Consolidation Reference Manual

C2 Assets

C2-4 Worked examples - cost setting on entry

Entry step A (ACA calculation)

C2-4-242 Determining the amount of a deferred tax liability to be used at ACA step 2, including use of administrative short cuts

Description

This example shows how to work out, for the purposes of subsection 705-70(1A), the amount of a deferred tax liability (DTL) to be used at ACA step 2 where the DTL for the joined group can be assumed to be less than it was for the joining entity. Administrative short cuts are available for this purpose in certain circumstances.

Commentary

Generally the liability to be added at step 2 is the amount that would be recognised in the joining entity's notional financial statement at the joining time, determined in accordance with the entity's accounting principles for tax cost setting. The entity's accounting principles for tax cost setting are the accounting standards or authoritative pronouncements of the Australian Accounting Standards Board, just before the joining time. → subsection 705-70(1), subsection 705-70(3), section 995-1, ITAA 1997.

However, if, in accordance with the joining entity's accounting principles, the amount of the accounting liability of the joining entity would be different when it became an accounting liability of the joined group, the latter amount is treated as the amount of the liability. → subsection 705-70 (1A), ITAA 1997

An example of an accounting liability that would be affected by this rule is a deferred tax liability (DTL).

When determining the value of a DTL, the amount recognised in the notional statement of financial position should be the amount that would have been recognised if the deferred tax assets (DTA) and DTL had not been set off in accordance with AASB112 (previously AASB 1020, AAS 3) 'Income Taxes'.

The purpose of subsection 705-70(1A) is to ensure that the appropriate amount of ACA is allocated to reset cost base assets. Where a head company of a consolidated group acquires another entity to bring into the group, it is assumed that the head company will pay only the market value for the net assets of the entity. In deciding what it is willing to pay, the head company will factor in the value of DTL in the joining entity that will be recognised by the consolidated group at the joining time. Without an adjustment, the resulting higher acquisition price, together with the existing value of DTL in the joining entity, would effectively create a double count in the ACA. By replacing the joining entity's value for DTL with the amount that would be the accounting liability of the joined group, this double counting is negated.

Subsection 705-70(1A) therefore requires the value of the joining entity's DTL when it becomes a DTL of the group to be used at step 2 of the ACA calculation, rather than the DTL included in the joining entity's financial statements immediately before the joining time.

Determining the most accurate value for what will become the DTL of the group may require several iterations of the ACA calculation. For example, the correct amount for DTL to be used at step 2 can be worked out using a process of trial and error. The ACA is first calculated based on a particular value of DTL. This could be the DTL carried by the joining entity before the joining time, or a considered estimate of what that value might be. This ACA amount is then allocated to the reset cost base assets of the joining entity to determine their tax cost setting amounts (TCSAs). This in turn allows an amount for the DTL to be determined for the head company based on the TCSAs. If this new DTL is different to the DTL used in the first ACA calculation, a second ACA calculation is required using the new DTL. This process is repeated until the DTL determined for the head company is the same as that used in the last iteration; that is, until there is no longer any variation in the value of the DTL between iterations. It is this amount of the DTL in the joining entity that becomes the DTL of the joined group, and the amount that should be used for the purposes of ACA step 2.

In view of the compliance costs of such an iterative process, the subsection 705-70(1A) adjustment is not required for transitional entities. For similar reasons, no capital loss needs be worked out where CGT event L7 applies in respect of a DTL for a transitional entity. → sections 701-32 and former 701-34, IT(TP)A 1997; paragraphs 1.156 - 1.162 of the Explanatory Memorandum to Tax Laws Amendment (2004 Measures No. 6) Bill 2004; 'Transitional rules' in C2-1-010

Where subsection 705-70(1A) is relevant, compliance costs may be reduced by applying one of the three administrative short cut methods outlined below. If these short cut methods are not suitable for your circumstances and you would like to use another administrative approach, contact the ATO for guidance.

Administrative short cuts

1.

You can perform two or three ACA iterations and then make an informed judgement to estimate the final result, and then redo the calculation using that estimate, so as to shorten the iterative process required to produce a result.

2.

You can apply a 'materiality' factor to the change in value at each iteration to limit the number of iterations required - i.e., you do not need to do another iteration provided the change in value of the DTL between iterations is 2% or less and less than $1 million dollars → 'Short cut method 2: applying the materiality factor', p. 3.

3.

You can stop the process at any point in the iterative cycle provided the value of the DTL at that point is less than the DTL used in the previous iteration.

The short cut methods are illustrated in Example 1.

In some cases, applying section 705-70(1A) may not require numerous iterations and thus consideration of the short cut methods is not required. See Example 2, where the correct DTL was determined by the second iteration.

Note : In cases where an existing consolidated group acquires all of the membership interests in a joining entity for a price reflecting the full market value of its assets, and it is expected that no adjustment will be needed for over-depreciation, so that no discount has been allowed in the purchase price for DTL of the joining entity, the starting value for DTL in the iterative process could be zero. This should reduce the number of iterations required.

Example 1

Facts

Sub Co is incorporated by head company HCo for $200,000 on 1 July 2004. At that time Sub Co acquires property for $100,000 and a depreciating asset for $100,000. For the year ending 30 June 2005, Sub Co derives accounting income (also assessable income) of $100,000. No dividends were paid. The asset is depreciated 20% for accounting purposes and 50% for tax purposes.

