Senate

Revised Explanatory Memorandum

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

Chapter 10 - Indirect value shifting

Outline of chapter

10.1 This chapter outlines and explains the scope and operation of the IVS rules in Division 727.

10.2 Division 727 has new rules to regulate the impact of IVS on the tax consequences (mainly capital losses) that may relate to equity and loan interests in affected entities. These proposed rules replace Divisions 138 and 139 of the ITAA 1997.

10.3 Broadly, 'indirect value shifting', in Division 727, refers to a reduction in the value of equity or loan interests in one entity, and an increase in the value of equity or loan interests in another entity, that results from an unequal exchange of value between those entities. This happens when the first entity provides economic benefits to the second entity and receives no economic benefits, or receives economic benefits of less value, in return. The value shift at the interest level is referred to as 'indirect' because the changes in the values of equity or loan interests in the entities reflect the reduced or increased values of the entities themselves. Division 727 focuses on these reflected changes in the value of equity or debt interests.

Context of reform

10.4 Numerous deficiencies in the IVS rules in the ITAA 1997 were discussed in Chapter 29 of A Platform for Consultation . A more comprehensive IVS regime was raised for consideration in that chapter. The key features of that regime were a comprehensive range of realignments in the adjustable values of interests in entities and a loss-focused approach to making those realignments.

10.5 Recommendation 6.16 of A Tax System Redesigned recommended that gains or losses ought not be triggered on indirect value shifts. It was recognised that in many cases, this would lead to inappropriate multiple recognition of gains and losses in the tax system. It was sufficient that gains and losses be recognised when interests were actually realised, provided that tax value realignment occurred.

10.6 A tax value adjustment regime was preferred over other methods for recognising the impact of an indirect value shift because:

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it can be worked out and mostly done at the time of the value shift;

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it is an observable response in a self-assessment environment;

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it removes complications if other transactions occur before realisation; and

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people are familiar with the approach because it is used under the current law.

10.7 Recommendation 6.16 recommended a loss-focused approach be adopted for implementing the changes to tax values. Under a loss-focused approach, adjustments are only made when the value shift reduces the market value of equity or loan interests below their tax values. Adjustments are made to the tax values to the extent necessary to prevent a tax loss or increased tax loss from arising when this occurs.

10.8 The loss-focused approach was thought to achieve the right balance between integrity objectives and containment of compliance costs.

10.9 Proposed new Division 727 gives effect to recommendation 6.16 in the context of the current tax law by providing for adjustments to the adjustable values of equity and loan interests in entities affected by an indirect value shift. It recognises, however, that in some cases the cost of complying with the IVS measures can be reduced by allowing adjustments to be made when interests in entities are realised, rather than at the time of the value shift. Delaying adjustments until interests are realised at a loss may reduce duplication of effort - for example, where more than one IVS has happened - and may eliminate the need for adjustments altogether where, with the lapse of time, an exemption from the IVS rules becomes available, or the interest is not actually realised at a loss.

10.10 Division 727 therefore also introduces a realisation time method of adjustment that may be adopted as an alternative to adjusting the adjustable values of equity and loan interests as at the time of the value shift. Adjustments made using this method must be on a loss-focused basis.

10.11 If the choice is made to adjust the adjustable values of equity and loan interests as at the time of the value shift, Division 727 offers a further choice whether or not to adopt the loss-focused basis. A choice not to apply the loss focus means that the adjustable values of interests must be adjusted regardless of whether the interests would be realised at a loss. Its advantage is that it may allow greater increases to be made to the adjustable values of interests that gained value as a result of the IVS.

Summary of new law

Key parameters and concepts of the Division

10.12 Division 727 addresses IVS that arises in relation to equity or loan interests in companies or trusts.

10.13 IVS arises because of value shifts out of a company or trust to any entity, but usually to another company or trust.

10.14 For the Division to apply , affectedentities must be within a framework of control or, for closely-held companies or trusts, a common ownership test must be met in relation to them. Where one or more of these control or other tests are met, there will be 'affected owners' for the purposes of the Division.

10.15 The Division may require adjustments either to the adjustable values of interests held by affected owners, or to losses or gains arising when the interests are realised. Adjustments are required if the value shift might otherwise lead to inappropriate tax outcomes.

10.16 Broadly, there is an indirect value shift where, under a scheme , entities provide (or fail to provide) economic benefits to each other so that there is an inequality in the market value of benefits provided and received. The Division proceeds on the basis that such transactions and other dealings will have the indirect effect of shifting value from interests in a 'losing entity' to interests in a 'gaining entity'.

10.17 There are no consequences of an indirect value shift if the entities deal at arm's length with each other in relation to providing the benefits.

10.18 This Division does not adjust for tax purposes the values of the economic benefits actually provided by the losing and gaining entity. Those retain their existing values as provided for under the usual income tax and CGT rules. The Division focuses only on the indirect effects of the provision of those benefits.

10.19 A simple example demonstrates the type of IVS with which the Division deals.

10.20 In Diagram 10.1, B Co provides C Co with $25 million more in economic benefits than it receives from C Co in return under a scheme, thereby reducing the value of A Co's interests in B Co and correspondingly increasing the value of A Co's interests in C Co. B Co is a 'losing entity' under the scheme and C Co is a 'gaining entity'.

Diagram 10.1: When does an indirect value shift arise?

10.21 Economic benefits can flow in other directions and have an impact on the value of interests. For example, B Co could provide economic benefits to A Co in return for no economic benefits from A Co, leading to a potential decrease in the value of A Co's interests in B Co.

10.22 The Division addresses the impact of the disparity in economic benefits provided between B Co and C Co in Diagram 10.1 on the interests that A Co has in B Co and in C Co, assuming that A Co satisfies the affected owner tests as referred to in paragraph 10.196.

10.23 Example 10.1 demonstrates more specifically the likely consequences of the Division's operation.

Example 10.1

In the diagram below A Co wholly owns and controls B Co and C Co. The entities are not members of a consolidated group. B Co transfers property with a market value of $180 million to C Co in return for a cash payment of $50 million.

This results in a value shift of $130 million from B Co to C Co. B Co is a 'losing' entity to the extent of $130 million and C Co is a 'gaining' entity to the same extent.

Unadjusted for, the transaction would enable A Co to sell its shares in B Co for a loss of $50 million but defer any increased gain on its shares in C Co by not selling these.

MV = market value

The effect of Division 727 would usually be either to cancel the loss when A Co sells its shares in B Co or to reduce the adjustable value of A Co's shares in B Co to prevent the loss arising (i.e. by reducing their adjustable values to $50 million). Adjustments would usually be made to prevent inappropriate gains arising when A Co sells any of its shares in B Co.

Practical scope of the measures

10.24 An indirect value shift can only result from a scheme involving the provision of economic benefits. The term 'economic benefits' has its ordinary meaning. This is discussed further in paragraphs 10.58 to 10.59.

10.25 The concept of 'scheme' is broad. It does not require a tax avoidance purpose and is defined to mean any arrangement or scheme, plan, proposal, action or course of action or conduct, whether unilateral or otherwise. See the definition of 'scheme' in subsection 995-1(1) of the ITAA 1997.

10.26 Although these concepts are broad, the Division is cast in a way that limits its scope in a practical sense:

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firstly, dealings at arm's length and dealings at market value do not have consequences under the Division;

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secondly, only entities satisfying certain control or common ownership requirements are potentially affected; and

•

thirdly, a wide range of transactions and dealings are excluded from the measures. This ensures the measures are appropriately targeted with a view to identifying only significant and material value shifts, while at the same time containing compliance costs.

10.27 Special attention is paid to services. There are a number of specific safe-harbours for services; and if the provision of services is at least 95% (by value) of the economic benefits involved in a value shift there are consequences under the Division only in limited circumstances.

Arm's length and market value dealings excluded

10.28 It is important to emphasise that the application of the Division can always be avoided by ensuring that entities deal with each other:

•

on an arm's length basis; or

•

by providing benefits at market value.

10.29 There is a rule that allows the adjustable value of depreciating assets that cost less than $1.5 million and for which write-off is available under Division 40 to be chosen as a proxy for their market values. If the value given to an asset in the books of the entity that transfers the asset is higher than the adjustable value, it is used instead. This special rule can also apply to a group of depreciating assets.

Distributions not double counted

10.30 The Division also ensures that there is no double counting of distributions as economic benefits under the IVS rules and under the rules relating to distributions.

10.31 No anti-overlap rule is required when the owners of interests in an entity receive payments of money or other forms of property from the entity in return for giving up their interests or for giving up rights they have as holders of the interests (e.g. a right to a distribution or to a non-assessable payment). This is because the concept of economic benefits provided to an entity is taken to include the ending of an interest in that entity, or the ending of particular rights in relation to an equity interest.

Only certain entities are affected

10.32 The Division only applies to a 'losing' entity that is a company or a trust and there are exclusions for certain superannuation entities. A 'gaining' entity can be any entity, including an individual.

10.33 The Division also requires that the losing and gaining entity satisfy at least one of the following tests:

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an ultimate controller test - one entity must control the other or both must be controlled by the same entity; and

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a common ownership nexus test - broadly, both the losing and gaining entities must be closely-held and there must be at least 80% common ownership between the entities. (Special rules apply where not all interests in an entity are fixed.)

10.34 Widely-held gaining and losing entities are excluded from the Division unless the ultimate controller test is satisfied.

10.35 For compliance cost reasons, entities that are eligible to choose the STS or that would meet the CGT small business net asset threshold ($5 million) do not have to make adjustments under this Division. However, the general anti-avoidance provisions in Part IVA of the ITAA 1936 can still apply to value shifting schemes the sole or dominant purpose of which is to create losses or reduced gains on interests in entities.

Exclusions - automatic

10.36 There are a number of otherexclusions from the need to make adjustments under the Division. The following indirect value shifts have no consequences under the Division:

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by way of a general de minimis exclusion, value shifts of $50,000 or less;

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services provided for at least their direct cost or for not more than a commercially realistic price (but only if the service component of the benefits provided is at least 95% on a market value basis);

•

property transferred for at least the greater of its cost or cost base, provided no affected owner acquired its interest in the losing entity after the property was acquired by it;

•

distributions to members or beneficiaries that have consequences under other provisions of both the ITAA 1936 and the ITAA 1997; and

•

shifts 'down' a wholly-owned chain of entities where there are, for example, no loan interests held in the losing entity that lose value as a result of the shift. (This exclusion does not apply to certain indirect value shifts that involve entities in a consolidated group or a multiple-entry consolidated group.)

Exclusion - for certain services only indirect value shifts under the realisation time method

10.37 A further exclusion is available for value shifts involving the provision of services if the realisation time method for adjusting for value shifts applies (see paragraphs 10.163 to 10.192). Again, the exclusion is available only if the service component of the benefits provided is at least 95% (on a market value basis). Value shifts of this kind are disregarded unless one or more specified events happen or thresholds are exceeded.

10.38 Briefly these events and thresholds are:

•

Another provision of the income tax law has varied an amount (e.g. a deduction claimed) in respect of services in an income tax return lodged by the losing or gaining entity for a year in which an affected owner owned interests in the entity. For example, this may have happened if a determination has been made under Part IVA or Division 13 of the ITAA 1936. The amount of variation must be at least $100,000.

•

An ongoing or recent service arrangement has reduced, or reduces, the value of the losing entity by at least $100,000. In some cases, the safe harbour can be as high as $500,000 for larger entities.

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While an affected owner owned interests in a losing entity that is a group service provider, service arrangements have reduced the value of the entity by a total of at least $500,000.

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Individual or related abnormal service arrangements have reduced the value of a losing entity that is not a group service provider by at least $500,000. The upper limit of the safe harbour is $5 million.

10.39 This exclusion, together with the loss-focused basis of the realisation time method, enables entities to choose not to monitor service related value shifts on an ongoing basis. Only if an interest is realised at a loss will there be a requirement to examine the impact of service-related value shifts, and then only where very significant shifts in value may have occurred while the interest was held.

10.40 Lastly, for entities to which the realisation time method applies, an indirect value shift may have no consequences for a particular affected interest if it happened more than 4 years before the interest is realised, provided the amount of the value shift was less than $500,000.

What are the consequences if the Division does apply

No immediate gains or losses arise - but adjustments for later outcomes

10.41 This Division does not cause assessable gains or losses to arise. It either reduces or increases the adjustable values of equity or loan interests in entities, or (if the realisation time method applies) reduces losses or gains that would otherwise arise. Special rules apply for interests held as trading stock or revenue assets, with the same object in mind.

Realisation time method applies unless adjustable value method chosen

10.42 Adjustments are made according to the realisation time method unless a choice is made to adjust the adjustable values of equity and loan interests just before the IVS time for the scheme. The IVS time is when all the benefits under the scheme can be identified and all the providers and recipients of benefits are in existence and can be identified. If interests are realised before the IVS time, the realisation time method of adjustment must be applied to those interests.

Realisation time method

10.43 Under the realisation time method, adjustments are made in relation to interests held by affected owners when the interests are disposed of or realised in some other way. Because of the loss-focused approach, adjustments are required to interests in the losing entity only if a loss or deduction would arise on realisation of the interests as a result of the value shift. The loss or deduction is adjusted by an amount that is reasonable, having regard to the extent to which the value shift is reflected in the market value of the interest.

