House of Representatives

Explanatory Memorandum

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

Chapter 1 - Cost setting rules - consolidated group and linked entities joining, trusts and other rules

Outline of chapter

1.1 This chapter explains the modifications to the cost setting rules contained in Part 3-90 of the ITAA 1997, that were included in the May Consolidation Act and the June Consolidation Bill.

1.2 This chapter explains the modifications to the cost setting rules for:

•

a consolidated group joining an existing consolidated group;

•

multiple entities, linked through membership interests, joining an existing consolidated group;

•

the assets of trusts that join a consolidated group; and

•

the interests that a consolidated group holds in a trust that leaves the group.

1.3 This chapter also explains the measures which address revenue risks arising from the cost setting rules.

Context of reform

Cost setting rules

1.4 The treatment of assets held by entities that join a consolidated group is based on the asset-based model discussed in A Platform for Consultation and recommended by A Tax System Redesigned .

1.5 This model dispenses entirely with the income tax recognition of separate entities within a consolidated group. It treats a consolidated groups cost of acquiring an entity that becomes a subsidiary member as the cost to the group of acquiring the assets of that entity.

1.6 A consolidated groups cost of acquiring an entity includes the cost of acquiring the membership interests in that entity. The cost also includes the liabilities of the entity that become liabilities of the consolidated group. Adjustments are made for retained earnings and losses that accrue to the consolidated groups interest in the entity whilst the consolidated group is acquiring the entity to prevent double taxation of gains and duplication of losses. Generally, these adjustments apply where the group holds some interests in the subsidiary member prior to consolidation. An adjustment is also made by deducting the value to the consolidated group of tax deductions that the consolidated group becomes entitled to because of an entity becoming a subsidiary member.

1.7 The cost setting rules for the basic case of a single entity joining a consolidated group are discussed in Chapter 5 of the explanatory memorandum to the May Consolidation Act. The cost setting rules for the case of a consolidated group forming and special rules on transition are discussed in Chapter 1 of the explanatory memorandum to the June Consolidation Bill.

1.8 A consolidated groups cost for membership interests in a subsidiary member when it leaves a consolidated group is based on the cost to the group for the net assets of the subsidiary. The rules for an entity leaving were discussed in Chapter 5 of the explanatory memorandum to the May Consolidation Act.

1.9 This treatment of the acquisition and disposal of subsidiary members by a consolidated group prevents the double taxation of gains and duplication of losses arising within the group and allows for assets to be transferred between members of the group without requiring cost base adjustments to address value shifting.

Summary of new law

Cost setting rules for a consolidated group or linked entities joining an existing consolidated group

1.10 Where a consolidated group joins another consolidated group, it is recognised that modifications are required to the rules for the basic case of a single entity joining an existing consolidated group. These modifications acknowledge that the consolidated group being acquired is treated as a single entity for income tax purposes.

1.11 Similarly, the basic case rules are modified where multiple entities, which are linked through membership interests join an existing consolidated group because of the acquisition of membership interests by the group in one of the entities. These modifications take into account that the rules need to apply to a number of entities becoming members at the same time.

Cost setting rules for trusts

1.12 Special rules are required to work out the tax cost setting amounts when trusts join or leave a consolidated group. The rules for working out the tax cost setting amount in the basic case does not deal with trusts, which are different to companies in a few respects.

Measures to address unintended tax benefits

1.13 Additional measures prevent, in certain circumstances, a consolidated group receiving unintended tax benefits from the application of the cost setting rules as a result of:

•

the tax values of trading stock receiving an uplift on consolidation;

•

internally generated assets giving rise to periodic tax deductions for the decline in value of the assets where the costs of creating the asset have already been previously allowed as deductions; and

•

the combined application of the current CGT provisions ascribing a market value cost base to membership interests that lose their pre-CGT status, and the consolidation cost setting rules that reset the cost of revenue assets such as trading stock and depreciating assets of an entity that becomes a subsidiary member of a consolidated group.

Detailed explanation of new law

1.14 The new law explained in this Chapter is discussed under the following topics:

•

rules for a consolidated group joining another consolidated group (see paragraphs 1.16 to 1.29);

•

rules for multiple entities, linked through membership interests, joining an existing consolidated group (see paragraphs 1.30 to 1.46);

•

rules for the assets of trusts that join a consolidated group (see paragraphs 1.47 to 1.72); and

•

rules for interests that a consolidated group holds in a trust that leaves the group (see paragraphs 1.73 to 1.86).

1.15 This chapter also explains the measures which prevent unintended and inappropriate tax benefits arising from the cost setting rules (see paragraphs 1.87 to 1.114 and paragraphs 1.118 to 1.181).

Rules for when an existing consolidated group joins another consolidated group

1.16 When an existing consolidated group (the acquiring group) acquires another existing consolidated group (the acquired group) the entities in the acquired group become subsidiary members of the acquiring group. The cost setting amount for the assets is worked out on the basis that, the head company of the acquired consolidated group is treated as a single entity that becomes a member of a consolidated group. This allows the rules for the basic case of a single entity that becomes a subsidiary member of an existing consolidated group to apply as though the head company of the joining group were the only entity becoming a subsidiary member of the group. [Schedule 4, item 4, subsection 705-175(1)]

1.17 In order for the acquired consolidated group to continue to be treated as a single entity up until the time it becomes part of the acquiring consolidated group it is necessary to modify the operation of the core rules in Division 701. This is because under the normal operation of the consolidation rules the acquired consolidated group would break up because the head company, when it becomes a subsidiary member of another group, would cease to qualify to be a head company. This would result in each of the subsidiary members of the acquired consolidated groups being treated as leaving entities and the rules in Division 711 requiring the head company to work out the cost for the membership interests in each of the leaving entities. Each of these entities and the head company would then be treated as joining entities with the consequence that the cost setting rules in Division 705 would be required to be applied individually to each entity. [Schedule 4, item 4, paragraph 705-175(2)(a)]

1.18 Subdivision 705-C therefore operates to reduce compliance costs by simplifying the cost setting rules where an existing consolidated group acquires another by modifying the core rules and the cost setting rules for the basic case of a single entity becoming a subsidiary member so that they apply to treat the acquired consolidated group as a single entity (i.e. there is no break up of the consolidated group prior to it becoming a part of the acquiring consolidated group). [Schedule 4, item 4, paragraph 705-175(2)(b)]

Modifications to the core rules

1.19 The core rules in Division 701 are modified in the case of a consolidated group being acquired by another so that they:

•

ensure that provisions of the core rules which apply where an entity ceases to be a subsidiary member (other than section 701-25 which deals with tax neutral consequences of a head company ceasing to hold assets) will not apply where Subdivision 705-C applies [Schedule 4, item 4, subsection 705-180(1)] ;

•

modify the entry history rule so that in its application to the head company of the acquired group joining the acquiring group the history of the subsidiary members of the acquired group (including those which have previously ceased to be members) is included in the head companys history. The history of those members that have left the acquired group (including history from prior to joining the acquired group) is relevant if the assets, liabilities, or businesses of that entity have been transferred to entities that have not left the acquired group [Schedule 4, item 4, subsection 705-180(2)] ;

•

ensure that in working out the income tax consequences for the head company of the acquired group in the period up to the time it becomes part of the acquiring consolidated group there are tax-neutral consequences from the head company ceasing to hold the assets of the group [Schedule 4, item 4, subsection 705-180(3)] ; and

•

modify the operation of section 701-30 so that it applies to the case of a consolidated group joining another consolidated group to enable the income tax consequences for the period prior to joining the acquiring group to be determined [Schedule 4, item 4, subsection 705-180(4)] .

Modifications to the cost setting rules for the acquiring group

1.20 The cost of acquiring the assets of the acquired group is determined using the same rules that apply in the basic case of a single entity becoming a subsidiary member of an existing consolidated group subject to some modifications. The key principle is that Subdivision 705-A is applied on the basis that the only member of the acquired group that is a joining entity is the head company of the acquired group and that each of the subsidiary members of the acquired group are treated as parts of that head company. [Schedule 4, item 4, section 705-185]

1.21 Modifications to the cost setting rules are made where:

•

the acquired group has over-depreciated assets (see paragraphs 1.24 to 1.26);

•

certain rights and options have been issued by subsidiary members of the acquired group to members of the acquiring group (see paragraph 1.27); and

•

there are employee shares in a subsidiary member of the acquired group or certain rights and options issued by subsidiary members of the acquired group to entities other than the acquired group or acquiring group (see paragraph 1.28).

1.22 A modification is also made to the rules regarding the pre-CGT factors for assets of the acquired group (see paragraph 1.29).

1.23 Amendments are also made to Division 711 (about tax cost setting amounts for membership interests in an entity that leaves a consolidated group) to ensure that the provisions which treat certain membership interests as having been acquired before 20 September 1985, in both a single entity and multiple entity leaving cases, do not apply where a consolidated group is acquired by another consolidated group. [Schedule 4, items 6 and 7]

Adjustment for over-depreciated assets

1.24 Adjustments are required to the rules which restrict the amount that is treated as a cost setting amount for over-depreciated assets (section 705-50). An asset is over-depreciated, at a particular time, if there has been some depreciation (i.e. a reduction in its adjustable value) and its market value exceeds its adjustable value. The policy in relation to over-depreciated assets generally does not recognise the cost for those assets to the extent of the ongoing income tax deferral related to them. This policy is maintained where a consolidated group joins another consolidated group.

1.25 Where a consolidated group acquires another consolidated group the tax deferral that arose because of over depreciation can still be present. This can occur in two situations:

•

the asset was, just prior to the time of the original consolidation, held by the head company of the acquired consolidated group and is over-depreciated at the time that consolidated group is acquired by the acquiring consolidated group; or

•

the asset was brought to the acquired consolidated group by a joining entity where:

-

the asset is still over-depreciated at the time the acquired consolidated group becomes a part of the acquiring consolidated group; and

-

the original unfranked dividends paid prior to the date of the original consolidation were finally paid to an entity which was entitled to the section 46 rebate and was not the head company of the acquired consolidated group or a subsidiary member of that group (see Example 1.1).