HCo forms a consolidated group with Sub Co on 1 July 2005. Its financial performance and financial position at the joining time is as follows:

Sub Co's franking account has a credit balance on 30 June 2005 of $15,000 (on a tax paid basis, under the Simplified Imputation System). The converted balance is then grossed-up under subsection 705-90(3) to $35,000. After adjusting for hypothetical payments etc. under subsection 705-90(4), the step 3 amount is limited to $35,000.

Sub Co's book value for the depreciating assets is $80,000 and adjustable value is $50,000. In this case the market value of the depreciating asset is equal to its book value at the joining time.

Calculation

The following calculation shows how the value of the DTL to be used at step 2 of the ACA calculation is determined, starting, for convenience, with the joining entity's DTL amount.

This does not match the DTL used in ACA step 2. This amount is used in the next iteration.

After the second iteration the DTL is $3,627. This does not match the DTL used in step 2 in the second ACA iteration. This amount is used in the next ACA iteration.

After the third iteration the DTL is $3,516. This is different to the amount used in ACA step 2 for this iteration, although the difference is gradually reducing. The process is continued until the number does not change.

To the nearest dollar the amount used for DTL at step 2 of the ACA calculation in the 6 ^th iteration is the same as the DTL calculated for the group at the end of the 6 ^th iteration. The correct amount of DTL to be counted at step 2 of the ACA under subsection 705-70(1A) is therefore $3,529. The step 2 amount will be $18,529 ($15 000 + 3,529) and not $24,000 (as in the first iteration).

Applying the short cut methods to Example 1

Short cut method 1: shortening the process by informed judgement

Example 1 demonstrates that the result for the DTL at each iteration will lie between its original value in the joining entity and the first value calculated in the head company. The difference in value between iterations gradually declines until the DTL used in step 2 is the same as the DTL determined for the group. The use of an informed judgement after, say, two or three iterations may reduce the number of iterations required to reach the final result.

In Example 1, after the third iteration you could make the judgement that in the next iteration you will insert a value for the DTL of, say, $3,520. After two more iterations you may want to make another informed judgement of the DTL value to be inserted in the next iteration.

Short cut method 2: applying the materiality factor

The number of iterations can be reduced by applying a materiality factor to the percentage change in DTL between iterations - i.e., you do not need to do another iteration provided the change in value of the DTL between iterations is 2% or less and less than $1 million dollars.

This short cut method is demonstrated using Example 1 in table 15. By iteration 4, the change in the DTL value (i.e., $3,531-$3516 = $15 or 0.43%) is 2% or less and less than $1 million. Therefore, using this short cut, the number of iterations required in this example is limited to four.

Short cut method 3: stopping the process when the DTL is less than the previous iteration

Example 1 demonstrates how the DTL value 'zig zags' between the original value in the joined entity and the first value calculated in the head entity. The change in the value of the DTL becomes smaller with each iteration.

The ATO will accept a value determined by you where you choose to stop at any point in the iterative process, provided the value of the DTL at that point is less than the DTL used in the previous iteration.

For instance, in Example 1, you may choose to halt the process after iterations 1 or 3. If you choose to stop at these iterations the DTL value that you would use at step 2 of the final ACA calculation would be $2,800 or $3,516 respectively.

Example 2

Facts

Head company HCo is the head company of an existing consolidated group. It acquires 100% of the membership interests in Sub Co for $245,500 on 1 July 2003. As a result Sub Co joins the consolidated group. Sub Co's balance sheet is shown in table 16.

Before the joining time, Sub Co paid an unfranked dividend of $15,000 to its holding company. The holding company was entitled to an inter-corporate dividend rebate in respect of the dividend.

Sub Co's book value for the Depreciating Asset is $80,000 and adjustable value is $50,000. In this case the market value of the Depreciating Asset is equal to its book value at the joining time.

Calculation

The following example shows how to work out the value of the DTL to be used at step 2 of the ACA calculation, starting, for convenience, with the joining entity's DTL amount.

This does not match the DTL used in ACA step 2. This amount is used in the next iteration.

This matches the DTL used in ACA step 2. Therefore, in this example, further iterations are not required and the short cuts do not need to be considered.

The final tax cost setting amounts for the reset cost base assets are the amounts as in table 21 - the amounts at the second iteration.

References

Income Tax Assessment Act 1997 , subsections 705-70(1) and 705-70(1A); as amended by

•

New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002 (No. 90 of 2002)

•

Tax Laws Amendment (2010 Measures No. 1) Act 2010 (No. 56 of 2010), Schedule 5, Part 8

Income Tax Assessment Act 1997 , subsections 705-70(3) and 995-1(1) as inserted by Tax Laws Amendment (2010 Measures No. 1) Act 2010 (No. 56 of 2010), Schedule 5, Part 8

Income Tax (Transitional Provisions) Act 1997 , sections 701-32 and 701-34 ; as inserted by Tax Laws Amendment (2004 Measures No. 6) Act 2005 (No. 23 of 2005), Schedule 1, Part 9

Explanatory Memorandum to Tax Laws Amendment (2004 Measures No. 6) Bill 2004, paragraphs 1.156 - 1.162

Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 1) Bill 2010, Chapter 5

History

Revision history

Section C2-4-242 first published 3 December 2003.

Further revisions are described below.

Current at 6 May 2011