Adjustable value method - loss focused or non-loss-focused

10.44 If a choice is made instead to adjust the adjustable values of interests held by affected owners in the losing and gaining entities, all adjustments are made just before the IVS time. A loss-focused approach may be adopted, or alternatively full adjustments may be made to adjustable values regardless of whether a loss or deduction would arise on realisation of the interest at that time. In either case, adjustments to the adjustable values of interests in the gaining entity are limited having regard to the extent of the adjustments made for the losing entity.

10.45 Diagram 10.2 demonstrates the operation of the Division and when it may have consequences for an indirect value shift.

Diagram 10.2: When an indirect value shift has consequences

Detailed explanation of new law

Introduction

What is an indirect value shift?

10.46 An indirect value shift results from the provision of economic benefits by a losing entity to a gaining entity for no consideration, or in return for economic benefits of less market value. Division 727 deals with the effect of this on the market values of equity and loan interests in the losing and gaining entity. The Division only applies to non-arm's length dealings between losing and gaining entities.

Why the value shift is 'indirect'

10.47 The value shift is referred to as 'indirect' because the effect of the unequal provision of economic benefits between entities is likely to be reflected in the market values of interests in those entities.

10.48 The Division proceeds on the basis that transactions and other dealings not carried out at market value will have the indirect effect of shifting value from interests in a 'losing entity' to interests in a 'gaining entity'.

What are the consequences of an indirect value shift?

10.49 If the Division applies, the consequences are either

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adjustments to losses or deductions that arise on realisation of direct and indirect interests in the losing entity, and adjustments to gains or income that arise on direct and indirect interests in the gaining entity; or

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reductions, and sometimes increases, to adjustable values (e.g. cost bases) of direct and indirect equity and loan interests in the losing entity or gaining entity as applicable.

10.50 The effect of these adjustments is, generally, to prevent inappropriate losses arising on decreased value interests because of an indirect value shift, and to relieve inappropriate gains on increased value interests. [Schedule 15, item 1, section 727-95]

No adjustments need to be made by certain entities

10.51 Entities eligible for the STS and entities that would satisfy the CGT small business net asset threshold of $5 million are not required to make any adjustments under this Division. [Schedule 15, item 1, subsection 727-470(2)]

10.52 However, the general anti-avoidance provisions in Part IVA of the ITAA 1936 can apply to value shifting schemes the sole or dominant purpose of which is to create losses or reduced gains on interests in entities.

Determining whether a scheme results in an indirect value shift

10.53 A scheme can result in one or more indirect value shifts if, as at the time when the scheme was entered into, or at a later time, one or more economic benefits have been, are being, or are to be provided in connection with the scheme [Schedule 15, item 1, subsection 727-150(1)] . There may be an indirect value shift if the economic benefits provided by one entity to another entity under the scheme are of greater value than the economic benefits (if any) provided in return.

10.54 Whether there is an indirect value shift is determined at the IVS time for the scheme.

Scheme

10.55 Scheme is defined to mean any arrangement or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. Arrangement means any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings. There are definitions of these terms in subsection 995-1(1) of the ITAA 1997.

10.56 The concept of a scheme is very broad. No tax avoidance purpose is required for the purposes of Division 727. Part IVA may also be attracted in circumstances where the sole or dominant purpose of a value shifting scheme is to cause a loss or reduced gain to be made on an equity or debt interest in an entity.

10.57 For the purposes of Division 727, there can be a scheme to do something that causes a value shift, or a scheme not to do something that, if done, might have prevented a value shift. But a scheme does not include something that happens solely by the operation of normal market forces.

Economic benefits

10.58 Economic benefits are not specifically defined and therefore the term takes its ordinary meaning. Economic benefits are benefits of commercial or economic value to the entity receiving the benefit, in the sense of increasing or maintaining its wealth or value. Examples of economic benefits include, but are not limited to, services performed for an entity's benefit, or the right to have such services performed, or property (including money) receivable, or received, by an entity. [Schedule 15, item 1, section 727-155]

10.59 Economic benefits must be considered and assessed independently of any obligations or liabilities assumed in obtaining the benefits. For example, if a property is acquired on condition that the vendor's liability in respect of it will be progressively discharged, the purchaser receives an economic benefit consisting of the potential use of the property, while also giving an economic benefit to the vendor by way of assumption of the liability.

Economic benefits must be provided

10.60 The meaning of 'provide' an economic benefit includes to allow, confer, give, grant or perform the benefit [Schedule 2, item 73, amendment to definition of 'provide' in subsection 995-1(1)] . A non-exhaustive list of examples of providing economic benefits is included in section 727-155. For example, providing an asset or services to an entity, incurring a liability to an entity, or doing something that increases the market value of an asset the other entity holds are all examples of providing an economic benefit.

Things treated as economic benefits provided

10.61 Division 727 applies as if the ending of a shareholder interest, or interest as a beneficiary of a trust, or the ending of a right or option to acquire such an interest, in an entity were an economic benefit that the owner of the interest provides to the entity. The ending of a right that an owner of such an interest had because of owning the interest is also treated as an economic benefit that the owner of the interest provides to the entity. [Schedule 15, item 1, subsection 727-155(3)]

10.62 Unlike the extinguishment of a liability owed to an entity, the ending of an equity interest in another entity, or the ending of a right arising out of that interest, would not usually be regarded as the provision of an economic benefit to the second entity. The effect of treating it as the provision of an economic benefit is to ensure that the IVS rules do not have inappropriate consequences where, for example, shares are cancelled in an entity or a final dividend that has been declared is paid. A similar rule is not needed for the ending of a loan because that is an economic benefit (a reduction in the amount of a liability) provided to the debtor under ordinary concepts.

Example 10.2

Shares held by X Co in D Co are cancelled in exchange for money equal in amount to the market value of the shares immediately before the cancellation. In this case, X Co provides economic benefits equal in market value to the money provided by D Co. There is no indirect value shift.

Example 10.3

A non-assessable distribution of $10,000 attracts CGT event E4. Provided the non-assessable distribution is equal to the market value of the right the beneficiary has to receive it (which would presumably be the case) there is no indirect value shift between the trust and the beneficiary.

10.63 In this chapter, 'provides' a benefit, is sometimes used as a shorthand expression for 'has provided, is providing, or will provide' as the context of the provision referred to suggests.

Indirect value shift also deals with the indirect effects of a direct value shift addressed by Division 723 or 725

10.64 The definition of an indirect value shift, and the other rules in Division 727, are extended to cover the indirect effects that a direct value shift under Division 725 has on the market value of direct or indirect interests in entities that are affected owners of down interests or up interests or both [Schedule 15, item 1, sections 727-905 and 727-910] .(A value shift under Division 723 would normally attract the operation of the IVS rules without being specifically provided for because there are actual economic benefits provided.)

Example 10.4

A Co and B Co hold all the shares in C Co. D Co holds a controlling shareholding in A Co as well as in B Co. Under a scheme, share rights are varied such that A Co's shares in C Co decrease in value and B Co's shares in C Co increase in value. The indirect effect of this is that D Co's shares in A Co decrease in value and D Co's shares in B Co increase in value.

Division 727 applies on the basis that there has been an indirect value shift from D Co's shares in A Co to D Co's shares in B Co.

Provided in connection with a scheme

10.65 An economic benefit is provided in connection with a scheme if it is provided under the scheme or is reasonably attributable to something done (or omitted to be done) under the scheme by the provider or recipient, or by a third party. The entity that does, or omits to do, the thing need not be a party to the scheme. [Schedule 15, item 1, subsections 727-160(1) and (2)]

Amount of the indirect value shift

10.66 The scheme results in an indirect value shift from one entity (the losing entity) to another (the gaining entity) if, broadly, there is an inequality in the market value of economic benefits provided and received in connection with the scheme. This covers the case where both entities provide benefits and also where one entity does not.

10.67 The market value of an economic benefit to be provided is determined at the earliest time at which the benefit can be identified, the provider and recipient of the benefit are in existence and can be identified, and the providing of the benefit or any additional benefits does not depend on any contingency. Neither the losing entity nor the gaining entity under the indirect value shift needs to be a party to the scheme. A benefit can be provided by act or omission. [Schedule 1, item 1, subsections 727-150(2) to (5)]

Inequality of economic benefits

10.68 For an indirect value shift to occur there must be an inequality of economic benefits in a transaction between 2 entities, so that one entityloses value while the other gains it. [Schedule 1, item 1, subsections 727-150(3) and (4)]

10.69 A dealing at market value does not generate an inequality of economic benefits and no indirect value shift results. Although 2 entities may not be at arm's length, if they benchmark their non-arm's length dealings to market value, the Division can have no application. [Schedule 1, item 1, subsections 727-150(3) to (5)]

What is meant by market value?

10.70 Market value is worked out on the basis of what a willing but not anxious provider of the benefit would agree on as payment for the benefit with a willing but not anxious acquirer of the benefit.

10.71 This general rule is based upon the common law test for market value as developed in Spencer v The Commonwealth (1907)
5 CLR 418 (the Spencer test). The High Court provided a summary of this test in Abrahams v FCT (1944)
70 CLR 23 at 29 where Williams J said that market value is the price which a willing but not anxious vendor could reasonably expect to obtain and a hypothetical willing but not anxious purchaser could reasonably expect to have to pay if the vendor and purchaser had got together and agreed on a price in friendly negotiation.

10.72 Market value is currently defined in subsection 995-1(1) of the ITAA 1997 and directs that anything that prevents or restricts the conversion of the benefit into money, is disregarded in working out the market value of a non-cash benefit. It is proposed that this rule will also apply in working out the market value of economic benefits that are non-cash benefits.

10.73 The kinds of things that might prevent or restrict the conversion of the benefit into money include:

•

conditions that affect transferability of the benefit to another entity, for example, where it is illegal to transfer a right; and

•

the absence of an actual market for the economic benefit.

10.74 The existing definition contains an additional valuation rule that reduces the amount of the market value of an asset by the entitlement to input tax credits under the GST. It does not apply for the purposes of Division 727. [Schedule 15, item 58, definition of 'market value' in subsection 995-1(1)]

10.75 Market value is a question of objective fact. It sets up a hypothetical transaction in a notional market place and asks the question what payment would be agreed as between willing but not anxious parties for the economic benefit that is sought to be valued.

10.76 This formulation gives rise to a number of issues in practice.

Characteristics of the market place

Which market is the relevant one?

10.77 In working out the market value, the courts will make appropriate assumptions about the market in question. These assumptions can be affected by the actual transaction under consideration. For example, a large volume of goods sold could be expected to attract a discount. Each item would have a lower market value in such a situation than if it had been sold alone.

10.78 The market for an economic benefit can be defined in terms of its participants. For example, there could be a wholesale market, a GST-exempt market and a retail market for a given asset. Similarly for land, one can identify one specialised market consisting of developers or another consisting of suburban residents.

10.79 Generally, the hypothetical market place that the Spencer test requires is a wide and general market rather than a specialised market in which the best possible price might be limited.

10.80 This approach has been confirmed in a number of Australian decisions. For example, in Brisbane Water County Council v Commissioner of Stamp Duties (NSW)
80 ATC 4051 at 4054;
[1979] 1 NSWLR 320 at 324 it was held that market value is the best price which may reasonably be obtained for the property to be valued if sold in the general market.

10.81 Transactions in the hypothetical market place occur in an orderly manner, and are organised to obtain the best possible price by attracting the greatest number of potential acquirers.

Where there is no market, one is assumed

10.82 A market value test requires that there is a market place of some kind. In the absence of any actual market for the thing being valued, or where it is impossible for any such market to exist, the courts are willing to assume that a market exists.

10.83 The assumption of a hypothetical market means that economic benefits that are inherently not capable of being transferred will still have a market value. Those economic benefits are of value and the IVS rules require a quantification of that value. The hypothetical market place is a test that is flexible enough to enable such economic benefits to be valued.

10.84 The courts have also been reluctant to find that something is incapable of having a market value attached to it, for example, share rights that are subject to restrictions and contingencies.

10.85 Entities that have worked out, or been advised of, an arm's length consideration for the purposes of Division 13 of the ITAA 1936 (international transfer pricing) will not need to undertake a separate market valuation process. This is because an arm's length consideration under Division 13 is predicated upon the entities having dealt on arm's length terms.

Special rule for transfer, for adjustable value, of depreciating asset acquired for less than $1.5 million

10.86 As a special compliance cost saving measure, the market value of an economic benefit consisting of the transfer of a depreciating asset or the right to have such a transfer made can be taken to be equal to the asset's residual value, which is the greater of the asset's adjustable value when the economic benefit was provided, and the value assigned to the asset at that time in the transferring entity's books of account. [Schedule 15, item 1, section 727-315]

10.87 This rule is used to determine if there has been an indirect value shift by the transfer, or right, and if so, the amount of it [Schedule 15, item 1, section 727-300] . Both transferor and transferee must choose to have the market value so treated. This ensures that no value shift will be regarded as happening for interests in the losing or gaining entity.

10.88 The rule applies to a depreciating asset (not being a building or structure) that would be eligible for write-off under Division 40 of the ITAA 1997 (the new capital allowances regime). [Schedule 15, item 1, section 727-315]

10.89 A depreciating asset is defined in section 40-30 of the ITAA 1997 as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. It includes some intangible assets, but does not include land or trading stock.

10.90 Specifically, the special rule can apply if a depreciating asset, or a related right, is transferred for an amount that is equal to its residual value at that time, provided:

•

the cost of the depreciating asset to the transferor is less than $1.5 million; and

•

it is reasonable for that entity to conclude that the market value is not more than 20% above or below the residual value at the time the benefit is provided.