1.26 Section 705-50 applies appropriately to the first situation mentioned above without modifications. However, section 705-50 is modified to apply appropriately in the second situation so that it will not apply if the dividend is finally paid to:

•

if the acquired consolidated group existed at that time - a member of the acquired group; or

•

otherwise - an entity that later became a member of the acquired group.

[Schedule 4, item 4, section 705-190]

Example 1.1: Over-depreciated assets

A head company (HC1) and a joining entity (JE) formed a consolidated group on 1 July 2002. The JE had an over-depreciated asset (with a market value of $100 and an adjustable value of nil) on 1 July 2002 and has paid an unfranked dividend of $100 to HC1 prior to 1 July 2002.

The members of another consolidated group (HC2) have always held 60% of the shares in HC1 and on 1 July 2004 acquires the remaining 40% of the shares. HC1 and JE join the consolidated group headed by HC2 on 1 July 2004. At that time the asset is over-depreciated to the extent of $60 (with a market value of $60 and an adjustable value of nil). The unfranked dividend received by HC1 had not been distributed as at 1 July 2004.

The tax deferral of $100 present when JE and HC1 formed a consolidated group will be accounted for when HC1 and JE join the HC2 consolidated group as follows:

•

the over-depreciation has been reduced to $60 by 1 July 2004;

•

when HC1 joins HC2 the amount of the profit that accrued to interests of HC2 and added at step 3 when working out HC1s ACA will not include the dividend paid earlier by JE. This is because section 705-90 only adds profits to the extent that they can be franked; and

•

the amount paid by HC2 for the remaining 40% of the shares in HC1 will include an amount paid for the profits retained by HC1. Consequently, tax paid by the sellers of those shares on the proceeds will account for the balance of the tax deferral.

Adjustment for certain rights and options issued by subsidiary members of the acquired group

1.27 The cost to a consolidated group of acquiring a right or option (issued by an entity) will form part of the cost of acquiring that entity under subsection 705-65(6) in working out the cost of membership interests (step 1 of the ACA). The operation of subsection 705-65(6) in the basic case is modified where a consolidated group joins another consolidated group so that it treats as a membership interest in the head company of the acquired consolidated group a right or option created or issued by a subsidiary member of the acquired group where that right or option is held by a member of the acquiring group. [Schedule 4, item 4, section 705-195]

Adjustment for membership interests or certain rights and options issued by subsidiary members of the acquired group which are held by outside entities

1.28 Modifications are also required to the rules for the basic case to ensure that the step 2 amount (for liabilities) in working out the ACA is increased to treat, the following as part of the cost of acquiring the acquired consolidated group where they are not held by members of either the acquired consolidated group or the acquiring consolidated group:

•

certain employee membership interests in subsidiary members of the acquired consolidated group; and

•

certain rights or options to acquire membership interests in subsidiary members of the acquired group.

These modifications are required to ensure that interests or rights or options that are issued by subsidiary members of the acquired group (and not just those in the head company itself) are appropriately taken into account. [Schedule 4, item 4, section 705-200]

Working out the pre-CGT factor for assets of the acquired group

1.29 The pre-CGT status of membership interests that cease to be recognised when an entity becomes a member of a consolidated group is preserved by working out a pre-CGT factor and attaching this to certain assets of the entity when they become those of the head company. The pre-CGT factor for assets of the acquired group that was worked out when the assets became those of the head company of the acquired group are replaced with new pre-CGT factors determined by the application of section 705-125 to the acquisition of the group by the acquiring group. The pre-CGT factors are therefore worked out by reference to the pre-CGT status of the acquiring groups membership interests in the acquired group. [Schedule 4, item 4, section 705-205]

Rules for when multiple entities linked through membership interests join an existing consolidated group

1.30 When a consolidated group acquires an entity that either alone or together with one or more existing members of the consolidated group owns all of the membership interests (other than disregarded employee share interests) in other entities (the linked entities), all of these linked entities will become members of the consolidated group at the same time. The cost setting rules for this case are contained in Subdivision 705-D.

1.31 This case does not apply where the multiple entities that are linked through membership interests comprise a consolidated group, as the rules relating to a consolidated group joining an existing consolidated group (see paragraphs 1.16 to 1.29) will apply.

1.32 Example 1.2 provides a simple example of multiple linked entities.

Example 1.2

If the Fratton consolidated group acquires all of the membership interests in Portsmouth Co then both Portsmouth and Southampton companies will become members of the consolidated group. Portsmouth Co and Southampton Co in this case are linked entities because they become members of a consolidated group as a result of an event that happens in relation to one of them.

1.33 A modification is made to the provision which excludes the operation of Subdivision 705-A where Subdivision 705-D applies to make it clear that Subdivision 705-D applies where one or more linked entities become subsidiary members of an existing consolidated group at the same time because of an event that happens to one of them. [Schedule 4, item 4, section 705-215]

Modifications to the cost setting rules for the acquiring group

1.34 The cost of acquiring the assets of the acquired group is determined using the same rules that apply in the basic case of a single entity becoming a subsidiary member of an existing consolidated group subject to some modifications. The modifications are required to take account of the existence of multiple entities becoming subsidiary members at the same time. In this regard the modifications are similar to those required where a consolidated group is formed although it is necessary to take account that there are already subsidiary members of the consolidated group in existence at the time the linked entities become subsidiary members. [Schedule 4, item 4, section 705-220]

1.35 Modifications to the cost setting rules are made for:

•

determining the order in which tax cost setting amounts are worked out (see paragraphs 1.37 to 1.39);

•

working out step 4 of the ACA for successive distributions of certain profits (see paragraphs 1.40 to 1.41);

•

taking into account owned losses of certain linked entities (see paragraph 1.42); and

•

adjustments to the tax cost setting amount for certain assets where there has been a loss of pre-CGT status of membership interests in the linked entity (see paragraphs 1.43 to 1.45).

1.36 A modification is also made to the rules for determining the pre-CGT factors for assets of the linked entities (see paragraph 1.46).

Order of application of deemed purchase of linked entities assets

1.37 Where a consolidated group (the joined group) and another entity (the first linked entity) jointly own another entity (the second linked entity) and the joined group acquires the first linked entity such that consequently the second linked entity also becomes a member of the group, it is necessary to first apply the rules for working out the ACA for the first linked entity. This will then set a cost setting amount for those assets, including the membership interests in the second linked entity. The cost setting amount for the membership interests in the second linked entity will then determine the cost base for those membership interests for the purpose of determining the joined groups ACA in relation to the second linked entity and so on . [Schedule 4, item 4, subsections 705-225(2) and (3)]

Example 1.3

Market Garden Co is jointly owned by Sealion Co and a member of a consolidated group (the original member). The consolidated group acquires all of the membership interests in Sealion Co and consequently Market Garden Co also becomes a member of the consolidated group.

First, work out the cost setting amount for Sealion Cos assets, including the membership interests Sealion Co holds in Market Garden Co.

Then work out the cost setting amount for Market Garden Cos assets. For this purpose, part of the cost base of the membership interests in Market Garden Co is determined from the deemed purchase price payment for all of Sealion Cos assets. The other part will be determined from the cost base of the membership interests held by the original member of the consolidated group in Market Garden Co.

1.38 Applying the cost setting rules in a top down manner to membership interests in other linked entities held by a linked entity removes the need for the later operation of the value shifting rules in relation to these membership interests. [Schedule 4, item 4, subsection 705-225(4)]

1.39 Rights and options held by a linked entity, that were created or issued by another linked entity, to acquire membership interests in that other linked entity will be treated as if it were a membership interest in that other entity for the purposes of working out step 1 (cost of membership interests) of the ACA. [Schedule 4, item 4, subsection 705-225(5)]

Adjustments for successive distributions of profits

1.40 A modification to step 4 of the ACA calculation is required where linked entities join a consolidated group to prevent the duplication of reductions in the ACA for distributions that are effectively a return of the cost of acquiring membership interests. This duplication can occur if reductions are made separately for the distributions of the same profits through the linked entities.

1.41 Where there is a reduction to the ACA under step 4 because of a distribution of profits from a linked entity there will not be a further reduction under step 4 for any subsequent distributions of the same profits by other linked entities. [Schedule 4, item 4, section 705-230]

Allocation of ACA to membership interests in linked entities with certain losses

1.42 The rule for the allocation of the ACA to reset cost base assets is modified where a reset cost base asset is a membership interest in a linked entity (the first linked entity) held by another linked entity and the first linked entity has an amount of losses that will be deducted under step 5 in working out the ACA. For the purpose of allocating the ACA, the value to be used for the membership interest in the first linked entity is its market value plus the amount of that membership interests pro-rata share of the losses. [Schedule 4, item 4, section 705-235]

Adjustments to the tax cost setting amount for certain assets where there has been a loss of pre-CGT status of membership interests in the linked entity

1.43 Under measures discussed in detail in paragraphs 1.89 to 1.114 the head companys cost of certain assets are reduced in certain circumstances where the groups membership interests in that entity were previously pre-CGT membership interests. The main provision is section 705-57.

