest under the value shift to the up interest. The proportion is the increase in market value (or discount given) of the up interest to the sum of the increases in market value of, and discounts given on, all up interests. [Schedule 15, item 1, section 725-365, step 2 in the method statement]

Example 8.7

An affected owner, Alf, has, on capital account, 3 post-CGT down interests of the same class each with a pre-shift adjustable value of $1 million and pre-shift market values each of $2 million. There is a direct value shift of $2 million in total from these interests to a different class of interests, 2 of which are held by another affected owner, Betty, and 2 that are not so held. (These are the only interests on issue). These 4 interests increase in market value from $4 million to $6 million in total (or to $1.5 million each).

The value shifted from the interests of Alf to those of Betty according to step 2 in the method statement in section 725-365 is $1 million.

$2 million (sum of market value decreases) * $1 million (sum of increases for affected owners) / $2 million (sum of increases for all owners).

The notional adjustable value of the value shifted from Alfs interests to Bettys is $0.5 million.

$3 million (sum of Alfs pre-shift adjustable values) * $1 million (value shifted to Bettys interests) / $6 million (pre-shift market value of Alfs interests).

The decrease in adjustable value for each of Alfs down interests would be (step 4 in the method statement) $0.5 million / 3 = $0.166667 million for each interest.

Alf would also have a taxable gain under step 5 of $0.166667 million on each interest (total $0.5 million).

8.131 It is important to note that the market value effect of factors other than those causing the direct value shift need to be disregarded when working out decreases and increases in market values of interests under the scheme. [Schedule 15, item 1, section 725-165]

8.132 Broadly, where there is a pre-shift loss on a down interest, the adjustable value of the interest is reduced on the basis of the value shifted to each up interest [Schedule 15, item 1, section 725-380] . This treatment ensures that pre-value shift losses are not inappropriately removed (as may be the case if the rule for gains , which reduces adjustable value proportionately to the value shifted, were used).

Example 8.8

An interest has a pre-shift adjustable value (reduced cost base) of $600, a pre-shift market value of $400, and a $200 market value is shifted from the interest to that of a different affected owner. The adjustable value (reduced cost base) is reduced by $200 and not by $200 / $400 * $600 = $300. This appropriately preserves the pre-value shift loss on the interest.

8.133 The increase to the adjustable value of an up interest is made taking into account the value shifted to that interest from a down interest. The increases calculated in this way approximate what the value shifted would have cost the affected owner if it acquired the value shifted at its market value. [Schedule 15, item 1, section 725-370, steps 2 and 3 in the method statement and section 725-375, step 2 in the method statement]

Example 8.9

Considering the position of Betty in Example 8.7, and applying the method statement in section 725-375, the value shifted to Bettys interests is $1 million as follows:

Applying step 2: $1 million (market value increases) * $2 million (sum of decreases in market value of down interests) / $2 million (total value of the direct value shift).

The increase in adjustable values for each of Bettys 2 interests is $1 million / 2 = $500,000 (step 3).

8.134 The value shift relevant for working out the increase to the adjustable value of an up interest depends upon whether the sum of the decreases in market value of all down interests because of the scheme is greater than, equal to, or less than the sum of the increases in market value of, and discounts given on, all up interests. [Schedule 15, item 1, section 725-375, step 2 in the method statement]

8.135 Generally, an increase to the adjustable value of an up interest will reflect the increase in market value of the interest because of the direct value shift from a down interest.

8.136 However, the above approach ensures that an increasing adjustment cannot exceed the direct value shift from the down interest. In some cases, the increase can be less than the direct value shift from the down interest.

8.137 This happens where the decreases in market values of the down interests relating to the thing done under the scheme are greater than the increases in market values of, and discounts given on, the up interests. In such cases the increase to adjustable values for the up interest should not exceed the increase in its market value because of the direct value shift.

8.138 It should be noted that an uplift to the adjustable value of an up interest can only be made to the extent that the increase in market value is reflected in the interest at a later time.