[Schedule 15, item 1, paragraphs 727-315(1)(e) and (f)]

10.91 The treatment of the market value of an economic benefit as equal to the depreciating asset's residual value is for the purposes only of this Division.

Example 10.5

TR Co transfers an item of plant at book value (which is greater than adjustable value) to DG Co. The plant cost $1.4 million and is transferred for $0.4 million. The latest valuation for the asset (12 months before date of transfer) was $0.8 million.

Assume there are no other special factors affecting the asset, and that TR Co and DG Co choose to have the rule apply to the market value of the benefit.

The valuation relief will not apply. It would not be reasonable for TR Co to conclude that the actual market value met the threshold requirements and a market value assessment will need to be made.

10.92 Similar treatment can apply where 2 or more depreciating assets (or rights to transfer of such assets) are provided as economic benefits. The total market value of the depreciating assets is treated as being equal to the total of the assets' residual values at the time the benefits are provided. [Schedule 15, item 1, subsection 727-315(2)]

10.93 In these cases, the cost of each depreciating asset must be less than $1.5 million, and it must be reasonable to conclude that the total of the assets' market values is not more than 20% above or below the total of the assets' residual values. [Schedule 15, item 1, paragraphs 727-315(2)(a) and (b)]

Preventing double counting of economic benefits

10.94 If an economic benefit consists of a right to have economic benefits provided, then it is the right that is taken into account, and not the benefits subsequently provided.

10.95 In other words, the Division captures the economic benefit at the earliest feasible time and determines its market value at that time. This is the time when the scheme is likely to affect the market values of interests in the losing and gaining entities. Thus, if a benefit is the right to have something provided, the actual benefits provided pursuant to that right are disregarded. [Schedule 15, item 1, subsection 727-165(1)]

'Reflected' economic benefits disregarded

10.96 If there is an indirect value shift because of an unequal exchange of economic benefits between a losing entity and a gaining entity, it might be argued that the losing entity also provides an economic benefit to those holding interests (directly or indirectly) in the gaining entity and the gaining entity provides an economic benefit to those holding interests (directly or indirectly) in the losing entity.

10.97 This would cause an inappropriate double, or multiple, application of the Division. Such 'reflected' economic benefits are to be disregarded in determining whether there is an indirect value shift. [Schedule 15, item 1, subsection 727-165(2)]

Example 10.6

Company A provides economic benefits to Company C. The market value of these economic benefits exceeds the market value of economic benefits provided by Company C in return.

For the avoidance of doubt, reflected economic benefits are disregarded. Thus, for example, Company C is not considered to have provided an economic benefit to the shareholders in Company A because of the benefits it provided to Company A itself.

IVS time for the scheme (IVS time)

10.98 The question whether the scheme results in one or more indirect value shifts is determined at the IVS time for the scheme and any indirect value shift is taken to happen at the IVS time. [Schedule 15, item 1, subsections 727-150(2) and (6)]

10.99 The IVS time is when all the parameters of the indirect value shifts under a scheme are known. That is, it is known between, or among, which entities the shift or shifts occur, each losing and gaining entity is in existence, it is possible to identify all of the economic benefits, the provision of the benefits are not contingent, and the full amount of the value shift can be worked out. [Schedule 15, item 1, subsection 727-150(2)]

Realisation of interest at a loss before an IVS time

10.100 In the vast majority of cases, the IVS time will be at or soon after the scheme is entered into.

10.101 In limited cases, expected to occur infrequently, an interest may be realised before the IVS time. In such cases, only some of the parameters of the IVS may be known. For example, it may be known that an entity will provide economic benefits for less than their market value to associated entities, but they may not be identified. Thus, there is a losing entity, but as yet an unidentified gaining entity or entities.

10.102 If a loss or deduction arises on realisation of an interest before the IVS time, a realisation time approach applies to make any reductions to the loss or deduction . The alternative of adjusting the adjustable values of interests in identified losing and gaining entities is not available in these circumstances.

10.103 Special rules are provided to deal with the realisation of interests before the IVS time [Schedule 15, item 1, sections 727-850 to 727-875] , and they are discussed in paragraphs 10.294 to 10.308.

Conditions

10.104 An indirect value shift has consequences under Division 727 only if the following are all satisfied:

•

the losing entity is at the time of the indirect value shift a company or trust (except a superannuation entity as listed in section 727-125) - discussed in paragraphs 10.106 to 10.109;

•

in the provision of at least one of the economic benefits from which the indirect value shift results, the losing and gaining entity are not dealing at arm's length - discussed in paragraphs 10.110 to 10.120;

•

the ultimate controller (section 727-105) or common ownership nexus (section 727-110) test is satisfied for the losing and gaining entity - discussed in paragraphs 10.121 to 10.126; and

•

there is no exclusion that stops the indirect value shift having consequences - discussed in paragraphs 10.127 to 10.192.

[Schedule 15, item 1, section 727-100]

10.105 The reason for these limitations and exclusions is to target the measures so that their impact is where it is considered the greatest risk to the integrity of the tax laws arises; and to help contain compliance costs.

Losing entity must be a company or trust

10.106 The losing entity must be a company or trust (other than a superannuation entity) whereas the gaining entity can be any entity, including an individual or a superannuation entity. [Schedule 15, item 1, paragraph 727-100(a) and section 727-125]

Example 10.7

David owns all the shares in DavidCo. DavidCo renders services to David as an individual for no consideration. Value is shifted between DavidCo and David, causing the value of David's shares in DavidCo to decline such that they can be sold at a loss. Division 727 is capable of applying to such an arrangement.

Example 10.8

David owns all the shares in DavidCo1 and in DavidCo2. DavidCo1 transfers property at less than market value to DavidCo2. Value is shifted from DavidCo1 to DavidCo2 and this is reflected in a decrease in the market value of David's shares in DavidCo1 and an increase in the market value of his shares in DavidCo2. Division 727 is capable of applying to such an arrangement.

10.107 A superannuation entity is a complying or non-complying superannuation fund, a complying or non-complying approved deposit fund, or a pooled superannuation trust [Schedule 15, item 1, section 727-125] . The reason for excluding indirect value shifts from these classes of entities from the Division is that such entities do not have interests in them in respect of which losses can be made for tax purposes.

10.108 A non-fixed trust in respect of which no entity has a fixed entitlement to any income or capital may be a losing or gaining entity. If the only interests in a non-fixed trust are mere rights to be considered and to have the trust duly administered, those interests are unlikely to have a market value that could be affected by a value shift.

10.109 The result of this can be, assuming all the requirements of the Division are met, that if value is shifted from a company or a fixed trust (or a non-fixed trust in which there are interests that have some fixed entitlements) to a non-fixed trust, there may be consequences (reductions to losses or adjustable values) for interests in the losing entity, but no complementary adjustments for interests in the non-fixed trust gaining entity.

Non-arm's length dealing

10.110 If the parties have dealt at arm's length in relation to the provision of all economic benefits under a scheme, Division 727 has no application, even though strictly a value shift may have occurred because the market value of benefits provided and received are unequal. [Schedule 15, item 1, paragraph 727-100(b)]

10.111 The Division only has consequences in respect of an indirect value shift if the losing entity and gaining entity have not dealt at arm's length in providing benefits from which the indirect value shift results under the scheme . This is an extremely important exclusion from the operation of the Division.

What is an arm's length dealing?

10.112 The question whether entities have dealt with each other at arm's length is a question of fact to be decided in all of the circumstances. Arm's length is defined in subsection 995-1(1) of the ITAA 1997 as requiring a consideration of any connection between the parties and of all the relevant circumstances.

10.113 An important feature of the arm's length dealing test is that it is the dealing that is examined, rather than the relationship between the parties. It follows that related parties can deal with one another at arm's length, and unrelated parties can deal not at arm's length with each other.

10.114 The test for arm's length dealings has been developed judicially, usually in the context of parties who are not at arm's length. The test has been stated in terms of an assessment of whether the actual parties have behaved in the manner in which parties at arm's length would normally do, so that the outcome of their dealing is a matter of real bargaining: per Hill J in The Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT
91 ATC 4007 at 4015; (1990)
21 ATR 1123 at 1132.

10.115 Parties that are not related are generally presumed to have engaged in real bargaining, unless there is evidence to the contrary. This means that parties to an ordinary commercial transaction will not need to show that they have engaged in real bargaining, unless the dealing has features that render it colourable in some way.

10.116 Of course, if the parties are in fact related then this relationship may lead to the conclusion that the bargain that was struck between the parties was not in fact the result of an arm's length dealing. However, the connection between the parties is simply a step in the course of reasoning: per Davies J in Barnsdall v FCT
88 ATC 4565 at 4568; (1988)
19 ATR 1352 at 1355.

10.117 An important element of an arm's length dealing is that the parties have acted severally and independently in forming their bargain: per Lee J in Granby v FCT
95 ATC 4240 at 4243; (1995)
129 ALR 503 ; (1995) 30 ATR 400 at 403. This involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction.

10.118 Consequently, parties can not be said to have dealt at arm's length with each other where one party has, for example:

•

colluded with the other party to achieve a particular result;

•

accepted the direction of the other party; or

•

simply acquiesced to that other party's will.

See the Federal Court decision in Collis v FCT
96 ATC 4831 ;
33 ATR 438 . It demonstrates that parties that are at arm's length may deal with each other in a non-arm's length way.

10.119 It is not necessary to show that all benefits provided under the scheme have been provided on an arm's length basis. The key consideration is that the Division will not apply if the relevant entities dealt with each other at arm's length regarding the provision of the benefits causing the value shift. [Schedule 15, item 1, section 727-100]

10.120 Arm's length dealings or benchmarking the exchange of benefits to market value are the 2 key ways to avoid the application of the Division.

Ultimate controller and common ownership nexus test

10.121 The next main requirement is that the entities must satisfy one or more of an ultimate controller test or a common ownership nexus test at some time during the IVS period. [Schedule 15, item 1, section 727-100]

10.122 The IVS period is the period starting immediately before the scheme was entered into and ending at the IVS time. [Schedule 15, item 1, subsection 727-150(7)]

Ultimate controller test

10.123 This test requires either that, at some time during the IVS period, the losing entity and the gaining entity have the same ultimate controller, or that the same entity be the ultimate controller of each entity at a different time during that period [Schedule 15, item 1, section 727-105] . The test is also met where the gaining entity is the ultimate controller of the losing entity or vice versa. What is an ultimate controller, and the way the control tests work, are described in Chapter 11.

Common ownership nexus test

10.124 The common ownership nexus test applies only if both the losing entity and the gaining entity are closely held at some time during the IVS period. Entities are closely-held if they have fewer than 300 members (if a company) or fewer than 300 beneficiaries (if a fixed trust), or if they are a non-fixed trust. Concentration of ownership tests may result in an entity with 300 or more members or beneficiaries being treated as closely-held. [Schedule 15, item 1, section 727-110]

10.125 The common ownership nexus test is set out in the table in section 727-400 [Schedule 15, item 1, section 727-400] . Further discussion of the elements in the table is contained in Chapter 11.

10.126 Diagram 10.3 explains the basic operation of and consequences of the Division, assuming the control or common ownership nexus test is met. It is important to determine whether any exclusion may apply, with the result that an indirect value shift does not have consequences under Division 727.

Diagram 10.3: IVS consequences assuming the control or common ownership nexus test is met

Indirect value shifts that have no consequences and anti-overlap rule for distributions

10.127 Diagram 10.4 sets out the cases where an indirect value shift has no consequences under both the realisation time method and adjustable value method. Diagram 10.5 sets out additional circumstances where an IVS has no consequences only where the realisation time method applies.

Diagram 10.4: When does an indirect value shift have no consequences?

Diagram 10.5: Additional exclusions when an affected interest is realised and the realisation time method applies

10.128 The exclusions where indirect value shifts have no consequences may be divided into automatic exclusions and realisation time method exclusions. The effect of these exclusions is that the indirect value shift is disregarded in the sense that the adjustments that would otherwise be made under the Division are not required to be made.

Automatic exclusions

General de minimis exclusion

10.129 An indirect value shift is disregarded entirely if the amount of it does not exceed $50,000 [Schedule 15, item 1, section 727-215] . The de minimis exclusion ensures that compliance costs are not incurred in determining the effect of immaterial or insignificant value shifts.

10.130 However, the de minimis exception does not apply if indirect value shifts happen under different schemes involving the same losing entity and, in all the circumstances, it can reasonably be concluded that the main reason or the only reason for the different schemes was to keep the indirect value shift for any one scheme under $50,000. [Schedule 15, item 1, subsection 727-215 (2)]

Disposal of CGT asset at cost

10.131 An indirect value shift is disregarded if a losing entity disposes of a CGT asset to a gaining entity for economic benefits in return that are not less than the greater of the asset's cost base at the IVS time and the asset's cost. A CGT asset includes trading stock, a depreciating asset and any other item of property or right recognised at law or in equity. [Schedule 15, item 1, section 727-220]

10.132 The exclusion applies only to a transfer or disposal (alienation) of the asset. It does not apply where a right is created over the asset (e.g. a lease), although a right to have the losing entity transfer the asset to the gaining entity is covered.

10.133 The exclusion does not apply if, after the losing entity acquired the asset, an affected owner acquired a direct or indirect equity interest in the losing entity, unless, as at the IVS time, the economic benefits provided in return for the asset are not less than the greatest of the asset's cost, its cost base, and the asset's market value immediately before the last time such an owner acquired a primary equity interest or indirect primary equity interest in the losing entity. [Schedule 15, item 1, subsection 727-220(3) and (4)]

10.134 This rule ensures that an artificial loss cannot later arise on the realisation of an old or new equity interest in the losing entity that is attributable to the level of economic benefits received for the asset.