1.44 Section 705-240 is included to modify the operation of section 705-57 where linked entities join a consolidated group. In this case section 705-57 will only apply where the direct membership interests of the head company in a linked entity are modified by the operation of section 705-40. This is because section 705-240 requires that the original cost base of membership interests a linked entity holds in another linked entity is not applied when working out the ACA of the other linked entity. Rather it is the cost base of the direct membership interests of the head company that is applied to arrive at the cost base of membership interests that a linked entity holds in another linked entity. [Schedule 4, item 4, subsection 705-240(2)]

1.45 However, where section 705-57 has applied to the revenue type assets of a linked entity and the head company holds direct membership interests in the linked entity, any membership interests that linked entity holds in another linked entity is also treated as a revenue type asset. Accordingly, the cost of such a membership interest is reduced under section 705-240. The cost base of such membership interests can be reduced below the subsidiary linked entitys terminating value for the interests for this purpose. This reduction in the cost base of membership interests that a linked entity holds in another linked entity is referred to in the law as the notional section 705-57 reduction amount and also applies to membership interests lower level linked entities hold in other linked entities. [Schedule 4, item 4, subsections 705-240(3), (4) and (5)]

Determining the pre-CGT factor for certain assets of the joining linked entities

1.46 If any of the membership interests in an entity that becomes a subsidiary member are pre-CGT assets, the pre-CGT status of those interests is preserved by attaching a pre-CGT factor to certain assets of the subsidiary member at the joining time. A modification is made to the general operation of this rule for retaining the pre-CGT status of certain assets by attaching a pre-CGT factor to assets that underlie pre-CGT membership interests held by members of the joined group. This ensures that the pre-CGT factor is determined by regard to the pre-CGT membership interests of the consolidated group acquiring the linked entities. [Schedule 4, item 4, section 705-245]

Example 1.4

Continuing on from Example 1.3, assume that the membership interests held by Sealion Co and the original member of the consolidated group in Market Garden Co are both pre-CGT assets. Only the pre-CGT membership interests held by the original member of the consolidated group in Market Garden Co are taken into account in determining the pre-CGT factor to be attached to the applicable assets acquired from Market Garden Co.

This is achieved by first determining the pre-CGT factor for the applicable asset of Sealion Co by taking into account the membership interests held by members of the joined group which are pre-CGT assets (in this example, the membership interests are not pre-CGT assets). Secondly, the pre-CGT factor for the applicable assets of Market Garden Co is determined by taking into account the membership interests held by members of the joined group which are pre-CGT assets. As the only relevant membership interests which are pre-CGT assets are those held by the original member of the consolidated group in Market Garden Co, then only the applicable assets acquired from Market Garden Co will have a pre-CGT factor attached to them.

Trusts joining a group

1.47 When an entity joins a consolidated group, the cost base of the groups membership interests in the entity normally forms the core of the ACA that becomes the cost to the consolidated group of the acquiring entitys assets.

1.48 This works well in the case of companies because all membership interests in a company will have a cost base. That is also true of many trusts but not of all. For instance, you might acquire rights that amount to a membership interest in a trust because an amount is settled on a discretionary trust, but not get a cost base for them. Usually, if someone acquires an asset without paying for it, subsection 112-20(1) of the ITAA 1997 will give them a cost base equal to the assets market value. However, that provision does not apply if the asset arises because someone created a right in them (subparagraph 112-20(1)(a)(i) and section 104-35), which is the case with rights arising from a settlement on discretionary trust.

1.49 If the normal cost setting provisions were allowed to apply, the assets of a discretionary trust that joins a consolidated group would get a nil cost base. And that would mean that the proceeds of realising the trust assets, which could have been distributed tax free to the beneficiaries before consolidation, would instead become taxable capital gains of the head company after consolidation. The first amendment to the tax cost setting rules is designed to prevent that outcome.

Example 1.5: Generating taxable gains if no change made

Suppose the normal tax cost setting rules applied to trusts that join a consolidated group and that Amanda settled $100,000 on a discretionary trust, the eligible objects of which were Glennco Pty Ltd and Simonewsky Products Ltd. If the trust bought a block of land with the money, it could sell it at any time and distribute the $100,000 tax free to the companies. CGT event E4 (which usually applies to payments a trustee makes in respect of interests in a trust) does not apply here because the discretionary interests are not considered to be interests in a trust (Taxation Determination TD 97/15).

Now suppose that Glennco and Simonewsky were a consolidated group. When the trust was formed, it would join that group. Because the companies paid nothing for their membership interests in the trust and because the market value rule does not apply in this case, the cost base of their membership interests would be nil. Consequently, the cost base of the land would be nil. If the land were sold for its $100,000 value, the head company would have to include a $100,000 capital gain in its assessable income.

Increasing step 1 of the allocable cost amount calculation

1.50 To avoid that outcome, the first amendment increases the ACA for a trust that joins a group. Step 1 of the ACA calculation is increased by the amount that was settled on the trust independently of the group and that could have been distributed tax free if the trust had not joined the group. That increase will then be pushed down to increase the cost base of the trusts assets.

Example 1.6: Fixing the problem

In the previous example, the zero cost base of the companies membership interests in the trust would be increased by the $100,000 settled by Amanda. That amount would be pushed down to a $100,000 cost base for the land in the head companys hands. Therefore, there would be no capital gain if the land were sold for its $100,000 value.

What membership interests does the modification apply to?

1.51 The increase to the ACA only applies to a membership interest in the trust that, when the trust joins the group:

•

is neither a unit nor an interest in the trust;

•

has no cost base; and

•

only began to be owned because something was settled on the trust.

[Schedule 5, item 6, subsection 713-20(2)]

1.52 The first dot point deals with whether or not the amount could have been distributed tax free. CGT event E4 will treat a distribution from a trust as subject to the capital gains rules if it is made in respect of a unit or interest in a trust. So, the amount could only have been distributed tax free if the membership interest is not a unit and not an interest in a trust. Taxation Determination TD 97/15 explains that an interest as a discretionary beneficiary is not an interest in a trust for the purposes of CGT event E4, so the membership interests of discretionary objects will satisfy this pre-requisite.

1.53 The second and third points require the membership interest to be the result of a gift. That requires that they have no cost base. However, that alone is not enough because, it is possible, there could be a case where the cost base is nil but not a gift (e.g. purchasing for nothing an interest without value). So, the third point requires the membership interest to have arisen because an amount was settled on the trust. Amounts settled by the discretionary object would give rise to a cost base, so would fail at the second point. Effectively then, only amounts settled by someone else will satisfy these requirements.

Example 1.7: Which membership interests are affected by the modification

Eric settles $1 million on trust for Inudex Pty Ltd and White Line Jewellery Pty Ltd in such proportions as the trustee considers appropriate. Inudex is in a consolidated group that later acquires White Line, at which point White Line and the trust join the group.

What the group paid for its interest in White Line will in part be pushed down to form the groups cost base for White Lines membership interest in the trust. Because that membership interest has a cost base, it will not be eligible for the modification.

However, Inudexs membership interest is not an interest in the trust (because it is only a right as a discretionary beneficiary), has no cost base (because it paid nothing to acquire it) and was acquired only because Eric settled the $1 million. Therefore, the modification will apply when working out the ACA for Inudexs membership interest in the trust.

How the modification is worked out

1.54 The modification compares 2 amounts and increases step 1 of the ACA calculation by the lesser of them. [Schedule 5, item 6, subsection 713-20(2), step 5 of the method statement]

1.55 The first amount starts as the sum of all amounts settled on the trust up to the joining time. If an amount was settled as property rather than cash, then its market value at settlement is used. A settled amount is not counted to the extent that it has formed part of the cost base of a membership interest in the trust that step 1 has already counted. For example, an amount settled by the head company to give it a membership interest in the trust would already have been counted under step 1, even though some of that settled amount might be distributed to holders of discretionary membership interests if the trust were brought to an end. [Schedule 5, item 6, subsection 713-20(2), step 1 of the method statement]

1.56 That amount is then reduced to leave just the part that would have been paid to holders of the membership interests that satisfy the pre-requisites discussed in paragraph 1.51 if, at the joining time, the trust had ended by realising all its assets and distributing everything to the beneficiaries. [Schedule 5, item 6, subsection 713-20(2), step 2 of the method statement]

1.57 In most cases this will mean working out how the trustee would have exercised his or her discretion in such circumstances. The trustee can be assumed to do what is most reasonable and further help can be found by examining the terms of the trust deed, the history of past distributions and who controls the trust. This is discussed in more detail in paragraphs 1.84 to 1.86.

1.58 Next, that amount is further reduced by the part of it that would have been included in the beneficiarys assessable income or would have been taken into account in working out the beneficiarys capital gain or capital loss. What is left will be the part of the settled amount that the trustee could have distributed tax free. This amount constitutes the first comparative amount. [Schedule 5, item 6, subsection 713-20(2), step 3 of the method statement]

Example 1.8: The tax free part of the settled amount

Continuing the previous example, we need to work out the modification that applies to the trusts ACA because of Inudexs membership interest.

Step 1 is the $1 million settled on the trust by Eric.

Step 2 requires us to decide how much would have been distributed to Inudex if the trust had ended when it joined the group. In this case, we will assume that half would have gone to Inudex, so step 2 leaves us with $500,000.

Step 3 takes away the part of the $500,000 that would have been included in Inudexs assessable income or formed part of a capital gain or loss. In this case, it would all have been tax free, so the result of step 3 is still $500,000.

1.59 The second amount is compared to the first (explained in paragraphs 1.55 to 1.58), to operate as a cap on the increase in the ACA. That second amount is the total amount settled on the trust either directly by the groups head company or by an entity that is independent of, and unconnected to, the group. Amounts settled as property use their market value at settlement. [Schedule 5, item 6, subsection 713-20(2), step 4 of the method statement]

1.60 Independent and unconnected entities include every entity that is not :

•

a current or past member of the group or an entity that, because of a scheme, may become a member of the group in the future;

•

an entity that was an associate of any such member when it settled the amount;

•

an entity that settled the amount in accordance with the instructions, wishes, etc. of any such member or associate;

•

a partnership that included any such member or associate when it settled the amount; or

•

a company or trust that, when the amount was settled, is controlled by a current, past or future member of the group for value shifting purposes, or would be if all such members and their associates were associates of each other.

[Schedule 5, item 6, subsection 713-20(3)]

1.61 The control for value shifting purposes test refers to the control tests proposed for the GVSR. It essentially treats a company or trust as controlled by another entity that (together with its associates) can control the voting power or the distribution of income or capital of the company or trust. In applying the test here, every current past or future member of the group is treated as an associate of every other such member.

Example 1.9: How the cap works

Wiltord Pty Ltd capitalises Thierry Pty Ltd with $99. Thierry uses the $99 to purchase 99% of the shares in Outsider Pty Ltd. Mrs Hubbard purchases the remaining 1% for $1.

Outsider settles $99 on the Parlour Trust, a discretionary trust whose objects are Wiltord and Thierry.

Wiltord, Thierry and the Parlour Trust then consolidate.