8.139 This time varies according to the character of the interest. For example:

•

for an interest held on capital account - the time a CGT event happens to it [Schedule 15, item 1, subsection 725-240(5)] ;

•

for an interest that is held as trading stock:

-

when the interest is disposed of, if it happens in the income year the increase time happens in;

-

at the end of income years where the closing value of trading stock is worked out at cost;

-

when the interest is disposed of in the income year in which the increase time happens, or in a later income year if the closing value of trading stock for the previous year was at cost; [Schedule 15, item 1, subsection 725-310(4)] and

•

for an interest held on revenue account - the time when it is disposed of or otherwise realised [Schedule 15, item 1, subsection 725-320(4)] .

8.140 Taxing events generating a gain can happen in disposal treatment cases where a down interest has a pre-shift gain. This occurs if value is shifted between the interests of different affected owners, or if the interests are owned by the same affected owner but have different characteristics.

8.141 In such cases, the transfer of value from the owner of the down interest is treated as if it were a disposal of the value to the holder of the up interest. Any gains (CGT, trading stock or revenue) are included in assessable income.

8.142 Gains are generally worked out with regard to the difference between the amount of the value shifted and the portion of the adjustable value of the down interest relating to the value shifted. [Schedule 15, item 1, section 725 - 365, step 5 in the method statement]

What is roll-over treatment?

8.143 Reductions to the adjustable values of down interests are made with reference to the proportion of the adjustable value that relates to the value shifted in pre-shift gain cases, and to the value shifted in pre-shift loss cases. This is the same as disposal treatment. [Schedule 15, item 1, section 725-365, steps 1 to 4 in the method statement]

Example 8.10

Returning to Example 8.7, assume that Alf held the interests previously referred to as being owned by Betty, and assume that he held them on capital account and they are post-CGT up interests. The same reduction in adjustable value of Alfs decreased value shares as calculated for the disposal case (to Betty) would occur for the transfer to his other shares. There would, however, be no taxing event because value has simply moved between interests held by the same person.

8.144 How the increase to the adjustable value of an up interest is worked out depends upon whether the down interest from which the value is shifted has a pre-shift gain or not. If the down interest has a pre-shift gain, any increase is with regard to the proportion of the down interests adjustable value that relates to the value shifted [Schedule 15, item 1, section 725-370, step 3 in the method statement] . In pre-shift loss cases, the increase is on the basis of the value shifted [Schedule 15, item 1, section 725-375, step 3 in the method statement] .

Example 8.11

Continuing Example 8.10, the increase to the adjustable value of Alfs shares (that increased in value by $1 million) is calculated using the method statement in section 725-370. The increase in adjustable value is:

Step 2: Notional adjustable value for decreases: $0.5 million.

Step 3: $0.5 million * $3 million / $3 million = $0.5 million.

Step 4: The increase is $0.5 million / 2 = $0.25 million (each).

8.145 Changes to the adjustable values of interests in a pre-shift loss roll-over case will be less than the changes that will arise if the pre-shift gain method is used. This is because in pre-shift loss cases the portion of the adjustable value relating to the value shifted is always greater than the value shifted.

8.146 Allowing changes to be made using the higher amounts will effectively allow unrealised losses to be transferred between interests under the roll-over treatment. [Schedule 15, item 1, section 725-380, steps 2 and 3 in the method statement]

8.147 The detailed Example 8.12 at the end of this chapter covers disposal and roll-over cases.

Effect of the character of the down and up interests

8.148 The consequences of a scheme for down interests and up interests also depends on the character of the interests. That is, on whether they are held solely on capital account, or are trading stock or revenue assets. [Schedule 15, item 1, subsection 725-205(1)]

8.149 The most common case is where all of an affected owners down and up interests are held on capital account at the decrease or increase time (or time of issue) for each interest. For this reason, there are specific rules in the DVS provisions (Subdivision 725-D - see section 725-240) to deal with the CGT consequences for these interests. [Schedule 15, item 1, note to subsection 725-205(2)]

8.150 Separate rules (Subdivision 725-E) exist for the less common situation where one, or more, of the down or up interests of an affected owner are held as trading stock or revenue assets at the decrease or increase time for each interest. These rules deal with the trading stock and revenue asset consequences of the direct value shift for these interests. [Schedule 15, item 1, note to subsection 725-205(2)]

8.151 The DVS rules and tables are structured in this way to help simplify the presentation of the law.

8.152 The rules for interests which are held as trading stock or revenue assets will not be relevant for most affected owners holding down interests or up interests because their interests will be held on capital account.