Example 10.9

X Co acquired 95% of the shares in Y Co (and becomes its controller) for $4.75 million. At that time Y Co held a single asset with a cost base of $5 million and a market value of $5 million. Later, the market value of the asset increased to $10 million at which time X Co acquired the remaining 5% of the shares in Y Co.

Y Co later transfers the asset to X Co for $5 million (when its market value was $12 million). The exclusion does not apply. (If it did, then X Co could sell its new shares in Y Co and realise a capital loss of $250,000 (i.e. 5% of $5 million.)

However, if the asset were transferred for $10 million, the exclusion would apply.

10.135 The exclusion does not extend to a situation where property is transferred for more than its market value, or more than a price that might be established in an arm's length dealing. In the first case, there is likely to be an indirect value shift from the transferee to the transferor.

Safe-harbours for indirect value shifts involving services

10.136 There are 2 safe-harbours applying to services. These are in addition to the general de minimis exclusion discussed in paragraphs 10.129 to 10.130, the realisation time method exclusions discussed in paragraphs 10.163 to 10.192 and the exclusion for services provided 'downstream' (e.g. by parent to subsidiary) where the value of loans is not affected (see paragraphs 10.160 to 10.162). [Schedule 15, item 1, sections 727-230 and 727-235]

10.137 The services covered by the safe-harbours are broadly defined in section 727-240. The doing of work (such as professional work and providing advice) is a provision of services for this purpose even though property may be supplied in association with the work done. However, the safe-harbours may not apply if property of significant value is provided under a scheme that results in an indirect value shift. [Schedule 15, item 1, paragraphs 727-230(a) and 727-235(1)(a)]

Services provided by losing entity to gaining entity for at least direct cost

10.138 The first safe harbour relates to benefits consisting of services provided by a losing entity to a gaining entity for a price of at least the direct cost to the losing entity of providing the services. [Schedule 15, item 1, section 727-230]

10.139 Where related entities provide services either across or up a chain of entities, a charge of at least the direct cost of providing the services is often made to ensure entitlement to tax deductions for those costs. Services provided down the chain (e.g. by a parent) may not be charged for, but theexclusion discussed in paragraphs 10.160 to 10.162 is likely to apply in wholly-owned non-consolidated groups.

10.140 The safe harbour for services provided for at least their direct cost applies only to economic benefits that consist of services to the extent of at least 95% of the market value of the benefits.

10.141 Where such service benefits are provided for at least their direct cost, it is unlikely that the provision of the services themselves would create, or increase, a loss on interests in the losing entity, although in limited cases a loss might be created if the amounts of unrecouped indirect costs are significant. By definition, though, it is usually not feasible to link indirect costs with the services provided.

10.142 The 'direct cost' for any service is to be determined in accordance with generally accepted accounting principles or practices [Schedule 15, item 1, paragraph 727-245(1)(a)] . A direct cost is a cost that is reasonably capable of being traced to the provision of the services in question. In this context, direct costs can include both variable and fixed costs. A direct cost does not include an opportunity cost.

Example 10.10

Guard Co is a provider of mobile and electronic security surveillance services for related and unrelated parties. Guard Co benchmarks at cost the contract price for services it provides to related parties.

The direct costs include:

•

the direct costs (e.g. labour and transport) of making specific call-outs, and of doing requested guard and dog surveillance; and

•

the direct costs of inspecting security monitoring devices installed on the guarded premises.

10.143 If services are to be provided in the future, the direct costs are to be determined on the basis of a reasonable estimate of those costs. [Schedule 15, item 1, paragraph 727-245(1)(b)]

10.144 It is necessary under the valuation rules to compare the total market value of the economic benefits to be received by the losing entity with the present value of the costs expected to be incurred. [Schedule 15, item 1, paragraph 727-230(b)]

10.145 For this reason the provisions refer to the present value of the direct cost of providing the services. Present value is to be determined taking into account the time value of money. The present value is to be determined using the discount rate determined under section 109N of the ITAA 1936. [Schedule 15, item 1, subsection 727-245(3)]

Services provided by gaining entity to losing entity for not more than a commercially realistic price

10.146 The second safe harbour relates to services that are not reasonably considered to be overcharged. (If services are provided for more than their true value, the provider, not the recipient, of the services is the gaining entity.) [Schedule 15, item 1, section 727-235]

10.147 In order for the safe harbour to apply, the value shift must relate to benefits provided by the gaining entity that comprise services to the extent of at least 95% of the market value of the benefits.

10.148 At the IVS time, the total market value of the economic benefits provided by the losing entity cannot be more than the total present values of the direct costs and indirect costs of providing the service (or a reasonable allocation of them) together with a commercially realistic mark-up.

10.149 If there is a mark-up (or range of mark-ups) on costs that would be an arm's length mark-up based on industry practice, then that mark-up (or, if a range, the top of the range) provides the upper limit for the safe-harbour. Often the amount ascertained by applying the mark-up to the present value of the total costs will very closely approximate the market value of the service itself. If the amount charged is in fact the market value of the services there is no value shift; but the cost plus mark-up may be easier to determine than the market value.

10.150 In the absence of a specific mark-up based on industry practice, a standard mark-up of 10% will be accepted. [Schedule 15, item 1, subsection 727-235(3)]

10.151 As is the case for the services safe-harbour discussed in paragraphs 10.138 to 10.145, the costs for the purpose of this safe harbour are to be determined in accordance with generally accepted accounting practices and, to the extent that services are to be provided in the future, on the basis of a reasonable estimate of those costs. [Schedule 15, item 1, section 727-245(1)]

Example 10.11

Think Co and Big Co are 100% commonly owned, but not members of a consolidated group. Think Co provides advertising consulting services to Big Co as well as to other companies in the controlled group, but has no dealings with independent parties. Think Co does not deal with its related entities in an arm's length manner.

Think Co calculates the direct costs and share of indirect costs of providing its advertising services to be $160 per hour. A market equivalent mark-up on such costs for the type of service that Think Co provides is 8%. Thus, provided Think Co does not charge Big Co (or other group companies) more than $172.80 per hour, it can take advantage of this safe-harbour. Alternatively, it can benchmark its services to market value in which case the safe harbour would not be needed.

If the service provided by Think Co were a unique one, a mark up of 10% on relevant costs (and therefore a charge of 110% of relevant costs) would be within the safe harbour.

10.152 For the purposes of both of these safe-harbours for indirect value shifts involving services, if the service involves lending money or providing some other form of financial accommodation, the amount of the loan or other financial accommodation is not taken into account as a direct or indirect cost of providing the service. However, this does not prevent the provider of the service taking into account, as a cost, any interest or other expenses it incurs to obtain or service any financial accommodation. [Schedule 15, item 1, paragraph 727-245(2)(a)]

10.153 Similarly, for services that consist of or include leasing, renting or hiring an asset, or other arrangements for the use of an asset, the cost of acquiring the asset or an interest or right in respect of it are not direct or indirect costs taken into account for the safe-harbours. [Schedule 15, item 1, paragraph 727-245(2)(b)]

Distributions and rights to distributions

10.154 An indirect value shift is disregarded if the economic benefits provided consist entirely of a distribution by a losing entity to a gaining entity, or a right to such a distribution, and the whole of the distribution is taken into account for tax purposes in any of the following ways:

•

The amount of the distribution, or the value of the right, is included in the gaining entity's assessable income or exempt income.

•

The distribution or right results in an adjustment to the cost base or reduced cost base of some or all of the shares or other primary equity interests the gaining entity has in the losing entity. (For example, CGT event G1 may happen and may cause adjustments to be made to the cost bases and reduced cost bases of shares when a company makes a non-assessable distribution to the shareholder; and CGT event E4 may have a similar result in the case of a non-assessable distribution from a trust.)

•

The distribution or right is taken into account in working out the capital proceeds, or capital gain, from a CGT event that happened to primary equity interests the gaining entity held in the losing entity. (For example, a distribution might be the consideration the losing entity provides in a buy-back of its shares or for the cancellation of trust interests.)

•

The distribution or right is taken into account in working out whether a gain or loss arises on the realisation of primary equity interests the gaining entity held in the losing entity as revenue assets or as trading stock.

10.155 The indirect value shift is also disregarded if part of the distribution or the right to a distribution is taken into account in one of the ways referred to in paragraph 10.154 and the remainder of the distribution or right is taken into account in one or more of the other ways referred to.

10.156 The term 'distribution' takes its ordinary meaning for the purpose of this exclusion, with one proviso: in a case where the losing entity is a corporate tax entity (see section 960-115 of the ITAA 1997) certain amounts or property that might not otherwise be considered distributions are taken to be covered by the term. These include unit trust dividends as defined in sections 102D and 102M of the ITAA 1936 and amounts paid or lent and debts forgiven that are taken to be dividends under other provisions in that Act.

10.157 This exclusion for distributions and rights to distributions from a losing entity prevents the IVS measures from applying to transactions that are adequately provided for elsewhere in the tax law and do not cause inappropriate losses to arise.

10.158 An example is a trustee of a non-fixed trust exercising its discretion by distributing net income from the trust in favour of a beneficiary. Since the beneficiary previously had no interest in the trust funds from which the distribution was made, no economic benefits pass from the beneficiary to the trustee. Although the conditions are met for the IVS measures to apply in this situation, their application would not be appropriate if the distribution is included in the beneficiary's assessable or exempt income. The exclusion applies in such cases and the indirect value shift is disregarded.

10.159 If the recipient of a distribution actually has a right to receive it, and gives up the right in return for receiving it, the recipient is taken to have provided economic benefits (see paragraph 10.62), and the specific exclusion is not required. [Schedule 15, item 1, section 727-250]

Shifts down a wholly-owned chain of entities

10.160 An indirect value shift is generally disregarded if the value is shifted down a wholly-owned chain of entities. [Schedule 15, item 1, section 727-260]

10.161 The main requirements for the exclusion are that the gaining entity is a wholly-owned subsidiary of the losing entity throughout the IVS period and, for example, the gaining entity owns no primary loan interests in the losing entity that are affected by the indirect value shift. For example, if a subsidiary has a non-recourse loan to its parent, a value shift from the parent to the subsidiary is not disregarded under this provision.

10.162 A losing entity is taken to wholly own a gaining entity if all the primary interests in the gaining entity are owned by the losing entity, by one or more entities that the losing entity wholly owns, or by a combination of the losing entity and one or more such entities.

Example 10.12

Loss Co holds 100% of the shares in Sub Co, and 60% of the shares in Gain Co. Sub Co holds the other 40% of the shares in Gain Co. Gain Co holds no direct interest in Loss Co or in Sub Co. Loss Co leases a property it holds to Gain Co for less than its market value. The indirect value shift is disregarded.

Example 10.13

Red Co holds 100% of the shares in Blue Co, but the companies are not consolidated. In March 2003Blue Co makes a 4 year loan to Red Co. The terms of the loan limit Blue Co, on any default by Red Co, to certain assets of Red Co for recovery of the debt. In March 2004 Red Co transfers one of the assets to Blue Co at less than market value. The value of Blue Co's debt interest is reduced, as the range of assets that Blue Co can look to for recovery of the principal of the debt owed by Red Co during the term of the loan has been reduced. The exclusion will not apply.

Realisation time method exclusions

10.163 The exclusions discussed in paragraphs 10.129 to 10.162 apply whether the realisation time method or the adjustable value method applies in relation to an indirect value shift. Additional exclusions are available (see Diagram 10.5) if the realisation time method applies. These additional exclusions are not relevant if a choice is made to adopt the adjustable value method.

10.164 An indirect value shift has no consequences under Division 727, for entities applying the realisation time method, if it happens at least 4 years before a particular interest in the losing entity is realised, and the amount of the value shift is less than $500,000. [Schedule 15, item 1, paragraph 727-605(2)(d)]

10.165 This exclusion is intended to limit entities' costs of compliance with the law in relation to less significant value shifts. Except in the case of value shifts of $500,000 or more, entities will only need to keep records of transactions that shift value between them for approximately the same length of time as they would keep them for other tax purposes.

10.166 Despite the 4 year limitation, adjustments that are made on realisation of interests in a losing entity within 4 years after the IVS time may be taken into account in determining what adjustments to make (before or after the 4 years ends) when interests in the gaining entity are realised.

Example 10.14

Alpha Co holds 100% of the shares in Beta Co and Gamma Co. Beta Co transfers an asset to Gamma Co for less than its market value, resulting in an indirect value shift of $400,000 from Alpha Co's shares in Beta Co to its shares in Gamma Co. One year after the IVS time for the scheme Alpha Co sells 25% of the shares in Beta Co, and sells a further 20% 5 years after the IVS time. Soon after the second interest is sold, Alpha Co sells some of its shares in Gamma Co.

If Alpha Co makes a loss on the shares sold one year after the IVS time, the loss may be reduced under Division 727 using the realisation time method. No adjustment would be required for the shares sold 4 years later. However, a profit made on Alpha Co's sale of shares in Gamma Co might be reduced, taking into account the adjustment made on the first sale of shares in the losing entity Beta Co.