Thierrys $99 ACA is allocated between its assets (the shares in Outsider and the membership interest in the Parlour Trust) in proportion to their market values. The market value of all the shares in Outsider is now $1, so Thierrys shares are worth $0.99. We will assume that the market value of Thierrys membership interest in the Parlour Trust is half of the trusts $99 value, that is $49.50. Therefore, of the $99 ACA, $1.94 would be allocated to the shares and $97.06 to the membership interest in the trust.

So, step 1 of the groups ACA for the Parlour Trust will be the $97.06 pushed down for Thierrys membership interest. Nothing is added for Wiltords membership interest because it paid nothing for it.

The trust modification to step 1 can apply here because Wiltords interest meets the pre-requisites (Thierrys interest does not because it now has a cost base as a result of consolidation). Under the modification, step 1 of the groups ACA will be increased by the lesser of:

•

the total amount settled on the trust that would have gone to Wiltord tax free if it had been distributed; and

•

the total settled either by Wiltord (the head company) or by entities independent of, and unconnected to, the group.

If the second amount was not there as a cap, the step 1 amount for the Parlour Trust would have been increased by $49.50. That would have been the wrong outcome because the groups $99 expenditure would then have produced total asset values of:

$1.94 + $97.06 + $49.50 = $148.50


However, in this case the second amount is nil because all the trust capital was settled by Outsider and Outsider was controlled by a member of the group when it settled the capital. Therefore, step 1 of the groups ACA for the Parlour Trust will stay at $97.06.

Increasing step 3 of the ACA

1.62 The first trust modification to ACA dealt with amounts of trust capital that could have been distributed tax free if the group had not consolidated. The next amendment does the same thing with trust profits that could have been distributed tax free.

1.63 When a company joins a consolidated group, step 3 in working out its ACA increases that amount by the undistributed, but frankable, profits in the company that had previously accrued to the group. These are the only profits that a company could distribute tax free to its shareholders.

1.64 However, trusts cannot frank their distributions, so some proxy is needed to extend the same treatment to trust profits. To do that, the amendment introduces a new step 3 for trusts, except corporate unit trusts and public trading trusts (which can frank their distributions). [Schedule 5, item 6, subsections 713-25(1) and (2)]

1.65 The amount added under step 3 to the ACA for a trust that joins a consolidated group is its realised, but undistributed, profits that accrued to the group before the joining time, except to the extent that:

•

they would have been covered by CGT event E4 if they had been distributed as they accrued (i.e. they would have reduced the cost base of the membership interest concerned or produced a capital gain); or

•

they recouped losses that accrued to the group before the joining time.

[Schedule 5, item 6, subsection 713-25(1)]

Example 1.10: Undistributed profits

Roddy settles $100,000 to create the Fitzwilliger discretionary trust, the eligible objects of which are the companies in the Fitzwilliger corporate group. The trustee purchases a property to rent to tourists. When that group later consolidates, the trust has earned rent of $10,000 that has not been appointed to any beneficiary.

Step 1 of the groups ACA for the trust will be $100,000 because of the trust amendment to step 1. The trustee has a liability to pay income tax of $4,850 on the rent, so the ACA will be increased to $104,850 under step 2.

Under the trust amendment to step 3, the ACA will be increased by $5,150 because that is the trusts realised, but undistributed, profit (i.e. $10,000 - $4,850). The profit would not have been taxed under CGT event E4 if it had been distributed as it accrued to the Fitzwilliger group because it would not have been a distribution in respect of a unit or an interest in the trust.

The total ACA is therefore $110,000. $10,000 of that will be allocated to the cash (a retained cost base asset) and the remaining $100,000 will be allocated to the rental property.

1.66 The profits must be undistributed simply because distributed profits are irrelevant; their status is wholly determined before the trust joins the group.

1.67 Undistributed doesnt mean that the amount must have been physically distributed; a constructive distribution is sufficient. For instance, if a trustee appoints profits to beneficiaries of a discretionary trust but physically retains them, the profits will legally have been distributed, either by way of notional distribution and loan-back to the trustee or by way of settlement on a separate (bare) trust for the appointed beneficiary.

1.68 If the profits have been distributed but loaned back, the trusts ACA will be increased by the liability to repay the loan but that increase will be allocated to the extra cash or other assets the trust has acquired as a result. If the profits have been distributed by settling a separate trust for the beneficiary, the original trusts assets will be unchanged and the new trust will have an ACA equal to the amount settled. In either case, that the profits are not physically distributed will not affect the cost bases of the trusts underlying assets.

1.69 The profits must be realised profits because increasing the ACA for unrealised profits would mean that they could avoid being taxed in anyones hands. Normally, realised profits will already have been subject to tax in the trustees hands and the aim here is simply to prevent them being taxed to the group a second time.

1.70 The requirement for the profits to have accrued to the group maintains the same position for trusts as for companies.

1.71 The first exception mentioned in paragraph 1.65 discounts profits that would have produced a capital gain under CGT event E4 if distributed. This covers the requirement that the distributions could have been made tax free. Since distributions from trusts that have not already been taxed to the beneficiary are usually taxable as capital gains under CGT event E4, the profits that could be distributed tax free by a trust are therefore the amounts not covered by that event. Specifically, they are:

•

distributions not in respect of a unit or an interest in the trust (i.e. distributions to discretionary beneficiaries); and

•

distributions that are in respect of a unit or an interest in a trust but that section 104-71 excludes from calculating the CGT event E4 capital gain (e.g. distributions of amount already taxed to the trustee).

1.72 The second exception mentioned in paragraph 1.65 excludes profits that recoup losses that accrued to the group before the joining time. That maintains the same position for trusts as for companies.

Trusts leaving a group

1.73 As amendments are needed for trusts that join a consolidated group, a few amendments are also needed for trusts that leave a group.

1.74 The general thrust of the tax cost setting rules for an entity that leaves a consolidated group is to work out the tax value of its net assets when it leaves and (with some modifications for deductions, intra-group liabilities and losses) attribute that value to the groups membership interests in the entity. The amount allocated to each interest becomes the groups cost base for the interest.

Cost bases of discretionary interests

1.75 Some membership interests in trusts might have no cost base because they are discretionary interests acquired because an amount was settled on the trust. When such a trust joins a consolidated group, the trust amendment to step 1 will work out an amount equivalent to a cost base for those membership interests (see paragraphs 1.54 to 1.61). If the normal rules were then applied to such a trust when it left the group, the group would acquire a cost base for its interests in the trust simply because it had joined, then left, the group.

1.76 Consolidation would then be a mechanism for generating cost bases for membership interests that would otherwise have no cost base. That could allow the holders of discretionary membership interests in the trust to recognise a loss (e.g. when the trust ended) that was properly a loss of the trust or not even a loss at all.

1.77 That problem is fixed by decreasing the cost setting amount that such a membership interest would otherwise have to nil. The membership interests that qualify are those that:

•

are neither a unit nor an interest in the trust;

•

have no cost base; and

•

only began to be held because something was settled on the trust.

[Schedule 5, items 2 and 3, subsection 711-15(1)]

1.78 These exactly match the interests that qualify for an increase in the ACA when the trust joins a group (see paragraph 1.51).

1.79 The ACA for a trust that leaves a group is still allocated to these interests. The amendment reduces their cost setting amount (and therefore their cost base) to nil only after the allocation. This means that the amount is not allocated to other assets, which would defeat the purpose of the amendment.

Example 1.11: Reducing the cost base of discretionary interests in a leaving trust

Evelyn settles $500 on the Nockwurst Discretionary Trust with Bratwurst Pty Ltd and Metwurst Enterprises Ltd (both companies in the consolidated German Sausages Group) as the only eligible objects. The trust must join the group.

Because the membership interests of Bratwurst and Metwurst qualify under the first trust amendment, step 1 in working out the trusts ACA will be increased from nil to $500. If that is the full ACA, it will be pushed down to form the cost bases of the trusts assets.

A day later, Bratwurst leaves the group, so the trust must leave too. If the tax values of the trusts assets are still $500, that will become the basis for setting the tax costs of the groups membership interests in the trust. Assuming $500 is also the final figure, it would be distributed between the membership interests of Bratwurst and Metwurst. The fourth trust amendment will apply to reduce the tax cost setting amounts to nil because those membership interests are not interests in the trust, had no cost base and only began to be owned because the $500 was settled on the trust.

When the group works out the cost base of its shares in Bratwurst (the next stage) it will start with a nil cost base for Bratwursts membership interest in the trust. The cost base of Metwursts membership interest in the trust will also be nil.

Pre-CGT status of discretionary interests

1.80 When a group has membership interests in an entity that it acquired pre-CGT, the pre-CGT status of those interests is preserved if the entity joins the group. That is done by a mechanism that attaches a pre-CGT factor to the joining entitys assets. If those assets ever leave the group with a leaving entity (not necessarily the entity they came into the group with), their pre-CGT factor is converted into a pre-CGT status for some of the membership interests the group holds in the leaving entity.

1.81 That mechanism is prevented from creating a pre-CGT factor in respect of any pre-CGT membership interest in a joining trust if the membership interest is neither a unit nor an interest in the trust. [Schedule 5, item 1, subsection 705-125(4)]

1.82 That amendment is intended to prevent transferring the pre-CGT status of membership interests in discretionary trusts (that are unlikely ever to be sold) to other, post-CGT, interests that are much more likely to become the subject of a CGT event.

1.83 Where a trust leaves a group, the pre-CGT factor attached to any assets of the trust is prevented from being converted into a pre-CGT status for any membership interest in the trust that is neither a unit nor an interest in the trust. This is the mirror of the rule that applies to such membership interests in trusts that join a group. It ensures that the pre-CGT factor is not wasted by being allocated to membership interests that are unlikely to be subject to a CGT event. [Schedule 5, items 4 and 5, subsections 711-65(8) and 711-70(6)]

Notional distributions by discretionary trusts

1.84 A number of consolidation provisions require you to work out how much would have gone to which beneficiaries assuming that the trustee had distributed an amount. In some discretionary trust cases, this can amount to a difficult exercise in fortune telling.