8.153 Table 8.3 shows when the different rules and tables apply.

Table 8.3: CGT and revenue consequences

where:

•

Your - CGT is an interest of an affected owner that is neither trading stock nor a revenue asset;

•

Your - revenue is an interest of an affected owner that is trading stock or a revenue asset; and

•

Other is another affected owner.

8.154 The character of other affected owners interests are not relevant to how an affected owners (your) interests are dealt with under the DVS rules. This is because direct value shifts to, or from, other owners receive disposal treatment. Character is only relevant for direct value shifts between interests of the same owner in working out if roll-over or disposal treatment should apply.

CGT consequences of the DVS scheme

8.155 Subdivision 725-D contains tables that specify the CGT consequences of the DVS scheme. [Schedule 15, item 1, sections 725-245 and 725-250]

8.156 The tables apply from the perspective of an affected owner ( you ) with a down interest or up interest. One table outlines when to work out changes to adjustable values [Schedule 15, item 1, section 725-250] . Another table outlines when there will be taxing events generating a gain [Schedule 15, item 1, section 725-245] . The methods for working out the changes to adjustable values and the gains are covered in Subdivision 725 F.

8.157 The tables reflect the fact that there can be direct value shifts from a down interest to a number of different up interests under a DVS scheme. The possible direct value shifts that can happen between the interests of affected owners are listed in the table in section 725-250. [Schedule 15, item 1, section 725-250]

8.158 The CGT consequences that can happen are:

•

the cost bases and reduced cost bases of down interests can be reduced;

•

the cost bases and reduced cost bases of up interests can be increased; and/or

•

one or more tax events generating a gain for a down interest.

[Schedule 15, item 1, section 725-240]

8.159 There may be a number of consequences for a down interest or an up interest under a DVS scheme. For example, where there are direct value shifts from an affected owners down interest to its own up interest, and to another affected owners up interest, the adjustable value of the down interest will be reduced with regard to 2 amounts (relating to each of the value shifts).

8.160 There may also be one or more tax events generating a gain for the down interest. Multiple changes to adjustable value and taxing events generating a gain can happen to the same interest under a DVS scheme. The change to the adjustable value is the total of the reductions or increases in such cases. [Schedule 15, item 1, subsections 725-255(2) and (3)]

8.161 As noted in paragraph 8.71, a down interest is only affected by the DVS rules if there is a material decrease in its market value. [Schedule 15, item 1, section 725-70]

8.162 The changes to adjustable values and taxing events generating a gain outlined in the table generally reflect the roll-over and disposal treatments. The relevant treatments where all interests are held on capital account are summarised in Table 8.4.

Table 8.4: Summary of disposal and roll-over treatments

8.163 If the adjustable value of an asset held on capital account is to be changed under these provisions, then both the cost base and reduced cost base of the asset must be adjusted. The table in section 725-250 is applied twice, once on the basis that the adjustable value is cost base and also with the adjustable value being reduced cost base. [Schedule 15, item 1, subsections 725-240(3) and (4)]

8.164 The gain for a taxing event that happens to a down interest that is an asset held on capital account is worked out using the cost base of the asset as the adjustable value [Schedule 15, item 1, subsection 725-240(2)] . Any gain from this taxing event is a capital gain (under CGT event K8, see section 104-240 of the ITAA 1997).