95% services indirect value shifts

10.167 Division 727 provides for a further exception, where the realisation time method applies, for 95% services indirect value shifts. [Schedule 15, item 1, sections 727-700 to 727-725]

10.168 To qualify as a 95% services indirect value shift, at least 95% of the relevant economic benefits provided by the losing entity must constitute services. (So, property benefits that are incidental to a value shift involving services can be disregarded, but value shifts involving a mix of property and services from the perspective of the losing entity will usually not qualify for the exception under the realisation time method). [Schedule 15, item 1, subsection 727-700(2)]

Example 10.15

Service Co is proposing to provide benefits to Zero Co for no consideration: a $20,000 property transfer and an $80,000 services agreement to repair and maintain the property.

If all benefits were provided under the one scheme or arrangement, this would not qualify as a 95% services indirect value shift because it is only 80% service-related. If Service Co were to transfer the property under one scheme or arrangement, and enter into a separate services agreement for repairs and maintenance under another scheme, the services agreement would qualify as a 95% services indirect value shift.

The legislation contemplates that the provision of service benefits would be split in this way to take advantage of the exclusion available, and such splitting would not attract the general anti-avoidance provisions in Part IVA of the ITAA 1936.

10.169 Schemes must therefore be deliberately structured to take advantage of the exclusion; for example, by separating out service agreements from transactions involving the provision of property or assets.

How the exclusion for 95% services value shifts operates

10.170 95% services indirect value shifts are effectively disregarded, except where a significant value shift involving services has happened in the years immediately before an interest in the losing entity is realised, or alternatively, during the period when the entity realising the interest had owned that interest, quite substantial value shifts involving services have taken place.

10.171 The exclusion for 95% services indirect value shiftsrecognises that, unlike most shifts in value concerning property, those involving services are likely to occur on a more frequent basis between related parties (especially where one of the related parties is a designated service provider), and also that services are often more difficult to value than property.

10.172 There are 4 circumstances in which a significant recent value shift or a more substantial value shift prevents a 95% services indirect value shift from qualifying for the exception. These circumstances are discussed in paragraphs 10.176 to 10.190. They relate to particular things that would either be known to the loss entity, or would reasonably be expected to be known to it because of the magnitude of the potential value shift.

10.173 In determining whether one of the disqualifying circumstances has arisen it is sometimes necessary to take into account not only 95% services indirect value shifts but also any indirect value shift involving the same entity that was predominantly for the provision of services. 'Predominantly' means more than 50% in terms of value. [Schedule 15, item 1, section 727-725]

10.174 By taking into account an indirect value shift related to the provision of services, but which is not a 95% services indirect value shift, the Division may require an adjustment in situations where the exclusion would have applied had only 95% services indirect value shifts been considered. Besides being taken into account for this purpose, these indirect value shifts that are only predominantly for services may be the subject of separate adjustments under Division 727.

Example 10.16

E Trust is a unit trust. Half of the units are owned by each of Sales Ltd and Support Ltd. In a non-arm's length arrangement, E Trust contracts to provide equipment, together with training and maintenance services for 5 years, to Office Co (half of the shares are owned by each of Sales Ltd and Support Ltd). The total contract price is $450,000, of which $240,000 is attributable to the training and maintenance services. Soon afterwards E Trust enters into a further contract, also under a non-arm's length arrangement, to maintain all other equipment owned by Office Co for the 5 year period. The contract price is $640,000. In each case the services component of the contract price is $60,000 less than the market value of the services to be provided.

The following year Sales Ltd sells its units in E Trust at a loss. Sales Ltd and Support Ltd do not choose to use the adjustable value method under Division 727.

The first of E Trust's contracts with Office Co results in a predominantly services indirect value shift, but not a 95% services indirect value shift. The exclusion for95% services indirect value shifts does not apply. Division 727 may require the loss on sale of Sales Ltd's units in E Trust to be reduced taking into account the value shifted under this contract.

The indirect value shift under the second contract is a 95% services indirect value shift. In determining whether the exclusion for 95% services indirect value shifts applies - in particular, whether ongoing or recent service arrangements have reduced the value of E Trust by at least $100,000 (see paragraphs 10.179 to 10.182) - both the predominantly services indirect value shift and the 95% services indirect value shift are taken into account.

Circumstances that prevent the exclusion from applying

10.175 The exclusion for 95% services indirect value shifts is not available if any of the following 4 circumstances has arisen.

Adjustment to tax return because a provision of the income tax law has varied an amount by at least $100,000

10.176 The first circumstance is an adjustment to an amount (or the inclusion of an amount) included in an income tax return lodged by the losing or gaining entity that relates to the services and affects the entity's taxable income or losses. Such an adjustment may result, for example, from a determination under Division 13 or Part IVA of the ITAA 1936, or some other matter relating to services that the losing entity or gaining entity either knows about or ought reasonably to be aware of.

10.177 It is also a requirement that the adjustment is made for an income year during which the interests are owned, for some period, by the entity that later disposes of them at a loss.

10.178 If, on the facts, some or all of the amount adjusted is representative of the 95% services indirect value shift, and the adjustment is at least $100,000, the exclusion for 95% services indirect value shifts is not available and Division 727 has its normal operation in relation to the value shift. [Schedule 15, item 1, section 727-705]

Example 10.17

A Co is the ultimate controller of B Co and C Co. In March 2003, B Co lends $100 million at less than a market rate of interestto C Co (a related non-resident party) on a long term basis in connection with an offshore venture that C Co is carrying on. The realisation time method applies to the indirect value shift that happens under the arrangement.

In May 2006, the Commissioner makes a determination under Division 13 of the ITAA 1936in relation to the arrangement, and amounts are included in the assessable income of B Co for its 2004 year of income. The total amount included is $200,000.

In November 2006, A Co realises an interest in B Co at a loss. At the realisation time, adjustments will be required in respect of the value shifted by the low interest loan.

Ongoing or recent service arrangement reducing the value of the losing entity by at least $100,000

10.179 Determining whether the second circumstance has arisen requires an examination of service arrangements that may reasonably be concluded to have depressed the market values of primary interests held by affected owners in the losing entity immediately before the time of the realisation (i.e. counting the realised interests) by at least $100,000. Primary interests include both equity interests and interests in loans.

10.180 Service arrangements do not have to be considered for this purpose if any part of the indirect value shift under the scheme happened earlier than the income year preceding the year in which the interest is realised. Therefore, the only services to be considered are ones that have been provided by the losing entity in the income year of the realisation or in the previous year, or have not yet been provided when the interests are realised. Indirect value shifts relating predominantly to services, whether or not they are 95% services indirect value shifts, must be taken into account. [Schedule 15, item 1, subsections 727-710(1) and (2)]

10.181 If 5% of the amount of the adjustable values of primary interests of such affected owners in the losing entity just before the realisation event exceeds $100,000, then the safe harbour is increased to this amount, subject to a maximum of $500,000. [Schedule 15, item 1, subsections 727-710(3) and (4)]

Example 10.18

A non-consolidated group sells off a controlled entity that is committed to provide services in the future to the group at less than their market value. This continuing arrangement depresses the market value of primary interests in the entity to be sold off by $450,000. Immediately before the sale of the controlled entity, the total amount of the adjustable values of primary interests held in the entity by affected owners is $20 million.

In this case, the threshold is not $100,000 but is $500,000 (5% of $20 million, $1 million reduced to the maximum of $500,000). Because the effect on market value is less than this ($450,000), the continuing service arrangement does not prevent the exclusion for 95% services indirect value shifts from applying.

10.182 If ongoing or recent service arrangements prevent the exclusion from applying, adjustments must be made under the Division for all 95% services indirect value shifts over $50,000 that have contributed to the depression in market value.

Aggregate of service arrangements reducing value of group service provider by at least $500,000

10.183 The third circumstance is where an interest is disposed of at a loss after intra-group service arrangements have reduced the value of a 'group service provider'. The entity, the interests in which are disposed of at a loss, must satisfy the group service provider criterion at some time during the whole period during which the interests are owned.

10.184 This criterion will be met at a particular time where it can be shown that the sole or dominant business activity conducted by the entity is the provision of services to a gaining entity or an affected owner under an indirect value shift, or to an entity having either the same ultimate controller as the service provider or the gaining entity, or a common ownership nexus with the service provider or the gaining entity. [Schedule 15, item 1, subsection 727-715(1)]

10.185 The entity's service arrangements over the whole period for which the affected owner owned interests must be examined; although any indirect value shift less than $500,000 under an arrangement predominantly for services is disregarded if it happened at least 4 years before the interest is realised. The safe harbour amount is usually $500,000. This may be increased to the lesser of:

•

5% of the adjustable values of primary interests held by affected owners in the losing entity; and

•

$5 million for each year for which the affected owner held the interest in the losing entity, subject to a $25 million maximum for periods of ownership over 4 years.

[Schedule 15, item 1, subsections 727-715(2) and (3)]

Abnormal service arrangement reducing value of non-group service provider by at least $500,000

10.186 The last circumstance is an abnormal service arrangement reducing the value of a non-group service provider by at least $500,000. This is not relevant to the realisation of an interest if the losing entity was a group service provider at any time while the interest was held. [Schedule 15, item 1, subsection 727-720(1)]

10.187 This provision is concerned with arrangements under which the providing of the benefits by the losing entity is not in the ordinary course of the losing entity's business. [Schedule 15, item 1, subsection 727-720(4)]

10.188 Two or more arrangements can be considered together to determine if the threshold is exceeded where it can reasonably be concluded that the sole or main reason for the separation of the arrangements is to ensure the exclusion for 95% services indirect value shifts continues to apply. [Schedule 15, item 1, subsection 727-720(2)]

10.189 The $500,000 safe harbour can be scaled up to $5 million depending on the amount of the adjustable values of primary interests held by affected owners in the non-group service provider. Again, indirect value shifts under arrangements predominantly for services are considered when applying the relevant threshold. [Schedule 15, item 1, subsection 727-720(3)]

10.190 An indirect value shift that is automatically excluded under Subdivision 727-C is not counted as part of the thresholds in the above tests. [Schedule 15, item 1, subsection 727-700(3)]

10.191 Table 10.1 can be used to determine whether there are circumstances preventing the exclusion for 95% services indirect value shifts from applying.

•

Columns 2 and 3 of Table 10.1 show the basic conditions and thresholds that apply to each realisation event.

•

Column 4 indicates increased thresholds that will apply where the adjustable values of primary interests held by affected owners in the losing entity exceed certain amounts.

•

SVS refers to an indirect value shift under which the benefits provided by the losing entity are predominantly services (or the right to services). This includes, but is not limited to, 95% services indirect value shifts.

•

MV means market value.

•

The ownership period is the period for which the interests to be realised have been held by the owner.

Table 10.1: Circumstances preventing the 95% services indirect value shift exclusion applying

10.192 If none of the 4 circumstances discussed in paragraphs 10.176 to 10.190 has arisen, adjustments are not required under the Division in relation to the 95% services indirect value shift.

Consequences of the IVS rules if there is an indirect value shift

10.193 If there is an indirect value shift, and no exclusion applies, Division 727 may require any loss on realisation of interests in the losing entity to be adjusted. An increased gain on realisation of interests in the gaining entity may also be adjusted.

10.194 Alternatively, if the adjustable value method is chosen, the adjustable values of interests in the losing entity may be reduced. The adjustable values of interests in the gaining entity may be increased.

10.195 In either case, the adjustments apply to equity or loan interests that 'affected owners' hold immediately before the IVS time in the losing and gaining entities ('direct' interests). Adjustments also apply to any equity or loan interests that 'affected owners' hold, immediately before the IVS time, in other affected owners ('indirect' interests) that have direct or indirect equity or loan interests in the losing or gaining entities.

Adjustments - which owners are affected

10.196 Who is an affected owner is set out in section 727-530. This is discussed in detail in Chapter 11.

10.197 The losing entity and the gaining entity may be affected owners for an indirect value shift. So, for example, an interest that the losing entity owns immediately before the IVS time in an affected owner that is an indirect interest in itself may be subject to adjustment. [Schedule 15, item 1, section 727-530, item 3 in the table]

Example 10.19

A Co owns all the shares in B Co which in turn owns all the shares in C Co. C Co is a losing entity. C Co has a loan interest in A Co. A Co is an affected owner, having an indirect interest in the losing entity C Co. Therefore, C Co is also an affected owner, and adjustments may be required if C Co's loan is realised at a loss, or to the adjustable value of the loan.

Active participants

10.198 There may be situations where an interest held by an active participant in a scheme consists of an equity or loan interest in another active participant that is an indirect equity or loan interest in the losing or gaining entity. Adjustments are not required in respect of the interest held in the second active participant unless the control or common ownership nexus test makes the active participant holding the interest, or the entity in which it is held, an affected owner. [Schedule 15, item 1, subsection 727-470(1)]

Entity eligible for the STS excluded

10.199 Adjustments are not made under the Division in respect of an equity or loan interest that an entity owns if the entity satisfies the conditions for becoming an STS taxpayer for each income year that includes any of the IVS period. [Schedule 15, item 1, paragraph 727-470(2)(a) and subsection 727-470(3)]

Entity that satisfies CGT maximum net asset value test for small business relief

10.200 As a further compliance cost-saving concession, adjustments are not made if the entity that owns an equity or loan interest would satisfy the maximum net asset value test in section 152-15 of the ITAA 1997 throughout the IVS period. Broadly, that test is satisfied if the entity, and its associated and connected entities as defined, have a net asset value of $5 million or less. [Schedule 15, item 1, paragraph 727-470(2)(b) and subsection 727-470(3)]

10.201 The Division does not require adjustments to be made in respect of an equity or loan interest in a superannuation entity, if the superannuation entity holds an interest in the losing or gaining entity, because no loss for tax purposes can be made on such an interest. [Schedule 15, item 1, subsection 727-470(4)]

What interests are affected?