1.85 The final trust amendment is intended to make that exercise easier. It says that some of the relevant factors that need to be taken into account are:

•

patterns of previous actual distributions; and

•

who controls the trust from time to time.

[Schedule 5, item 6, section 713-50]

1.86 The rule will apply to Part 3-90 of the IT(TP)Act 1997 in the same way as it applies to Part 3-90 of the ITAA 1997. [Schedule 5, item 13, subsection 700-1(2) of the IT(TP) Act 1997]

Measures to address revenue risks

1.87 Three measures were announced in the Minister for Revenue and Assistant Treasurers Press Release C72/02 on 27 June 2002 to ensure that the cost setting rules do not provide unintended tax benefits to groups during transition to consolidation.

1.88 The measures prevent, in certain circumstances, the consolidated group receiving unintended tax benefits as a result of:

•

the tax values of trading stock receiving an uplift on consolidation (see paragraphs 1.123 to 1.130);

•

internally generated assets giving rise to periodic tax deductions for the decline in value of the assets where the costs of creating the asset have already been previously allowed as deductions (see paragraphs 1.131 to 1.174); and

•

the combined application of the current law ascribing a market value cost base to membership interests that lose their pre-CGT status, and the tax cost setting rules that reset the cost of revenue assets such as trading stock and depreciating assets of an entity that becomes a member of a consolidated group (see paragraphs 1.89 to 1.114).

As the first two measures are included in the IT(TP) Act 1997 they are discussed later in the application and transitional provisions section of this chapter.

Membership interests that were formerly pre-CGT assets

1.89 Where there is a change in majority ownership of an entity, Division 149 of the ITAA 1997 (or section 160ZZS and Subdivision C of Division 20 of Part IIIA of the ITAA 1936) resets the cost bases of any pre-CGT assets held by the entity. These assets could include membership interests the entity holds in subsidiaries. However, the values for calculating depreciation, including for the calculation of the full balancing adjustment amount (treated wholly on revenue account under the capital allowance provisions) are not reset; nor are values for trading stock or other revenue assets.

1.90 The effect of consolidation and the resetting of the cost of assets, in circumstances where the cost base of previously pre-CGT membership interests have been increased, would also increase the cost for tax purposes of revenue type assets. This increase would result in an immediate cost to the revenue and the purpose of this measure is to defer this cost to more closely approximate its usage outside of consolidation. The measures apply where an entity joins a consolidated group (see paragraphs 1.91 to 1.101) and when a consolidated group is formed (see paragraphs 1.102 to 1.105).

Application of pre-CGT membership rules on joining a consolidated group

1.91 For this purpose Subdivision 705-A is amended to include section 705-57. This section requires the tax cost setting amount for the head company of certain assets of an entity that becomes a subsidiary member to be reduced, but not below the entitys terminating value for those assets (see section 705-30), in circumstances discussed below, where the groups membership interests in that entity were previously pre-CGT membership interests.

1.92 The certain assets referred to in paragraph 1.91 are trading stock, depreciating assets and other assets that are dealt with under the revenue provisions of the income tax law referred to in this chapter as revenue type assets. [Schedule 3, item 1, subsection 705-57(2)]

1.93 There are three circumstances in which section 705-57 could apply. The first is contained in subsection 705-57(3) which applies where, before the entity became a subsidiary member of a consolidated group the operation of Division 149, or its predecessor (subsection 160ZZS(1) and Subdivision C of Division 20 of Part IIIA of the ITAA 1936), resulted in membership interests that another subsidiary member held in the entity ceasing to be pre-CGT membership interests. [Schedule 3, item 1, subsection 705-57(3)]

1.94 The second circumstance is where a subsidiary member acquired the membership interests in an entity that becomes a subsidiary member from a controlled entity or through a chain of controlled entities and Division 149 or its predecessor had applied previously to the membership interests. The control test is that used in the GVSR. Subsection 705-57(4) operates to prevent subsection 705-57(3) being avoided by disposing of the membership interests to which that subsection would have applied to a controlled entity. [Schedule 3, item 1, subsection 705-57(4)]

1.95 The third circumstance is where Division 149 or its predecessor has never applied to pre-CGT membership interests in an entity however a member acquired those pre-CGT membership interests from a controlled entity or through a chain of controlled entities and as a result the pre-CGT status of the membership interests is lost. [Schedule 3, item 1, subsection 705-57(5)]

1.96 If any of the circumstances referred to in paragraphs 1.93 to 1.95 are met and the tax cost setting amounts worked out under Subdivision 705-A, disregarding section 705-57, for any revenue type assets is greater than the entitys terminating value for that asset then section 705-57 applies.

1.97 In applying section 705-57 it is necessary to calculate and allocate the ACA for the entity twice. The first calculation and allocation of the ACA ignores the application of section 705-57.

1.98 In the second calculation of the ACA only the step 1 amount in the table in section 705-60 is varied. The varied step 1 amount is the cost base and the reduced cost base of the membership interest included in the first calculation of the ACA reduced by the loss of pre-CGT status adjustment amount. The loss of pre-CGT status adjustment amount is the difference between the cost base and reduced cost base of the membership interests just after they stopped being pre-CGT membership interests and the cost base and reduced cost base just before they stopped being pre-CGT membership interests.

1.99 The second calculated ACA is allocated to all of the assets of the entity applying sections 705-20 to 705-55. However if this has the effect of reducing the cost of revenue type assets below the entitys terminating values for those assets their cost is only reduced to the terminating values. In allocating the ACA, the amount allocated to the non-revenue type assets is disregarded and the amount allocated to the revenue type assets is the assets tax cost setting amount.

1.100 The difference between the first allocation of ACA to the revenue type assets and the allocation after applying section 705-57 is the reduction amount which gives rise to a capital loss of the head company. This capital loss is available to be offset against capital gains over a period of 5 income years starting with the income year in which the entity becomes a subsidiary member (see paragraphs 1.110 to 1.114). [Schedule 3, item 1, subsections 705-57(6) and (7) and paragraph 705-57(2)(b)]

1.101 A transitional rule applies in certain circumstances to bring forward the access to the capital loss (see paragraphs 1.175 to 1.181).

Modified application of pre-CGT membership rules on formation of a consolidated group

1.102 Subdivision 705-B is also amended by the inclusion of section 705-163 to modify the application of section 705-57 in the case where a consolidated group is formed.

1.103 On formation of a consolidated group, section 705-57 will only apply where the direct membership interests of the head company in a subsidiary member are modified by its operation. This is because section 705-145 requires that the original cost base of membership interests a subsidiary member holds in another subsidiary member is not applied when working out the ACA of the other subsidiary member. Rather it is the cost base of the direct membership interests of the head company that is applied to arrive at the cost base of membership interests that a subsidiary member holds in another subsidiary member. [Schedule 3, item 2, subsection 705-163(2)]

1.104 However, where section 705-57 has applied to the revenue type assets of a direct subsidiary of the head company, any membership interests that subsidiary member holds in other subsidiary members is also treated as a revenue type asset and reduced in order to apply section 705-57 to the revenue type assets of that subsidiary member. The cost base of the membership interests can be reduced below the entitys terminating value for the interests for this purpose. This reduction in the cost base of membership interests that a subsidiary member holds in another subsidiary member is referred to as the notional section 705-57 reduction amount and applies as well to membership interests that lower level subsidiary members hold in other subsidiary members. [Schedule 3, item 2, subsections 705-163(3) to (5)]

1.105 Section 705-57 is also modified on formation to ensure that it does not apply where, prior to the formation time, the head company has acquired membership interests in an entity and as a result of that acquisition Division 149 or its predecessor applied to membership interests that the entity held in a subsidiary entity and those membership interests are later transferred with rollover relief to the head company. Section 705-57 should not apply in this circumstance because the head company has paid market value for the indirect membership interests in the entity. If those interests had been acquired directly by the head company Division 149 would not have resulted in an increase in the cost base of the membership interests. For this modification to apply the following conditions must be satisfied:

•

at the formation time the head company holds all of the membership interests in the subsidiary member;

•

except for this modification, subsection 705-57(6) would result in the application of an adjustment amount in the circumstances covered by subsection 705-57(4); and

•

the head company acquired membership interests in an entity for market value, and that entity transferred previously pre-CGT membership interests in the subsidiary member to the head company with rollover relief. The acquisition of membership interests by the head company must be from an entity where the head company did not control the vendor or vice versa and both were not under common control.

[Schedule 3, item 2, subsection 705-163(6)]

Interaction with CGT provisions: loss of pre-CGT status of membership rules

1.106 As a result of the reduction under section 705-57 (see paragraphs 1.97 to 1.99), when a revenue type asset is later sold, the head company may incur a tax liability that is higher than it would be if section 705-57 did not apply. This is because the ACA that is available for those assets at the joining time is less than it would otherwise have been. In recognition of this result, a capital loss equal to the reduction under section 705-57 is allowed to the head company.

1.107 The capital loss arises as a result of CGT event L1 happening. CGT event L1 happens just after the entity becomes a subsidiary member of the group [Schedule 3, item 6, subsection 104-500(2)] . This is to ensure that the capital loss that arises may be included in the head companys tax return.

1.108 The capital loss is calculated with reference to consolidation concepts contained in Part 3-90 of the ITAA 1997. This is because the concepts of capital proceeds and cost base are not relevant when determining the tax cost setting amount for an asset [Schedule 3, item 3] . The references to cost base and reduced cost base in section 705-57 are only relevant at the time the pre-CGT assets become post-CGT assets, this event occurring before the entity that becomes a subsidiary member becomes a part of the head company of the consolidated group.

1.109 The amount of the capital loss is equal to the reduction amount calculated under section 705-57 (see paragraphs 1.97 to 1.99) [Schedule 3, item 6, subsection 104-500(3)] . That capital loss is used to calculate the head companys net capital loss for the income year in which the entity that becomes a subsidiary member joins the group. However, the head company is only able to utilise 1/5 of the CGT event L1 capital loss each year, over 5 years.