8.165 The timing of changes to adjustable values and taxing events generating a gain are listed in Table 8.5. [Schedule 15, item 1, subsections 104-240(2), 725-240(3) and (4)]

Table 8.5: Timing of changes to adjustable values and taxing events

Consequences for trading stock or revenue assets

8.166 The consequences of a direct value shift between a down interest and an up interest, at least one of which is trading stock or a revenue asset, are dealt with in a similar way to that just discussed for assets held on capital account. The same interest can have a number of adjustable value changes or taxing events. [Schedule 15, item 1, subsections 725-240(1), 725-310(1) and 725-320(1) and section 725-340]

8.167 Ifan interest is trading stock the adjustable values which are changed are the cost base, reduced cost base and Division 70 (ITAA 1997) value or cost of the interest. The Division 70 value or cost of an interest is, at a particular time:

•

its trading stock value at the start of the income year in which the particular time occurs - if the interest was trading stock of its owner since the start of that year; or

•

its cost.

[Schedule 15, item 1, section 725-315]

8.168 For interests that are revenue assets, their cost bases, reduced cost bases and revenue asset costs are relevant. Revenue asset cost is a revenue assets cost at a point in time. It is the sum of amounts that would be subtracted from the gross disposal proceeds in working out any profit or loss that would be made if the revenue asset interest were disposed of at the point in time. This applies for the adjustable values of down interests and up interests whose market value increases because of the direct value shift [Schedule 15, item 1, subsections 725-325(1) and (2)] . The revenue asset cost for up interests issued at a discount is the consideration paid for the interest [Schedule 15, item 1, subsection 725-325(3)] .

8.169 Of the above adjustable values, only the reduced cost base is not relevant in determining if there is a gain from taxing events.

8.170 The table and other rules in section 725-335 deal with direct value shifts between down and up interests, where one or more of the affected owners interests are trading stock or revenue assets. The section deals with the trading stock and revenue asset consequences of the direct value shift. Each possible shift in value between the interests of affected owners is covered. The consequences of each shift are specified. Again, roll-over and disposal treatments apply as appropriate to the different direct value shifts.

8.171 The tables in Subdivision 725-D are still applied to determine the CGT consequences of the direct value shift. There can be different CGT consequences to those outlined in paragraphs 8.155 to 8.165 where one or more of the interests has a revenue asset or trading stock character.

8.172 One of the main differences between the table in Subdivision 725-D and the approach in section 725-335 is the way changes to CGT adjustable values are made for some direct value shifts between the down interests (with pre-shift gains) and up interests of the same affected owner.

8.173 Where all interests are held on capital account, value shifts between CGT down and up interests, which are either both post or pre-CGT assets, get roll-over treatment. [Schedule 15, item 1, section 725-250, items 1 and 2 in the table]

8.174 Where one of these interests is trading stock or a revenue asset there is disposal treatment (for CGT, trading stock and revenue asset adjustable values). [Schedule 15, item 1, section 725-245, items 2 and 3 in the table and section 725-250, item 4 in the table]

8.175 This change to the CGT treatment aligns any CGT and revenue asset gains, which arise from taxing events (section 118-20 of the ITAA 1997 applies to stop the same gain being assessed twice). If this were not done difficulties would arise in tracking when capital and revenue gains are made and by whom. This ensures that the same economic gain is only taxed once.

8.176 Another consequence of CGT disposal treatment applying is that, for pre-shift gain cases, a taxing event will happen where the down interest is trading stock. Section 118-25 of the ITAA 1997 disregards capital gains on trading stock.

8.177 Other differences in CGT treatment arise if there is a direct value shift between an affected owners down interests (that have pre-shift gains) and up interests, both of which are either trading stock or revenue assets. The differences are shown in Table 8.6.

Table 8.6: Subdivisions 725-D and E treatments

8.178 The CGT treatment change for the post-CGT to pre-CGT scenario ensures that the benefit of the roll-over at the revenue level is not removed because a capital gain arises. The approach also aligns the time when any gains will be made.

8.179 In the pre-CGT to post-CGT case, the adjustable values for CGT purposes receive disposal treatment and roll-over treatment is given to the revenue assets adjustable value. This ensures that the pre-CGT gain transferred under the direct value shift is not taxed as a capital gain when the up interest is realised. No taxing event generating a gain arises on the direct value shift itself.