10.202 Division 727 applies to 'affected interests' in a losing or gaining entity. Affected interests are either equity or loan interests in the entity or indirect equity or loan interests in the entity.

10.203 An equity or loan interest for the purposes of the Division may be either a primary interest or a secondary interest in the entity.

10.204 A primary interest in an entity is a primary equity interest or a primary loan interest in the entity [Schedule 15, item 1, subsection 727-520(2)] . A secondary interest is a right or option to acquire an existing or new primary interest in an entity [Schedule 15, item 1, subsection 727-520(5)] .

10.205 What constitutes a primary equity interest in an entity is set out in the table in subsection (3) of section 727-520. For a company, it is a share in the company or an interest as joint owner in a share. For a trust, it is an interest in the trust income or capital, any other interest in the trust, or an interest as joint owner in one of these interests. [Schedule 15, item 1, subsection 727-520(3)]

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

Indirect equity or loan interest

10.207 An equity or loan interest in an entity is an indirect equity or loan interest in another entity if the first entity owns an equity or loan interest in the other entity. An equity or loan interest in an entity is also an indirect equity or loan interest in another entity if the first entity owns an equity or loan interest that is an indirect equity or loan interest in the other entity because of another application of the rule in the section. [Schedule 15, item 1, section 727-525]

Example 10.20

A Co lends money to B Co which lends money to C Co. A Co's loan to B Co is an indirect equity or loan interest in C Co.

Methods for making reductions

10.208 There are 2 methods for making reductions under Division 727:

•

the realisation time method; and

•

the adjustable value method.

[Schedule 15, item 1, sections 727-455 and 727-550]

10.209 The realisation time method applies unless a choice is made to apply the adjustable value method. The realisation time method has the advantage that adjustments are only required to be made if interests in the losing entity are realised at a loss. Even if a loss does arise, it may not be necessary for the purposes of the realisation time method to determine to what extent the indirect value shift reduced the value of affected interests in the losing entity.

10.210 For indirect value shifts involving the provision of services, there are also significant safe-harbours and exceptions available under the realisation time method.

10.211 A choice to adopt the adjustable value method may produce a tax outcome that better reflects the economic effect of the value shift in cases where interests in the gaining entity are to be realised before any or all of the affected interests in the losing entity have been realised. This is particularly so if the losing entity chooses not to work out the reductions to adjustable values on a loss-focused basis.

Choosing the adjustable value method

10.212 A choice is made to use the adjustable value method as provided for in section 727-550. In general, if the common ownership nexus test applies, the choice must be made jointly by the ultimate owners who have common ownership of the losing and gaining entities. Otherwise, the choice can be made by the ultimate controller, or if there is more than one ultimate controller, by them jointly unless one is an ultimate controller in its own right (i.e. disregarding interests of its associates). [Schedule 15, item 1, subsection 727-550(2)]

10.213 The choice to adopt the adjustable value method need not be made until an affected interest in the losing or gaining entity is first realised after the IVS time for the indirect value shift. Once the first realisation occurs, the choice must be made within 2 years from that time. [Schedule 15, item 1, section 727-550(3)]

10.214 If a choice is made, a second choice may be made not to adopt the loss-focused basis for making adjustments under the adjustable value method. This choice must be made by the same ultimate owners or other entities that made the first choice and by the deadline that applies to that first choice.

10.215 The effect of the choices is to require all affected owners to adjust the adjustable values of their interests in the losing and gaining entities as provided for in Subdivision 727-H, using the loss-focused or non-loss-focused basis of adjustment according to the choice made.

10.216 Within one month after making a choice, the entity that makes it, or one of the entities, must inform all entities it knows are affected owners for the indirect value shift about the content of the choice. Owners of affected interests may give notice to an entity that was entitled to make a choice, asking whether a choice has been made. [Schedule 15, item 1, section 727-555]

Applying the realisation time method

10.217 If the realisation time method applies in respect of interests affected by an indirect value shift, consideration must be given to making adjustments whenever an affected interest in the losing entity is realised at a loss for tax purposes. In general, for each affected interest it is only on the first occasion at or after the IVS time when the interest is realised that an adjustment may be required. This is because any loss that results from the value shift would normally arise at this first realisation. (Adjustments for any interests realised before the IVS time are provided for in Subdivision 727-K). [Schedule 15, item 1, section 727-610]

10.218 For an interest held as trading stock, the first realisation event after the IVS time (unless the interest is sold during the income year) may be the end of the income year. If the interest was valued for trading stock purposes at its cost at the start of the income year, or was acquired during the year, and it is valued at its cost at the end of the year, no loss attributable to the value shift arises at that time. In this situation the end of the income year is not treated as the first realisation of the interest. Instead, any adjustments required under the realisation time method are made when the interest is sold, or when it is first valued under Division 70 at its market value.

10.219 No adjustments are required on realisation of interests in the losing entity if the amount of value shifted was less than $500,000 and the realisation occurs more than 4 years after the IVS time. [Schedule 15, item 1, paragraph 727-610(2)(d)]

When is an interest realised at a loss?

10.220 Division 727 applies to each affected interest according to the character it has for the affected owner who owns it. An interest may be held as a CGT asset, as a revenue asset or as trading stock. It may have more than one character: for example, simultaneously as both a revenue asset and a CGT asset. The Division applies to the interest in each relevant character. [Schedule 15, item 1, subsection 727-610(4)]

10.221 Whether an interest is realised at a loss depends on the character in which it is held. For a CGT asset, for example, the interest realises a loss for the purposes of the Division if the owner makes a capital loss on the interest. An owner makes a capital loss, for this purpose, even if the loss is disregarded under the capital gains provisions because a CGT roll-over applies or because Subdivision 170-D applies to the realisation.

Example 10.21

Walter Co owns 90% of the shares in Ross Co. Michael Co owns the remaining 10%. An indirect value shift happens between Ross Co (the losing entity) and Walter Co (the gaining entity). Shortly afterwards a new company, John Co, is incorporated and Walter Co and Michael Co exchange their shares in Ross Co for shares in John Co. They choose roll-over under Subdivision 124-G on the disposal of the shares.

If Walter Co would have made a capital loss, but for the roll-over, on disposal of its shares in Ross Co, adjustments may be required under Division 727 in respect of the disposal.

10.222 New Division 977 sets out the circumstances in which a loss is realised on an asset (including an interest in an entity) in its character as a revenue asset, a CGT asset or an item of trading stock. Division 977 is discussed in paragraphs 12.17 to12.27.

Interests in the gaining entity

10.223 When an affected interest in the gaining entity is first realised after the IVS time, adjustments may be available if a gain results from the realisation. As was the case for interests in the losing entity, if an interest held as trading stock was valued at its cost at the start of the income year, or acquired during the year, and is valued at its cost at the end of the year, the first realisation is taken to be when the interest is later sold or when it is first valued under Division 70 at its market value.

10.224 Consistently also with the realisation of interests in the losing entity, an interest in the gaining entity is realised for a gain, for the purpose of the Division, even if the gain is disregarded because a roll-over applies under the capital gains provisions.

10.225 The purpose of the adjustments available is to prevent the entity being inappropriately assessed on a gain solely because of an indirect value shift, in circumstances where adjustments have been made for interests in the losing entity [Schedule 15, item 1, section 727-620] . For integrity reasons, the amount of the adjustments that may be made in respect of interests in the gaining entity is limited by reference to the adjustments that have been made on realisation of interests in the losing entity [Schedule 15, item 1, section 727-625] .

10.226 Adjustments are only made in respect of interests in the gaining entity if the gaining entity is a company or trust, and are not made in respect of a superannuation entity. These qualifications confine the adjustments to entities in which the interests owned by affected owners are likely to gain in value as a result of a value shift.

Reductions to a loss on interests in losing entity

10.227 In the usual case, a loss that arises when a particular affected interest in the losing entity is first realised after the IVS time is reduced by an amount that is reasonable, having regard to the extent to which the indirect value shift reduced the market value of the interest. A reasonable estimate may be made of the extent to which the indirect value shift reduced the market value of the interest.

10.228 What amount of reduction is then reasonable should be determined in the light of the main object of the Division as expressed in section 727-95. A reasonable reduction will reduce the loss by the amount necessary to ensure it does not reflect any reduction in value that resulted from the indirect value shift. [Schedule 15, item 1, section 727-615]

Example 10.22

Head Co owns 5 million shares in a wholly-owned subsidiary Transfer Co. The adjustable value of each share is $1 and the market value $0.95.

Transfer Co sells an asset with a market value of $2 million to an associate (that is also a subsidiary of Head Co) in return for $1 million cash. Following the transaction, the market value of Head Co's shares in Transfer Co is $0.75 per share.

Six months later Head Co sells 3 million shares in Transfer Co for $0.77 per share, realising a loss of $0.23 per share. $0.20 of this loss is attributable to the indirect value shift. A reasonable reduction under the realisation time method would be $0.20 per share, reducing Head Co's loss to $0.03 per share.

10.229 The appropriate amount of an adjustment must take into account the particular characteristics of the interest being realised. The value of a loan that has priority over other debts owed by the losing entity, for example, might be less affected than those other debts by a scheme that shifts value out of the entity.

10.230 If the value of an interest has been reduced by an indirect value shift by more than the amount of the loss that would arise on realisation of the interest, the loss is reduced to nil.

Example 10.23

Under a scheme, LossCo disposes of an asset valued at $100,000 to GainCo for no consideration. LossCo's share capital consists of 10,000 shares with a market value before the value shift of $10.50 per share. The adjustable value of each share is $1. LossCo has also borrowed money from related companies under secured loan agreements.

The indirect value shift is unlikely to affect the value of the secured debt owed by LossCo. After the value shift the value of each share in LossCo would be reduced by $10 to $0.50, resulting in a loss of $0.50 per share if the shares are realised.

On realisation of any affected interest consisting of shares in LossCo, the loss on each share would be reduced by $0.50 to nil. No loss or gain would be realised on the shares for tax purposes.

10.231 There may be cases where a roll-over applies under Part 3.3 of the ITAA 1997 on realisation of an interest in the losing entity. If the interest is an affected interest, its reduced cost base at the time of the realisation event is reduced by the same reduction amount that would have applied to the loss made on the interest if there had been no roll-over. The reduction applies for the purpose of determining the reduced cost base of the interest for the new owner (if the roll-over is a 'same-asset roll-over') or the reduced cost base of a replacement asset (in the case of a 'replacement-asset roll-over'). [Schedule 15, item 1, subsection 727-645(1)]

Example 10.24

H and K, who are associates, between them own 50% of the shares in Mining Co. They paid $0.50 per share for their interests. The market value of the shares has since fallen to $0.35.

As a result of the non-arm's length disposal of a mining tenement, the market value of shares in Mining Co is further reduced to $0.25 per share. Subsequently, the company cancels all its shares and issues new shares to the shareholders at the rate of one share for every 4 shares previously held. H and K choose roll-over under Subdivision 124-E of the ITAA 1997 in respect of the cancellation of their shares.

The disposal of the mining tenement has resulted in a value shift from Mining Co to the purchaser (which H and K also owned 50% of the shares in). The value shift reduced the value of H's and K's shares by $0.10 per share and would have increased their loss by that amount if they had sold the shares before they were cancelled. The reduced cost base of the shares is reduced by $0.10 for the purpose of determining the reduced cost base of the new shares under section 124-15.

10.232 Subdivision 170-D of the ITAA 1997 may also be affected by the adjustments required for an indirect value shift under the realisation time method. Subdivision 170-D defers a capital loss or deduction that a company would otherwise have when it disposes of a CGT asset to, or creates a CGT asset in, a linked or connected entity. Generally, the capital loss or deduction becomes available when the CGT asset stops being held by a member of a linked group to which the company belongs or a connected entity.

10.233 If Subdivision 170-D applies the amount of the loss or deduction remaining after Division 727 adjusts the capital loss or realised on an interest in an entity that was the losing entity for an indirect value shift, is disregarded. [Schedule 15, item 12, subsection 170-270(2)]

Adjustments on realisation of interests in gaining entity

10.234 The realisation time method provides for the reduction of gains made on the realisation of interests in the gaining entity. Subject to certain caps, any gain should be adjusted by the amount that is reasonable having regard to the extent to which the value shift increased the market value of the interest. An estimate may be made of the extent to which the value shift affected the market value of the interest. [Schedule 15, item 1, section 727-620]

10.235 What adjustment would be reasonable must take into account whether all or part of the value that was shifted to the gaining entity is still reflected in the value of an affected interest when it is realised. If, for example, all of the increased value is removed before the affected interest is realised, no adjustment would be appropriate in respect of the affected interest.

10.236 The total adjustments made on realisation of affected interests in the gaining entity must not exceed the total reductions that have been made up to that time on the realisation of interests in the losing entity (including any adjustments made under Subdivision 727-K for interests realised before the IVS time: see paragraphs 10.294 to 10.308). A formula is provided in subsection 727-625(2) to achieve this. [Schedule 15, item 1, section 727-625]

10.237 If, apart from section 727-625, the adjustments made in respect of interests in the gaining entity would be greater in aggregate than the reductions previously made for interests in the losing entity, the formula takes the difference between those 2 amounts and apportions it between the interests then being realised in the gaining entity. The adjustment that would otherwise have been made in respect of each interest is reduced by this calculated amount. This cap is necessary to prevent affected owners benefiting from an adjustment in respect of interests in the gaining entity that is not matched (because of the loss-focused approach) by reductions in respect of interests in the losing entity.