Spreading the capital loss over 5 years

1.110 The capital loss made under CGT event L1 is spread over the 5 income years, starting in the income year in which the entity becomes a subsidiary member of the consolidated group. In each year the head company is entitled to use up to 1/5 of the entire CGT event L1 capital loss [Schedule 3, item 6, subsections 104-500(4) and (5)] . In certain circumstances, there are transitional provisions that allow the capital loss to be claimed earlier (see paragraphs 1.175 to 1.181).

1.111 The head company may make both a net capital gain and a net capital loss in the year the entity joins the consolidated group or the consolidated group is formed as a result of spreading the capital loss over 5 years.

1.112 Generally net capital losses are applied in the order that they are made (see section 102-15 of the ITAA 1997). The CGT event L1 capital loss forms part of the net capital losses for the year in which that event happens. The ordering rule will apply to the net capital losses (which contain CGT event L1 capital losses) even though the ability to use that net capital loss is spread over 5 years.

Example 1.12

The Extreme Sports Group makes the following capital gains and capital losses during the 2005/2006 income year:

Capital gains:	$200,000
CGT event L1 capital loss:	$500,000
Other current year capital losses:	$80,000

The amount of CGT event L1 capital loss available to be used in the year is $100,000. If the head company chooses to use that capital loss together with the other current year capital losses the following will be made by the group in the 2005-2006 income year:

Net capital gain (200,000 - 180,000):	$20,000
Net capital loss to be carried forward:	$400,000

The net capital loss will be a capital loss of the 2005-2006 income year, even though an additional 1/5 of the net capital loss becomes available each year, over the next 4 income years.

If in the 2006-2007 income year the group makes a net capital loss, this net capital loss is used to reduce capital gains of the 2007-2008 income year, before the available net capital losses of the 2005-2006 income year can be applied.

Tracking elements of the groups net capital losses

1.113 In the first 5 years after consolidating, the head company will need to track its use of the following capital losses:

•

net capital losses that form part of the transferred losses that are to be treated as a concessional loss under section 707-350 of the IT(TP) Act 1997;

•

that part of the net capital loss, made in the first year after the entity becomes a subsidiary member, that is attributable to the CGT event L1 capital loss amount that has either not been applied or is not available until a later year; and

•

that part of the net capital loss, made in the first year after the entity becomes a subsidiary member, that was not made under CGT event L1 or forms part of the concessional loss.

1.114 The various capital losses need to be tracked because the head company may not be able to use the entire amount of the available CGT event L1 capital loss or the available concessional loss.

Application and transitional provisions

1.115 The consolidation regime will apply from 1 July 2002.

1.116 This bill introduces transitional provisions that deal with:

•

2 measures to address unintended tax benefits from the cost setting rules:

-

treating certain trading stock as a retained cost base asset; and

-

allowing for reduced or no deductions for the decline in value of certain internally generated assets; and

•

allowing the balance of certain capital losses to be available where the pre-CGT membership interests provisions have applied.

1.117 Following the introduction of these transitional provisions and the transitional cost setting rules contained in the May Consolidation Act and the June Consolidation Bill, the structure of the cost setting transitional provisions will be as outlined in Table 1.1.

Transitional measures to address revenue risks

Determining continuing majority ownership

1.118 Trading stock and certain internally generated assets of an entity will be treated differently upon consolidation where the entity is a continuing majority-owned entity. The reason for this different treatment (i.e. different to the treatment normally provided by Division 705) is to ensure that the cost setting rules do not provide unintended tax benefits to groups on consolidation.

1.119 A continuing majority-owned entity is an entity that was majority owned at all times from the start of 27 June 2002 until the entity became a subsidiary member of a consolidated group (the designated group). [Schedule 9, item 2, subsection 701A-1(1)]

1.120 A person or persons are majority owners of an entity if they are beneficial owners, directly or indirectly through one or more interposed entities, of more than 50% of the market value of all the membership interests in the entity [Schedule 9, item 2, subsection 701A-1(2)] . It should be noted that membership interests do not include debt interests (see section 960-135 of the ITAA 1997 as amended by the May Consolidation Act, when that Act has commenced).

Where an interposed entity is a non-fixed trust

1.121 Where one or more of the interposed entities are not fixed trusts, all of the objects of the trust need to be identified. For the purposes of determining whether majority ownership exists, each of those objects will be treated as if they were beneficiaries of a fixed trust with equal interests in the income and corpus of that trust. [Schedule 9, item 2, subsection 701A-1(3)]

1.122 A trust would be a hybrid trust where the trustee has a discretion as to the application of the trust income or capital but there is at least one beneficiary with a fixed interest in that income or capital which cannot be affected by the exercise of the discretion. Accordingly where a hybrid trust is an interposed entity, the test in subsection 701A-1(3) applies to the extent that there are no fixed interests.

Example 1.13: Working out majority ownership through an interposed hybrid trust

In-the-Middle Trust is a hybrid trust that has one asset, a 100% shareholding in Rookie Co. Top Dog Co and Out-of-the-Way Co are the trusts 2 discretionary objects, and Deputy Co (a wholly-owned subsidiary of Top Dog) holds a 20% fixed interest in the income and corpus of the trust.

Top Dog is a majority owner of Rookie as it is taken to hold, indirectly through interposed entities (being In-the-Middle and Deputy), 60% of the membership interests in Rookie. This is calculated as follows:

•

Top Dog is taken to have a 50% interest in 80% of non-fixed interests in In-the-Middle, therefore providing an indirect interest in Rookie of 40%; and

•

Top Dog has a 100% interest in the 20% fixed interest in In-the-Middle, therefore providing a further indirect interest in Rookie of 20%.

Trading stock as a retained cost base asset

1.123 When an entity becomes a subsidiary member of a consolidated group, its trading stock will generally be a reset cost base asset of that group. However that trading stock will be treated as a retained cost base asset for head company core purposes if that entity was, at the time of becoming a subsidiary member, a continuing majority-owned entity. [Schedule 9, item 2, subsections 701A-5(1) and (3)]

1.124 The purpose of this provision is to ensure that trading stock cannot be given an uplifted tax cost setting amount, thereby preventing unintended tax benefits (in this case, a tax deferral) arising on consolidation.

1.125 Section 705-40 restricts the tax cost setting amount for reset cost base assets that are revenue assets (which includes trading stock) to the greater of the assets market value or its terminating value. Those values effectively ensure a tax neutral result for entity core purposes when an entity becomes a subsidiary of a consolidated group. However a tax deferral will arise if the market value of the trading stock at the time of the entity becoming a subsidiary member exceeds its terminating value as this excess will not have been subject to tax in the hands of the entity prior to consolidation. This is because Division 70 of the ITAA 1997 calculates assessable income or deductions for trading stock by determining the difference between the values of closing and opening trading stock on hand.

1.126 The provision does not apply where a majority interest in the entity was acquired after 27 June 2002 because the cost to revenue from the increased tax value for the trading stock will have been substantially offset by a higher market value of trading stock being reflected in the sale proceeds of vendors of that majority interest.

1.127 Once the tax cost setting amount of the retained cost base asset has been ascertained, that amount reduces the ACA that is available for allocation to the entitys reset cost base assets in accordance with paragraph 705-35(1)(b). The balance of the ACA will then be allocated among the reset cost base assets in accordance with paragraph 705-35(1)(c).

What is the value of the retained cost base asset?

1.128 Generally, trading stock will be a reset cost base asset and like other reset cost base assets, it will have one value which is relevant for entity core purposes and another value for head company core purposes. For entity core purposes the emphasis is, in almost all cases, on ensuring that there is no tax consequence for the entity becoming a subsidiary member of the consolidated group. For trading stock this is achieved by subsection 701-35(4) valuing closing trading stock on hand at a tax neutral amount such as the opening value of trading stock on hand or the amount of the outgoing incurred by the entity in connection with the acquisition of the asset. That value for entity core purposes is generally not relevant for head company core purposes because trading stock, like other reset cost base assets, will be ascribed a new value as a consequence of the allocation of the entitys ACA to each of its assets.

1.129 The value for trading stock that is a retained cost base asset is worked out in accordance with sections 70-45 to 70-70 of the ITAA 1997 immediately before the entity holding the trading stock becomes a subsidiary member of a consolidated group. That time is, or is taken by subsection 701-30(3) to be, the end of the income year. So, where trading stock is a retained cost base asset, this enables the entity to value its trading stock on hand at the end of the income year. [Schedule 9, item 2, paragraph 701A-5(2)(b)]

1.130 Retaining the value of trading stock means that closing value of trading stock on hand immediately prior to consolidation will equal the opening value of the trading stock on hand immediately after consolidation. Consequently, subsection 701-35(4) does not need to apply to ensure that Division 70 does not give rise to any tax consequence for trading stock that remains on hand at the end of the income year preceding consolidation. [Schedule 9, item 2, paragraph 701A-5(2)(a)]

Internally generated assets

1.131 Depreciating assets (including those that are internally generated assets) will generally be treated as reset cost base assets when an entity becomes a subsidiary member of a consolidated group. When this occurs, the ordinary operation of Division 705 will allocate a proportion of ACA to each identified asset that the entity brings into that group. This occurs even though some or all of the costs incurred in creating the asset were deductible. As such, unintended tax benefits may arise where, upon consolidation, the asset is allocated a tax cost setting amount from which the head company can claim a deduction for the decline in value under Division 40 of the ITAA 1997. This unintended benefit represents a risk to the integrity of the consolidation regime.

1.132 The unintended tax benefit is, however, only a timing issue. This is because, but for consolidation, the tax system would not recognise that part of assets cost that has already been allowed as deductions. As the ACA has been allocated to the asset, the head company is entitled to be able to use that ACA, but only to reduce a gain or recognise a loss that arises from the disposal of the asset. It should not be able to use that ACA to give rise to more immediate deductions through deductions for the decline in value of the asset. In that regard, this measure treats the tax cost setting amount allocated to internally generated assets in much the same way as it does for shares or land that are not trading stock.