8.180 The adjustable values for trading stock that are changed under the table in section 725-335 are listed in Table 8.7. [Schedule 15, item 1, section 725-315]

Table 8.7: Adjustable values for trading stock changed

8.181 The above values are adjusted by the amounts worked out applying the table in section 725-335. The method for achieving the change to adjustable value where the interest is trading stock is to treat the interest as having been sold and bought back. [Schedule 15, item 1, section 725-310]

8.182 The affected owner is treated as if they had sold the down interest that is trading stock to a third party, at arms length and in the ordinary course of business, for its adjustable value immediately before the decrease time. The owner is then taken to have bought back the interest for its adjustable value, as reduced by the total of the amounts worked out by applying the section 725-335 table. This happens immediately after the decrease time. [Schedule 15, item 1, subsection 725-310(2)]

8.183 A similar method is used to increase the adjustable values of an up interest that is trading stock. No assessable or deductible amounts arise for trading stock purposes as a result of the sale and repurchase. [Schedule 15, item 1, subsection 725-310(3)]

8.184 If there is an earlier direct value shift in the income year that affected the same trading stock interest, the interests adjustable value for the later value shift is its cost (being the reduced or increased adjustable value after the earlier direct value shift). [Schedule 15, item 1, note to section 725-315]

8.185 The method for changing the adjustable values of revenue assets is similar to that for trading stock. One important difference is that the asset retains its character as a revenue asset from the time it is bought back. [Schedule 15, item 1, subsections 725-320(2) and (3)]

8.186 If an item of trading stock or a revenue asset that is a down interest has a tax event generating a gain, the affected owner must include the gain in its assessable income. The gain is assessable income of the year in which the decrease time happens. [Schedule 15, item 1, subsection 725-335(4); Schedule 15, item 1, subsection 725-310(5)]

8.187 Gains are calculated, depending on the character of the down interest, with regard to cost base, Division 70 value or cost and revenue asset cost. Where a capital gain and revenue asset gain arise for the same DVS, section 118-20 of the ITAA 1997 applies to prevent the same amount being taxed twice. A capital gain that arises on a trading stock down interest is disregarded under section 118-25 of the ITAA 1997.

Neutral direct value shifts

8.188 The consequences of a direct value shift between a down and up interest are different for shifts that are neutral for an affected owner.

8.189 This will be the case where the total of the decreases in market value of the affected owners down interests is equal to the sum of the total of the increases in market value of the owners up interests and the total of discounts received by the owner on the issue of up interests to it. [Schedule 15, item 1, section 725-220]

8.190 The consequences change because the tables in Subdivisions 725-D and E are applied as if the only down or up interests that exist are those held by the particular affected owner. This results in the direct value shift only being between that owners down and up interests.

8.191 Under Division 140 of the ITAA 1997 this treatment was only available where the direct value shifts of all affected owners under the DVS scheme were neutral (see section 140-50 of the ITAA 1997). Now this treatment can apply on an affected owner by affected owner basis.

How to work out the amount of changes to adjustable values and gains from taxing events

8.192 Subdivision 725-F contains method statements to work out changes to adjustable values and gains. The nature and type of calculations have already been discussed.

8.193 Increases and decreases to adjustable values and gains must be worked out for each affected interest. A group approach is used to reduce the number of calculations that must be performed in many cases.

8.194 The group approach requires groups of down and up interests with the same attributes to be identified. Relevant attributes that the interests in a group may have include the same adjustable value, the market value of the interests increased or decreased by the same amount under the direct value shift. [Schedule 15, item 1, section 725-365, step 1 in the method statement]

8.195 Where each member of a group has the same attributes, the formulae in the method statements can apply as if there was a direct value shift between one down interest and another up interest. The result of these calculations are then divided by the number of interests in the group to arrive at the relevant amount of adjustment or gain for individual interests. [Schedule 15, item 1, section 725-365, step 4 in the method statement]

8.196 This approach sits somewhere between the previous approaches in Division 19B of the ITAA 1936 (interest by interest approach) and Division 140 of the ITAA 1997 (average effects of the value shift).