10.238 Special rules are required to determine whether the aggregate adjustments in respect of interests in the gaining entity would be greater than the aggregate reductions previously made on realisation of interests in the losing entity, and by how much, when the interest is held as a revenue asset. For an interest in the losing entity that was a revenue asset, the reductions to the loss arising on the interest as a revenue asset and to the capital loss arising on the interest as a CGT asset may be different. Similarly, if an interest that has gained in value was held as a revenue asset, the adjustment made to the revenue gain on realisation of the interest may differ from the adjustment made to the capital gain that arises. In both cases, the greater of the 2 adjustment amounts is used in applying the formula in section 727-625. [Schedule 15, item 1, section 727-630(4) and (5)]

10.239 For an interest in the losing entity that an affected owner held as trading stock, it is the adjustment made to the cost or value of the interest as trading stock that is used in applying the formula. On realisation of an interest in the gaining entity that was trading stock, the formula is worked out using the adjustment made to the value of the item as trading stock (if applicable) or the adjustment made to the assessable income on disposal. [Schedule 15, item 1, section 727-630(2) and (3)]

10.240 In a case where a roll-over applies under Part 3.3 of the ITAA 1997 on realisation of an interest in the gaining entity, adjustments may be made to the cost base of the interest. The cost base is increased by the same amount that would have applied to reduce the gain made on the interest if there had been no roll-over. If a cap would have applied in determining the reduction to be made to the gain, this is reflected in the amount of the uplift to the cost base of the interest.

10.241 The increase is made to the cost base of the interest at the time of the realisation event and applies for the purpose of determining the cost base of the interest for the new owner (if the roll-over is a 'same-asset roll-over') or the cost base of a replacement asset (if it is a 'replacement-asset roll-over'). [Schedule 15, item 1, subsection 727-645(2)]

An interest in both the losing and gaining entities

10.242 An interest in the gaining entity may at the same time be an interest in the losing entity. Depending on the extent of the interest in each entity, the value of such an interest may fall, increase or remain unchanged as a result of the indirect value shift.

10.243 In general, under the realisation time method it is appropriate in these situations to make adjustments according to the net effect of the indirect value shift on the value of the interest. If the net effect has been a reduction in the value of the interest, and the interest is realised at a loss, the loss is reduced by a reasonable amount having regard to the net reduction in value. If the indirect value shift has produced a net increase in the value of the interest, and a gain arises when the interest is realised, the gain may be reduced by a reasonable amount having regard to the net increase in value. No adjustments are made to a gain arising on realisation of an interest that fell in value as the net result of an indirect value shift, or to a loss on realisation of an interest that increased in value as the net result of an indirect value shift. [Schedule 15, item 1, paragraph 727-615(b)]

10.244 When an interest that had a net increase in value is realised and a gain arises, the amount of the reduction to the gain may be limited by section 727-625 (see paragraph 10.236). Also, if all or part of the value of the interest which was attributable to the increased value of the gaining entity, is not present when the interest is realised, that increased value (or the part) is disregarded in determining whether an adjustment is appropriate and the amount of the adjustment. (There may be cases in which, because the increased value is no longer present, the net effect of the indirect value shift has been to create a loss when the interest is realised. In this situation the loss must be adjusted as if the increased value had never been present.) [Schedule 15, item 1, section 727-620 and subsection 727-800(5)]

Example 10.25

R Co wholly owns S Co and has an 80% interest in T Co. S Co holds the remaining 20% interest in T Co and wholly owns U Co. An indirect value shift occurs between T Co and U Co causing the value of shares in T Co to fall and the value of S Co's shares in U Co to increase.

R Co later sells its interest in T Co and a part of its shareholding in S Co. R Co's capital loss on the shares in T Co is reduced to nil, applying the realisation time method.

There has been a net increase in the value of R Co's shares in S Co. The gain that R Co realises on sale of the part shareholding in S Co, so far as it is attributable to the indirect value shift, is less in total than the adjustment made on sale of the shares in T Co. Therefore R Co's gain can be reduced having regard to the full net increase in the value of the shares that were sold, provided the increased value is still reflected in the value of the shares.

If part of the value shifted to U Co were no longer reflected in the value of the shares in S Co when they were sold, it might be reasonable to make only a smaller reduction in the gain that R Co makes on the sale.

Split or merged interests

10.245 Provisions are included for making adjustments where equity or loan interests are split or merged between the time of a value shift and the first realisation of a particular affected interest. Broadly, adjustments must be made to the new interests as if they had existed at the time of the value shift and had been affected by it to the same extent as the previous interests were affected.

10.246 The 2 or more interests created by a splitting of an affected equity or loan interest, or the new interest or interests created by a merging of 2 or more affected equity or loan interests, are treated as if they had all those characteristics of the original interests that would have been relevant in deciding whether adjustments are required on a realisation of them, and the amount of the adjustments. So, the Division applies to any interest that replaced the original interest or interests following the split or merger as if it had been an affected interest held by an affected owner immediately before the IVS time. Adjustments are made based on a reasonable proportion of the adjustments that would have been appropriate for the original interest, had it still existed, or based on the aggregate of the adjustments that would have been appropriate (in the case of merged interests). [Schedule 15, item 1, sections 727-635 and 727-640]

How adjustments are made

10.247 The adjustment amount determined under Subdivision 727-G is applied to affected interests according to the character in which the interests are held. If an interest in the losing entity is not held on revenue account or as trading stock, any reduction required to be made on realisation of the interest is made to the capital loss that arises on realisation. An adjustment for an interest in the gaining entity that is not held on revenue account or as trading stock is made to the capital gain that arises on realisation.

10.248 Where a roll-over applies on realisation of an interest in the losing entity or gaining entity, any adjustments are made to the reduced cost base (in the case of the losing entity) or the cost base (in the case of the gaining entity) of the interest with effect from the time of the realisation.

10.249 A realisation for this purpose is any CGT event except CGT event E4 (dealing with capital payments for a trust interest) or CGT event G1 (capital payments for shares). [Schedule 15, item 1, paragraph 727-645(1)(a)]

10.250 If an interest is held on revenue account or as trading stock, adjustments are made in its character as a revenue asset or as trading stock. Adjustments are also still made to its character as a CGT asset to the extent there is a relevant capital loss. .

10.251 For an affected interest in the losing entity held on revenue account, the reduction required to be made is applied to the loss that arises for income tax purposes on realisation of the interest. For an affected interest in the gaining entity, the adjustment amount is applied to the profit that would be returned as a result of the realisation. [Schedule 15, item 1, sections 727-610, 727-615 and 727-620]

10.252 Adjustments are made in a different way for interests in their character as trading stock. In the case of an interest in the losing entity that is disposed of at a loss, a reduction is made to the cost of the interest as trading stock or to its value as trading stock at the start of the year in which the disposal happens. If the interest is retained and valued as trading stock at the end of an income year, the cost of the interest as trading stock or its value as trading stock at the start of that year is reduced to prevent a loss being recognised for tax purposes in that year. [Schedule 15, item 1, section 727-610, 727-615, 727-620; item 19, Division 977]

Example 10.26

On 1 August 2003 Trader Co purchases as trading stock 50% of the units in Investment Trust. Under an IVS scheme later that year, Investment Trust sells part of its investment portfolio for less than its market value to Benefit Co, a company controlled by Trader Co.

If Trader Co still holds its 50% interest in Investment Trust as trading stock at the end of its income year on 30 June 2004, and values it for tax purposes at its market value, that market value may be less than the cost of the interest. Division 727 prevents a loss from being recognised by reducing the amount Trader Co can deduct as the cost of the interest.

Alternatively, Trader Co might adopt the acquisition cost of its interest in Investment Trust as its value for trading stock purposes at 30 June 2004. If so, no loss results for the 2003-2004 income year. A loss may arise, however, when Trader Co sells all or part of its interest in a later year. In that case Division 727 reduces the value of the interest as trading stock at the start of the income year in which the disposal happens.

10.253 For affected interests in the gaining entity held as trading stock, the necessary adjustments are made by reducing the amount that would be included in the owner's assessable income on disposal of the interest, or reducing the value of the interest as trading stock on hand at the start of the income year.

Applying the adjustable value method

10.254 If a choice is made under section 727-550 to adopt the adjustable value method, Subdivision 727-H applies to determine whether adjustments are required in respect of an indirect value shift, and the amount of the adjustments. [Schedule 15, item 1, section 727-550]

Interests in the losing entity

10.255 Whether adjustments are required, and the extent of the adjustments, may depend on whether a choice has been made not to apply the loss-focused approach. The loss-focused basis only requires reductions to be made to the adjustable values of affected interests in the losing entity if a loss would have arisen had the interest been realised at the IVS time. On a non-loss-focused basis, adjustments are made in every case reflecting the effect of the indirect value shift on the market value of affected interests. [Schedule 15, item 1, subsection 727-770(5) and section 727-780]

10.256 The first step in determining what adjustments may be required is to work out whether the indirect value shift has produced a 'disaggregated attributable decrease' in the market value of an interest in the losing entity. [Schedule 15, item 1, section 727-775]

10.257 If it has, Subdivision 727-H may require the adjustable value of the interest to be reduced by a reduction amount. Otherwise, there is no reduction. [Schedule 15, item 1, subsections 727-775(3) to (4)]

What is a disaggregated attributable decrease?

10.258 To work out the disaggregated attributable decrease (if any), the market value of the interest at the IVS time must first be determined or reasonably estimated, but disregarding:

•

all effects on the market value from the time the scheme commenced except effects reasonably attributable to the indirect value shift; and

•

the effect (if any) the indirect value shift had on the market value of the interest to the extent it is also an interest in the gaining entity. (Whether an uplift is available in respect of this effect is determined under sections 727-800 to 727-810).

10.259 This amount is the notional resulting market value of the interest. [Schedule 15, item 1, subsection 727-775(2)]

10.260 If the notional resulting market value is less than the market value of the interest immediately before the scheme was entered into (in the case of interests acquired before the scheme was entered into) or is less than the market value of the interest when the owner last acquired it (if it was acquired after the scheme was entered into) - the old market value - the difference is the disaggregated attributable decrease.

10.261 If the notional resulting market value is greater than or equal to the old market value, there is no disaggregated attributable decrease. [Schedule 15, item 1, subsections 727-775(3) and (4)]

Amount of the reduction

10.262 Considering first the loss-focused approach: adjustments are only made if the notional resulting market value (following the indirect value shift) is less than the adjustable value of the interest immediately before the IVS time (the old adjustable value ). If it is greater than or equal to the old adjustable value, adjustments are not required on the loss-focused basis.

10.263 If the old market value is greater than or equal to the old adjustable value, and the notional resulting market value is less than the old adjustable value, the adjustable value is reduced to the notional resulting market value. This means that the indirect value shift cannot cause a loss to arise on disposal of the interest. [Schedule 15, item 1, subsection 727-780(2), item 1 in the table]

Example 10.27

Before the commencement of a scheme involving a shift of value from L Co to G Co, the market value of H Co's interests in L Co is $100,000 (reduced cost base $80,000). At the IVS time for the scheme, the market value of those interests is $50,000. The value shift under the arrangement is the sole cause for the reduction in value. H Co is an affected owner under the scheme.

Under the loss-focused approach, the required reduction for H Co's interests in L Co is limited to $30,000, the excess of the adjustable value over the notional resulting market value. No adjustment is required for the unrealised gain element ($20,000) of the shift.

10.264 If the old market value is less than the old adjustable value, and the notional resulting market value is less than the old adjustable value, the adjustable value is reduced by the amount of the disaggregated attributable decrease. This has the effect of preserving a loss that existed in an interest before the value shift, but the indirect value shift does not increase it. [Schedule 15, item 1, subsection 727-780(2), item 3 in the table]

Example 10.28

The market value of interests that Parent Co holds in Loss Co before a value shift is $120,000. The adjustable value of those interests is $150,000. As a result of an indirect value shift for which Parent Co is an affected owner, the market value of Parent Co's interests is reduced to $80,000.

The required reduction under the loss-focused approach to the adjustable values of Parent Co's interests will be the full attributable decrease ($40,000).

10.265 In summary, a reduction is required only if, as a result of the indirect value shift, a loss (or a greater loss) can be made on realisation of the interest. The reduction is such amount as is necessary to prevent the loss or the increased loss having an effect on the tax position of entities with affected interests in the losing entity.

10.266 Should a choice be made, however, not to adopt the loss-focused method, the adjustable values of affected interests are reduced by the disaggregated attributable decrease. No account is taken of whether the indirect value shift might result in a loss on realisation of the interests.

10.267 A safeguard has been included in case the reduction calculated under Subdivision 727-H is unreasonable (bearing in mind the object of the IVS measures) in an entity's particular circumstances. In that event a smaller reduction may be substituted. This smaller reduction must be determined on a reasonable basis having regard to the object of preventing inappropriate losses from arising on the realisation of interests whose value was affected by the indirect value shift. [Schedule 15, item 1, subsection 727-770(6)]

Effects of the Subdivision on the tax treatment of various kinds of assets

10.268 Special rules determine the adjustments to the adjustable values of various kinds of assets, including trading stock and revenue assets. Broadly, similar approaches apply for reductions and increases.

10.269 Unlike under the CGT provisions - where gains are measured by reference to cost base and losses by reference to reduced cost base - trading stock and revenue assets have a single cost figure for both purposes. For this reason certain modifications apply to the way the rules work for assets that are held as trading stock or on revenue account.