1.133 Section 701A-10 prevents this unintended tax deferral in certain cases by ascribing a dual cost to these assets upon consolidation:

•

a cost that is used when working out the decline in value under Division 40 and which is based on the entitys terminating value for the asset (which is calculated in accordance with subsection 705-30(3)); and

•

a cost that is used when a balancing adjustment event occurs or if the asset leaves the group with a leaving entity and which is based on the assets tax cost setting amount less any decline in value that has since been calculated.

1.134 Where an internally generated asset is given a dual cost, and a balancing adjustment event occurs for that asset a further deduction will be allowed . The amount of the deduction may further increase a deduction, or reduce or offset an assessable amount, calculated under the balancing adjustment provisions. Alternatively, where the asset leaves the consolidated group with an entity, the groups ACA for the entity will be increased. The amount of the increase is essentially the difference between the sum of the deductions for the decline in value that have been allowed and the sum of those deductions for the decline in value that would otherwise have been allowed.

1.135 The decline in value and balancing adjustments are calculated in accordance with Division 40 of the ITAA 1997.

What is an internally generated asset?

1.136 An internally generated asset is an asset for which more than 50% of the total amount of expenditure incurred in constructing or creating it that were of a revenue nature was claimed as deductions by the entity that constructed or created the asset. It should be noted that the entity that claimed the deductions does not have to have been the continuing majority-owned entity. [Schedule 9, item 2, paragraph 701A-10(1)(d)]

When this rule applies

1.137 An internally generated asset will be subject to reduced deductions for decline in value where:

•

it is a depreciating asset that becomes a depreciating asset of the head company of a consolidated group (because of the single entity rule in subsection 701-1(1)) at the time a continuing majority-owned entity becomes a subsidiary member of that group;

•

it was in existence at the start of 27 June 2002;

•

the continuing majority-owned entitys terminating value for the asset is less than the assets tax cost setting amount; and

•

for each balancing event that occurred for that asset prior to the continuing majority-owned entity becoming a subsidiary member of the group, there was rollover relief under section 40-340 of the ITAA 1997.

[Schedule 9, item 2, subsection 701A-10(1)]

1.138 The rule also applies where the head company disposes of the assets either directly or through the disposal of an entity to a buyer that is a controlled or controlling entity. In those cases, the dual costs mentioned above are worked out in a slightly different manner. The application of this rule is extended to cover these cases so that inappropriate opportunities to access these tax deferral benefits will not arise.

1.139 The rules will however cease to apply when the asset ceases to be held or any other balancing adjustment event occurs in relation to the asset and from that time, the relevant control tests do not continue to be satisfied.

1.140 The reduced deductions for the internally generated assets decline in value , as calculated under Division 40, will also be reduced where the conditions in paragraph 1.137 are satisfied and:

•

the internally generated asset is held by the head company because subsection 701-1(1) applies;

•

the asset is acquired from the head company by an entity and the relevant control tests are satisfied; or

•

the head company ceases to hold the asset because an entity ceases to be a subsidiary member of the group and the relevant control tests are satisfied; or

•

there is a subsequent direct disposal of the asset and the relevant control tests continue to be satisfied in relation to the new holder of the asset.

When the internally generated asset is held by the head company

1.141 When section 701A-10 applies and the asset is held by the head company, deductions for the assets decline in value are determined on the basis that the assets tax cost setting amount is taken to be equal to the continuing majority-owned entitys terminating value for the asset. The terminating value of an internally generated asset is its adjustable value just before joining time (as per subsection 705-30(3)). [Schedule 9, item 2, paragraph 701A-10(2)(a)]

Example 1.14: Head Company working out the decline in value

Melro Co is a continuing majority-owned entity and joins the Glam consolidated group on 1 July 2003. As a consequence, Glam (the head company) is taken to hold Melros internally generated asset.

The tax cost setting amount of the internally generated asset is $200,000, which is greater than the $50,000 adjustable value of the asset in Melros hands immediately before consolidation. (The $50,000 is the assets terminating value.) Assuming the remaining effective life is 5 years, the prime cost method of calculating the decline in value is used, and the asset is used only for a taxable purpose, the Glam Group is allowed a deduction for the assets decline in value of $10,000 for the income year ended 30 June 2004.

1.142 The decline in value will still be calculated for the asset where the continuing majority-owned entitys terminating value for the asset is greater than zero. For this to occur:

•

some of the costs incurred in creating or constructing the asset must not have been deductible because they were capital or of a capital nature; and

•

at least some of those capitalised costs have not already been subject to a decline in value calculation.

1.143 Thus, the assets actual tax cost setting amount, as calculated by Division 705, is disregarded for the purposes of calculating the decline in value that will or may be deductible after accounting for whether or not the asset was used for a taxable purpose.

When the head company ceases to hold the asset

1.144 The head company may cease holding the internally generated asset either through:

•

a direct disposal of the asset to another entity; or

•

the asset leaving the group when the leaving entity ceases to be a subsidiary member of the group.

A direct disposal

1.145 A balancing adjustment event occurs where the asset is sold or disposed of directly by the head company. The balancing adjustment effectively reconciles, at the time of the event, the assets adjustable value for tax purposes with its actual value, and any difference will be an assessable or deductible amount.

1.146 For the reasons noted in paragraph 1.132 the assets actual tax cost setting amount is used to provide the correct reconciliation of adjustable value to actual value of the asset. For the purposes of section 701A-10, this reconciliation is a 2 step process.

1.147 Firstly, a balancing adjustment calculation is made based on what would have been the assets adjustable value if the decline in value was worked out using its actual tax cost setting amount (even though this section prevents some or all of that decline from being deductible).

1.148 Secondly, for the income year in which the balancing adjustment event occurs, a deduction equal to the shortfall (as calculated in paragraph 1.149) is allowed for the head company.

1.149 The amount of the shortfall is the difference between:

•

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment event occurs (as worked out as if the tax cost setting amount was equal to the continuing majority-owned entitys terminating value for the asset); and

•

the deductions that would have been worked out using the internally generated assets actual tax cost setting amount.

[Schedule 9, item 2, subparagraphs 701A-10(2)(b)(i) to (iii)]

Example 1.15: Head Company working out a balancing adjustment

Carrying on from example 1.14, assume the asset was sold to Yay Co for $180,000 on 30 June 2004. Yay is an entity Glam controls for value shifting purposes. At this time, a balancing adjustment event has occurred and Glam records assessable income of $20,000 arising from its balancing adjustment calculation. The balancing adjustment amount is the difference between the assets termination value ($180,000) and its adjustable value just before the event ($160,000 - which is the assets adjustable value worked out using its actual tax cost setting amount of $200,000).

This balancing adjustment overstates the tax relief that was actually provided for the decline in value of the internally generated asset. As such, Glam is also allowed a claw back a deduction of $30,000. This is equal to the difference between the assets actual decline in value allowed as deductions ($10,000, based on the tax cost setting amount for decline in value purposes of $50,000) and the deductions that would have otherwise been allowed ($40,000, based on the actual tax cost setting amount of $200,000).

Accordingly, the net tax effect upon Glam ceasing to hold the asset is a deduction of $10,000.

1.150 This calculation is performed on the basis of deductions that are allowed or would be allowed, as opposed to the amount of the decline in value of the asset calculated, and in doing so, accounts for the fact that the asset may not have been used solely for a taxable purpose.

Where an entity leaves the group with the internally generated asset

1.151 Division 711 applies when an entity ceases to be a subsidiary member of the consolidated group, and as a result the head company is ascribed a cost base for the membership interests it holds in the entity immediately before it leaves the group. The cost base for the membership interests is calculated by pushing up onto those membership interests the values of the assets the entity takes with it when it leaves the group.

1.152 So, where the head company ceases to hold the asset because an entity ceases to be subsidiary member of the consolidated group, the groups ACA worked out under section 711-30 for the leaving entity is increased by the amount of the shortfall calculated under paragraph 1.149. [Schedule 9, item 2, subparagraph 701A-10(2)(b)(iv)]

Where the internally generated asset is acquired from the head company

1.153 Ordinarily the cost of acquiring a depreciating asset will form the basis of calculating its future decline in value for the purposes of Division 40 of ITAA 1997.

1.154 The cost will however be prevented from forming the basis of decline in value calculations where the entity that acquired the internally generated asset (the new asset holder):

•

acquired it from the head company;

•

at the time of acquisition:

-

either the head company or the new asset holder controls (for value shifting purposes) the other; or

-

another entity controls (for value shifting purposes) both the head company and the new asset holder; and

•

the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(3)]

1.155 The assets rollover adjustable value is the internally generated assets adjustable value just before it was acquired from the head company by the new asset holder. That adjustable value is worked out on the assumption that the head company had acquired the asset for an amount equal to the continuing majority-owned entitys terminating value for the asset. [Schedule 9, item 2, subparagraph 701A-10(3)(c)(i)]

1.156 The rollover adjustable value accounts for any second element of cost (such as improvements) and any decline in value that has been calculated by the head company.

1.157 Section 701A-10 does not continue to apply where, at the time the new asset holder acquired the internally generated asset, the assets rollover adjustable value is greater than or equal to the assets cost to the new asset holder [Schedule 9, item 2, paragraph 701A-10(3)(c)] . This reflects the intent of this provision, which is to defer deductions where the deductions for the decline in value of the asset would be greater than would otherwise be permitted by this section. The deductions allowed can never be greater than otherwise permitted where the assets rollover value exceeds the assets cost because as long as the control test is satisfied:

•

subsection 40-65(2) requires, where a depreciating asset was acquired from an associate, the new asset holder to use the same method of working out the decline in value as the associate; and

•

subsection 40-95(4) requires, where a depreciating asset was acquired from an associate, the new asset holder to use the same effective life as the associate.

Calculating the decline in value for the internally generated asset

1.158 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(3) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value. [Schedule 9, item 2, paragraph 701A-10(4)(a)]

Example 1.16: New Asset Holder working out decline in value

Using the facts in example 1.14, Yay Co acquired an internally generated asset for $180,000 on 30 June 2004. At that time, the control test was satisfied and the assets rollover adjustable value ($40,000 = $50,000 terminating value to the continuing majority-owned entity less $10,000 decline in value calculated by Glam) was less than Yays cost of the asset ($180,000).