8.197 The individual interest approach in Division 19B can result in inaccurate or inappropriate results in some cases, unless calculations are done to several decimal places.

8.198 On the other hand, Division 140 can average the value shift effects over interests whose market values are affected to different extents. The group approach appropriately allows averaging within groups of like interests, and takes account of different market value effects of the direct value shifts between different groups of interests.

Example 8.12

Les is the only controller of XYZ Co, a prosperous and ever-growing firm. XYZ Co was incorporated on 12 February 1988. The share structure of XYZ Co is as follows.

A class shares

There are 50 on issue and they give preferential rights to capital over B class shares. Les has 40 of these. Andrew also has 5 shares and 5 are held by Peter. Andrew has been an associate of Less for many years. Peter has never been an associate of Les or Andrew. Andrew is a trader in shares and his shares are trading stock of his business.

B class shares

There are 100 on issue. Fifty are held by Les and 50 by Peter.

C class shares

These have no rights to capital, but are preferential as to dividends over A and B. There are 10 of these on issue to Les.

Les has always held his shares on capital account. Andrew, Peter and Les all acquired their shares some years ago and still hold them after the share rights are varied.

Les alone causes XYZ Co to vary the share rights attaching to the A, B and C class shares so that their market values alter. The effects of the value shift are not expected to reverse.

The relevant details are as follows:

Type of share	MV pre-shift per share (total)	MV post-shift per share (total)	Adjustable value [F5] per share pre-shift
A class (* 50)	$10,000 ($500,000)	$8,000 ($400,000)	$100
B class (* 100)	$2,000 ($200,000)	$16,000 ($1,600,000)	$100
C class (* 10)	$150,000 ($1,500,000)	$20,000 ($200,000)	$200
Total market values of all shares	$2,200,000	$2,200,000

There is a direct value shiftunder Division 725 because:

•

there is a scheme involving one or more equity interests in XYZ Co;

•

there are decreases in the market value of A and C class shares in XYZ Co that are reasonably attributable to what Les did under the scheme (down interests); and

•

there are increases in the market value of B Class shares in XYZ Co that are reasonably attributable to what Les did under the scheme.

There will be consequences for affected owners of down and up interests in XYZ Co because:

•

XYZ Co is controlled by Les during the scheme period;

•

the effects of the direct value shift will not reverse; and

•

there is a material decrease in the market value of all down interests.

The affected owners , for whom adjustments of adjustable values and taxing events (where relevant) may apply are as follows:

•

Les is an affected owner of down interests (A class shares, C class shares), as he is a controller of XYZ Co during the scheme period;

•

for the same reason, he is an affected owner of up interests (B class shares); and

•

Andrew is an affected owner of down interests as he is an associate of the controller (Les) during the scheme period.

Peter is not an associate of Les, or an associate of Andrew (he is an associate of Les who holds down interests). As the scheme has been implemented by the sole acts of Les, it can be concluded that Peter is not an active participant. Therefore, Peter is not an affected owner, and the up interests and down interests held by him will not be adjusted under Division 725. Adjustments will also not be made for value shifts between the interests held by Les or Andrew and those held by Peter.

Adjustments for down interests held by Les

Only Subdivision 725-D applies here because none of Less interests is trading stock or a revenue asset.

The down interests held by Les (A class and C class shares) will be subject to changes in adjustable value for the value shifted to his up interests (B class shares) (section 725-250, item 1 in the table). As the 2 classes of shares do not have the same adjustable values, a separate application of the method statement in section 725-365 will be required for each group.

For value shifted from Less A class shares:

Value shifted: $80,000 * 700,000 / $1.4 million = $40,000

Notional adjustable value: $4,000 * $40,000 / $400,000 = $400

The decrease to the adjustable value of each of Less A class shares is $10 ($400 / 40 shares). The cost base (and reduced cost base) of each A Class share is reduced by $10 to $90.