Therefore, at 30 June 2005, Yay Co calculates its deduction for the assets decline in value as being $10,000. This is because Yay must retain the same effective life determination (noting that at acquisition, 4 years of effective life remained) and the same method for calculating the decline in value (being prime cost).

Calculating the balancing adjustment for the internally generated asset

1.159 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment event occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its actual cost to the new asset holder (even though this section prevents some or all of that decline from being deductible).

1.160 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

•

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value); and

•

the deductions that would have been worked out using the internally generated assets actual cost.

[Schedule 9, item 2, paragraph 701A-10(4)(b)]

Where a new entity acquires membership interests in the leaving entity

1.161 A new entity will acquire membership interests in the leaving entity immediately after that entity leaves the consolidated group. This is because it is that new entitys acquisition of those membership interest which results in subsection 701-1(1) ceasing to apply.

1.162 Section 701A-10 will continue to apply where:

•

an entity (which is referred to as the new asset holder) started holding the internally generated asset because it ceased to be a subsidiary member of the consolidated group;

•

the head company no longer holds all the membership interests in the new asset holder, and so, some or all of those membership interests have been acquired by a third entity (the buyer of the new asset holder);

•

at the time of acquisition:

-

either the head company or the buyer of the new asset holder controls (for value shifting purposes) the other; or

-

another entity controls (for value shifting purposes) both the head company and the buyer of the new asset holder; and

•

the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(5)]

1.163 The assets rollover adjustable value is the internally generated assets adjustable value just before that entity ceases to be a subsidiary member of the consolidated group. The adjustable value which forms the assets rollover adjustable value is based on the assumption that the head company had acquired the asset for an amount equal to the continuing majority-owned entitys terminating value for the asset. This amount accounts for any second element of cost (such as improvements) and any decline in value that has been calculated by the head company. [Schedule 9, item 2, subparagraph 701A-10(5)(c)(i)]

1.164 In this instance, the internally generated assets cost to the new asset holder is its adjustable value worked out on the basis that the decline in value was calculated using its actual tax cost setting amount as determined when the continuing majority owned entity became a subsidiary member of the consolidated group. [Schedule 9, item 2, subparagraph 701A-10(5)(c)(ii)]

Calculating the decline in value for the internally generated asset

1.165 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(5) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value. [Schedule 9, item 2, paragraph 701A-10(6)(a)]

Calculating the balancing adjustment for the internally generated asset

1.166 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its cost to the new asset holder (see paragraph 1.164).

1.167 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

•

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value); and

•

the deductions that would have been worked out using the internally generated assets cost (as per paragraph 1.164).

[Schedule 9, item 2, paragraph 701A-10(6)(b)]

Later acquisitions of the internally generated asset

1.168 Section 701A-10 will also continue to apply to the holder of the internally generated asset regardless of how many times the asset has been disposed of to other entities provided:

•

the control test continues to be satisfied; and

•

the assets rollover adjustable value is less than the assets cost to the new asset holder.

[Schedule 9, item 2, subsection 701A-10(7)]

1.169 For the purposes of subsection 701A-10(7), the new asset holder is the current asset holder because it acquired the internally generated asset from an entity that was the new asset holder under:

•

subsection 701A-10(3) - where the original new asset holder acquired the internally generated asset from the head company;

•

subsection 701A-10(5) - where the original new asset holder held the internally generated asset as a consequence of ceasing to be a subsidiary member of a consolidated group; or

•

subsection 701A-10(7) - because of a previous application of that subsection.

[Schedule 9, item 2, paragraph 701A-10(7)(a)]

1.170 The control test will continue to be satisfied where:

•

an entity whose control (for value shifting purposes) has resulted in the control test being satisfied for each previous instance it has had to be applied for the purposes of section 701A-10; and

•

at the time the internally generated asset was acquired, that same entity:

-

was a party to the acquisition and controls (for value shifting purposes) or was controlled (for value shifting purposes) by the other party; or

-

was not a party to each acquisition but, at the time of the acquisition, controls (for value shifting purposes) the parties to the acquisition.

[Schedule 9, item 2, paragraphs 701A-10(7)(b) and (c)]

1.171 The assets rollover adjustable value is the internally generated assets adjustable value just before the acquisition of the internally generated asset. The adjustable value which forms the assets rollover adjustable value is based on the assumption that every previous new asset holder had acquired the asset for its rollover adjustable value, as worked out under subsection 701A-10(3) (refer paragraph 1.155), subsection 701A-10(5) (refer paragraph 1.163), or subsection 701A-10(7) just before that acquisition took place. [Schedule 9, item 2, subparagraph 701A-10(7)(d)(i)]

Calculating the decline in value for the internally generated asset

1.172 While the new asset holder holds the internally generated asset and the conditions in subsection 701A-10(7) are satisfied, the assets decline in value is calculated on the basis that the asset was acquired by the new asset holder for an amount equal to the assets rollover adjustable value just before that acquisition. [Schedule 9, item 2, paragraph 701A-10(8)(a)]

Calculating the balancing adjustment for the internally generated asset

1.173 A balancing adjustment occurs when the new asset holder ceases to hold the asset or any other balancing adjustment occurs. The balancing adjustment calculation is based on what would have been the assets adjustable value if the decline in value was worked out using its cost to the new asset holder.

1.174 A deduction is also allowed to the new asset holder for the income year in which the balancing adjustment occurs. The amount of the deduction is the difference between:

•

the deductions for the internally generated assets decline in value up to the time when the balancing adjustment occurs (as worked out as if the asset was acquired for an amount equal to the assets rollover adjustable value just before that acquisition); and

•

the deductions that would have been worked out using the internally generated assets cost.

[Schedule 9, item 2, paragraph 701A-10(8)(b)]

Transitional provisions in relation to pre-CGT membership interests

1.175 A transitional provision is inserted into the IT(TP) Act 1997 to allow the group to claim the remaining CGT event L1 capital loss in certain circumstances.

1.176 The rationale for this transitional provision is to address the situation where the subsidiary member is disposed of before the 5 year period for claiming the loss has expired. In this circumstance the remaining CGT event L1 capital loss would not be available to offset the capital gain that could be made on disposal of the subsidiary.

1.177 The transitional provision does not apply to entities acquired after 30 June 2002 because consolidated groups will be aware of the pre-CGT membership interest provisions (i.e. sections 705-57, 705-163 and 705-240).

1.178 The transitional provision will apply where:

•

an entity that became a member of a consolidated group was subject to the pre-CGT membership rules contained in sections 705-57, 705-163 or 705-240 and was wholly-owned by the group at 30 June 2002;

•

that subsidiary member ceases to be a subsidiary of the group before the end of the 5 year period after the L1 CGT event happens; and

•

that subsidiary member leaves the group with all of the assets, other than excepted assets, it held immediately before joining the group.

[Schedule 3, item 8, subsection 701-12(1)]

1.179 If the transitional provision does apply, then the head company is entitled to apply the amount of the unrecouped CGT event L1 capital loss regardless of whether the 5 year period for claiming that capital loss has expired. [Schedule 3, item 8, subsection 701-12(3)]

What is an excepted asset?

1.180 In order to be an excepted asset, the asset must have been both:

•

a minor asset having regard to the size and nature of the business carried on by the head company as a consequence of the single entity rule treating the assets of the subsidiary entity to be assets of the head company; and

•

be disposed of in the ordinary course of that business.

[Schedule 3, item 8, subsection 701-12(2)]

1.181 Regard must be had to the nature and size of the business when determining whether an asset is a minor asset. What may be minor asset in relation to one business may not be a minor asset in relation to another business.

Consequential amendments

Consequential amendments as a result of inserting Subdivision 705-C

1.182 The inclusion of modifications in Subdivision 705-C to the core rules which apply where a consolidated group is acquired by another consolidated group has resulted in the following consequential amendments to provisions included in the May Consolidation Act and the June Consolidation Bill.

1.183 The consequential amendments are:

•

the second sentence of subsection 701-15(1) which refers to Subdivision 705-C is removed [Schedule 4, item 1] ; and

•

the second sentence of subsection 711-5(1) which refers to Subdivision 705-C is removed [Schedule 4, item 5] .

Consequential amendments as a result of the cost setting rules for trusts

1.184 The rules being added to deal with trusts that join or leave a consolidated group require a small number of changes to the existing consolidation provisions.

Informational amendments

1.185 Most of these simply add notes to existing provisions to draw attention to the changes made by the new trust provisions. [Schedule 5, items 8, 10, 11 and 14, notes to subsections 705-65(1), 705-90(1), 705-90(7) of the ITAA 1997; note to subsection 701-30(2) of the IT(TP) Act 1997]

Consequential amendments to step 3

1.186 The provision that works out step 3 of the ACA is not just altered if the joining entity is a trust but wholly replaced by a new provision. That requires minor changes to a number of provisions.

1.187 Section 705-60 lists all the steps involved in working out the ACA for an entity that joins a consolidated group and refers to the provisions that work each step out. An amendment adds a reference to the new provision that will work step 3 out for trusts. [Schedule 5, item 7, item 3 of the table in section 705-60]

1.188 The provision that usually works out step 3 is amended to make clear that it does not apply if the joining entity is a trust (other than a corporate unit trust or a public trading trust). [Schedule 5, item 9, subsection 705-90(1)]

1.189 Section 705-105 refers to the provision that calculates step 3. An amendment adds a reference to the new provision that calculates step 3 for trusts. [Schedule 5, item 12, section 705-105]

Consequential amendments as a result of inserting CGT event L1

1.190 The note after section 100-15 (overview of steps 1 and 2 of calculating a capital gain or capital loss) is up-dated to reflect that the concepts of cost base and capital proceeds are not relevant for CGT event L1. [Schedule 3, item 3]

1.191 The finding tables in sections 102-30 and 104-5 and the rules in relation to choice in section 103-25 of the ITAA 1997 have been amended to highlight to the reader the special rules relevant to CGT event L1. [Schedule 3, items 4, 5 and 7]