For value shifted from Less C class shares:

Value shifted: $1.3 million * 700,000 / $1.4 million = $650,000

Notional adjustable value: 2,000 * 650,000 / $1.5 million = $866.67

The decrease to the adjustable value of each of Less C class shares is $86.67 (866.67 10 shares). The cost base (and reduced cost base) of each C class share is reduced by $86.67 to $113.33.

No CGT event will apply to the shift because these are roll-over cases.

No adjustments will be required for the shift to the B class shares held by Peter, as Peter is not an affected owner under the scheme (section 725-250, item 9 in the table).

Note:

It is important to note that this is not a neutral value shift for Les, as the total increase in market value of interests held by him, (50 * $14,000 = $700,000) does not equal the total decrease in market value of his down interests, ((40 * $2,000) + $1.3 million = $1.38 million).

Reductions to the adjustable value of a down interest are made at the decrease time.

Adjustments for up interests held by Les

As above, only Subdivision 725-D applies here. To work out the adjustment to Less up interests (B class shares), work out the increases for the value shifted from Less A and C class shares, and for the value shifted from Andrews A class shares.

To work out the shift from Less A and C class shares use the method statement in section 725-370.

Notional adjustable values of Less A and C class shares:

($400 + $866.67) * $800,000 / $800,000 = $1,266.67

The increase for each sharewill be $25.33 (i.e.$1,266.67 50 shares).

To work out the shift from Andrews A class shares, the method statement in section 725-375 applies.

Value shifted: $700,000 * $10,000 / $1.4 million = $5,000

The adjustment for each sharewill be $100 (i.e. $5,000 / 50 shares).

Therefore, the cost base (and reduced cost base) of each B class share held by Les is increased by $125.33 ($25.33 + $100) to $225.33.

Adjustments and taxing events for down interests held by Andrew

As Andrews down interests are trading stock, the shift from those interests to the up interests held by Les will have both CGT and revenue consequences (Subdivisions 725-D and E). (As before, there are no consequences under the Division for the shift to up interests held by Peter). This is a disposal case.

CGT consequences

There will be an adjustment to the adjustable value of Andrews A class shares for the shift to Less B Class shares (section 725 -250, item 6 in the table). The adjustment is worked out under section 725-365:

Value shifted: ($10,000 * $700,000 / $1.4 million) = $5,000

Notional adjustable value: ($500 * $5,000 / $50,000) = $50

The decrease to the adjustable value of each of Andrews A class shares is $10 per share ($50 5 shares). The cost base (and reduced cost base) of each of Andrews shares is reduced by $10 to $90.

There is also a taxing event for the shift. The amount of the gain for each share under CGT event K8, worked out under step4 (($5,000 - $50) / 5 shares) equals $990. As the interests are trading stock, the CGT provisions will apply to disregard the gain (refer to section 118-25).

Revenue consequences

Trading stock value adjustments, and a taxing event generating a gain, will apply to the shift (section 725-335, item 7 in the table). The amount of the adjustment, as well as the amount to be included in assessable income are worked out under section 725-365. Applying the method statement, the adjustable value under Division 70 of the ITAA 1997 of each of Andrews A class shares will be reduced $10 to $90, and the amount to be included in assessable income will be $990 (($5,000 - $50) / 5 shares) per share. The gains will be included in the assessable income of the year in which the decrease time happens.

Note:

For trading stock purposes, Andrew will be treated as if he sold each of his A class shares for their pre-shift adjustable value ($100 per share) and repurchased them for their reduced adjustable value ($90 per share). This is the method for adjusting the adjustable values of trading stock under Subdivision 725-E.

The application of the method statement provides the same adjustments (capital and revenue) in this case because the cost base, reduced cost base and Division 70 value are the same. Where this is not the case different adjustments will be made to the different attributes.

All increases to adjustable values of up interests are made to the extent that the increase is reflected in the market value of the interest when a CGT event, or various other things, happen to the interest (e.g. subsection 725-240(5)).

Application and transitional provisions

8.199 The application and transitional provisions are discussed in Chapter 12.

Consequential amendments

8.200 There are a number of consequential amendments. A discussion of these is included in Chapter 12.