CGT assets

10.270 For a CGT asset (which may also be trading stock or a revenue asset), both the cost base and the reduced cost base of an equity or loan interest are reduced or uplifted immediately before the IVS time if the Subdivision provides for the adjustable value to be reduced or uplifted [Schedule 1, item 1, subsections 727-830(1) and (2)] . For this purpose the adjustable value of the interest is assumed to be its reduced cost base (for reductions) or its cost base (for increases) as appropriate [Schedule 15, item 1, subsection 727-830(4)] .

10.271 If the Division requires both a reduction and an uplift in the adjustable value of an equity or loan interest, the adjustable value is reduced by a net amount or, if the uplift is greater, remains unchanged. [Schedule 15, item 1, subsection 727-830(5)]

10.272 The cost base or reduced cost base is uplifted only to the extent that the increase in value is reflected in the market value of the interest when a later CGT event happens to it. It is not required, however, that the increase actually be reflected in the state or nature of the interest at that time. [Schedule 15, item 1, subsection 727-830(3)]

10.273 Reductions and uplifts also apply to pre-CGT assets. This is relevant for applying other provisions of the income tax law (including CGT) where it may be necessary to determine the reduced cost base or cost base of a pre-CGT asset. [Schedule 15, item 1, subsection 727-830(6)]

Trading stock

10.274 Rules are included to deal with the way the Subdivision applies to an equity or loan interest that is trading stock of an entity immediately before the IVS time and the tax consequences. [Schedule 15, item 1, subsections 727-835(1)]

10.275 Broadly, the adjustable value of trading stock is taken to be its value under Division 70 of the ITAA 1997 or its cost if not valued under that Division (e.g. if it was purchased during the relevant year of income). [Schedule 15, item 1, subsection 727-835(2)]

10.276 If the Subdivision reduces or increases the interest's adjustable value, the entity is treated as if it had sold the interest to someone else (at arm's length and in the ordinary course of business) for its adjustable value and, afterwards, the entity bought the interest back for the reduced or increased adjustable value as applicable. [Schedule 15, item 1, section 727-590 and subsection 727-835(3)]

10.277 The deemed disposition is stated in these terms to ensure that the owner of the interest is not taken to have received consideration equal to its market value. Effectively, the entity derives assessable income equal to the adjustable value which reverses the deduction available for the opening balance or cost under Division 70.

10.278 The entity is treated as having bought the interest back immediately afterwards for the reduced or increased adjustable value (i.e. after adjustment). The asset would retain its character as trading stock if in fact it remained trading stock.

10.279 The notional sale and repurchase are separated in time so that if another indirect value shift happens in relation to the interest later in the same income year, the adjustable value of the interest for the purposes of the Division at that later time is its cost on the notional repurchase or latest notional repurchase if more than one. [Schedule 15, item 1, paragraph 727-835(3)(b))]

Example 10.29

An interest of an entity that is trading stock with a value under Division 70 of $20,000 has its adjustable value increased under the Subdivision by $3,000. The entity is taken to have disposed of the trading stock for $20,000 (and therefore it derives $20,000 assessable income which offsets the deduction available in respect of the opening Division 70 value) and immediately after that time the trading stock is taken to have been reacquired for a cost of $23,000.

10.280 If the Subdivision requires both a reduction and an uplift in the adjustable value of an equity or loan interest, the value at which the interest is notionally repurchased is based on the net reduction or (if the uplift is greater) remains unchanged. [Schedule 15, item 1, subsection 727-835(5)]

10.281 Again, any uplift in the adjustable value that results from an indirect value shift is only taken into account to the extent that the increase in value is still reflected in the market value of the interest.

Revenue assets

10.282 For interests that are revenue assets, the total of the costs that would be taken into account in determining any profit or loss on disposal of the interest is treated as the interest's adjustable value. [Schedule 15, item 1, section 727-840]

10.283 The Subdivision applies to interests in their character as revenue assets in the same way it applies to trading stock.

10.284 Provisions similar to those for trading stock are made for net adjustments (where an interest is in both the losing and gaining entity) and for disregarding, in the notional repurchase price, any increase in value that is subsequently removed from interests in the gaining entity. [Schedule 15, item 1, subsections 727-840(3) to (5)]

Interests in the gaining entity

10.285 If there has been a reduction to the adjustable values of interests in the losing entity, adjustments may be made to the adjustable values of interests in the gaining entity. They are worked out using the scaling-down formula:

disaggregated attributable increase * (total reductions for affected interests / total disaggregated attributable decreases)


[Schedule 15, item 1, subsection 727-810(1)]

10.286 The 'disaggregated attributable increase' for an interest in the gaining entity is worked out on a similar basis to the disaggregated attributable decrease for interests in the losing entity. A 'notional resulting market value' is worked out. It is the market value of the interest at the IVS time (estimated on a reasonable basis), adjusted to remove:

•

all effects on the market value from the time the scheme commenced except effects reasonably attributable to the indirect value shift; and

•

the effect (if any) the indirect value shift had on the market value of the interest to the extent it is also an interest in the losing entity.

The amount (if any) by which the notional resulting market value is greater than the market value of the interest immediately before the scheme was entered into (in the case of interests acquired before the scheme was entered into), or is greater than the market value of the interest when the owner last acquired it (if it was acquired after the scheme was entered into), is the disaggregated attributable increase. [Schedule 15, item 1, section 727-805]

10.287 The 'total reductions for affected interests' in the formula means the total of all reductions made, because of the indirect value shift, to the adjustable values of affected owners' equity and loan interests in the losing entity and reductions made to losses that were realised on equity or loan interests in the losing entity. The latter reductions - made to losses realised on equity or loan interests - are those made in accordance with Subdivision 727-K (discussed in paragraphs 10.294 to 10.308) when interests in the losing entity were realised before the IVS time for the IVS scheme.

10.288 The 'total disaggregated attributable decreases' means the total of all disaggregated attributable decreases that the indirect value shift has produced in the market values of all affected equity and loan interests (including indirect interests) in the losing entity. If Subdivision 727-K has applied to reduce losses in respect of interests that were realised before the IVS time for the scheme, the 'total disaggregated decreases' also includes the total of disaggregated attributable decreases the presumed IVS produced in the market value of those realised interests: provided the indirect value shift to which the formula is being applied is the only indirect value shift, or alternatively the greatest of 2 or more value shifts, that occurred under the scheme. [Schedule 15, item 1, subsection 727-810(2)]

10.289 The total reductions for affected interests cannot exceed the total disaggregated attributable decreases for affected interests, so the fraction can never exceed one. Thus, the uplift can never exceed the disaggregated attributable decrease.

Example 10.30

The disaggregated attributable increase for a particular interest in the gaining entity is $1,480. The total reductions to adjustable values under section 727-780 for affected interests is $18,000 and the total disaggregated attributable decreases is $50,000. No interests were realised before the IVS time.

The maximum uplift that can be obtained on the interest in the gaining entity is: $1,480 * $18,000 / $50,000 = $532.80.

10.290 The amount of the uplift is capped to prevent owners of affected interests in a gaining entity receiving an undue benefit in this situation: part of the increased value of the affected owners' interests may be attributable to value shifted from interests in the losing entity that were not held by affected owners. If full uplifts were available in this situation, the affected owners in the gaining entity would be freed from any liability to tax on this increased value, although they and their associates would not have suffered any corresponding loss of value, and related adjustments, in relation to interests in the losing entity.

10.291 To prevent this, a cap is worked out based on the total amount of adjustments made to the adjustable values of direct affected interests in the losing entity. In effect, the maximum uplift available for each affected interest is the increase in the value of that interest that might be expected to have resulted if the total amount of adjustments made had been the value shifted. [Schedule 15, item 1, subsection 727-800(6)]

Example 10.31

Principal Co owns 90% of the shares in Down Co and 95% of the shares in Up Co. The remaining 10% of the shares in Down Co and 5% of shares in Up Co are owned by Adam and Brian respectively, who are not associates of Principal Co or active participants in the scheme.

A value shift from Down Co to Up Co causes the value of Principal Co's interest in Down Co to fall by $900,000 and its interest in Up Co to increase in value by $950,000. The adjustable values of Principal Co's shares in Down Co are reduced by $900,000. Adam's shares in Down Co have lost $100,000 value, and this is reflected in an increase in value in both Principal Co's and Brian's interests in Up Co.

The uplift available for Principal Co's interests in Up Co is capped at 95% of $900,000, that is, $855,000.

10.292 As was the case for interests in the losing entity, a different adjustment may be substituted if the uplift worked out under Subdivision 727-H is unreasonable in an entity's particular circumstances, considering the object of the IVS measures. The substituted uplift must be determined on a reasonable basis having regard to the object of the measures. [Schedule 15, item 1, subsection 727-800(7)]

10.293 An interest in the gaining entity may at the same time be an interest in the losing entity. In this situation no uplift is available in the adjustable value of the interest unless the adjustable value is required also to be reduced as a result of the value shift. An interest owned by an affected owner that confers an interest in both the losing and gaining entity cannot have its adjustable value uplifted to a level higher than it would have been if the scheme had not been entered into. [Schedule 15, item 1, subsection 727-800(5)]

Subdivision 727-K - Interest realised at a loss before IVS time

10.294 Diagram 10.6 sets out the tests for determining whether Subdivision 727-K may apply.

Diagram 10.6: Does Subdivision 727-K apply?

10.295 In limited circumstances, an equity or loan interest in a prospective losing entity may be realised at a loss before any IVS time has happened for a scheme. In such circumstances some of the information required to apply the normal IVS provisions may not be available. Consequently separate provision is made for these situations in Subdivision 727-K.

10.296 Such consequences may ensue only in the following circumstances:

•

a company or trust (except a superannuation entity) - referred to as the prospective losing entity - provides or might provide economic benefits in connection with a scheme;

•

before an IVS time has happened for the scheme, direct or indirect equity or loan interests in the prospective losing entity are realised and, apart from the Subdivision, a loss would result;

•

there is a presumed indirect value shift;

•

no automatic exclusion applies to the presumed indirect value shift; and

•

certain conditions about the prospective gaining entity or entities are satisfied.

[Schedule 15, item 1, section 727-850]

Example 10.32

XYZ Co is a member of a 100% owned, but non-consolidated group. It enters into an agreement with the parent entity to transfer an item of property for no consideration to another group company to be nominated by the parent entity at a specified date.

If equity or loan interests in XYZ Co are realised at a loss before the specified date, Subdivision K may apply to require an adjustment to be made under the realisation time method to reflect the value shifted out of the interest by the arrangement above.

Presumed indirect value shift

10.297 The concept of a presumed indirect value shift is similar to the concept of an indirect value shift, with the following modifications:

•

it must be reasonable to conclude that, in connection with the scheme, the prospective losing entity is providing benefits that can be identified to another entity or entities (which may or may not be identified or in existence); and

•

it must be reasonable to conclude that the total market value of these benefits will be greater than the market value of any identifiable economic benefits it may receive in return.

[Schedule 15, item 1, subsections 727-855(1) to (3) and 727-865(1)]

10.298 The provisions in Subdivision 727-B about providing economic benefits apply in the normal way to a presumed indirect value shift to determine whether unequal economic benefits have been or are likely to be provided and the amount of the presumed indirect value shift. The special market value rule for depreciating assets (see paragraphs 10.86 to 10.93) is also available.

10.299 If the economic benefit can be identified and is not contingent, and the entities involved can be identified and are in existence, at a time before the interest is realised, the benefit is valued at that time. Otherwise, it is valued at the time immediately before the interest is realised. [Schedule 15, item 1, subsection 727-855(2)]

10.300 The amount of the indirect value shift is the excess of the value of the benefits likely to be provided by the prospective losing entity over the value of any benefits it may receive. The indirect value shift happens at the realisation time. [Schedule 15, item 1, subsections 727-855(1) and 727-865(1)]

Conditions that must be known about the prospective gaining entity

10.301 There are certain things that must be known about the prospective gaining entity for the Subdivision to be attracted. [Schedule 15, item 1, section 727-860]

10.302 Enough must be known about the identity of at least one recipient or intended or possible recipient of the economic benefits from the prospective losing entity for it to be reasonable to conclude that if:

•

the presumed indirect value shift were an indirect value shift resulting from the scheme;

•

the IVS period ended at the time the interest is realised; and

•

the recipient were a gaining entity,

then either the ultimate controller test or the common ownership nexus test would be satisfied for the indirect value shift. [Schedule 15, item 1, subsection 727-860(2)]

10.303 Enough must also be known about the identity of the prospective gaining entity for it to be reasonable to conclude that in relation to the benefits being provided under the scheme, the entities are not dealing with each other at arm's length. [Schedule 15, item 1, subsection 727-860(3)]

10.304 It must be possible to determine whether these conditions are satisfied no later than the time by which the entity that realised the equity or loan interest must lodge an income tax return for that year or, if no income tax return is required, within 6 months after the end of the income year in which the realisation happens. [Schedule 15, item 1, subsection 727-860(5)]

Exclusions

10.305 In general, a presumed indirect value shift may be disregarded in the same circumstances in which an indirect value shift would have been disregarded under the realisation time method. All of the 'automatic exclusions' (see paragraphs 10.129 to 10.162) are relevant, with the exception of the exclusion for value shifted down a wholly-owned chain of entities. The exclusion for 95% services indirect value shifts also apply to presumed indirect value shifts. [Schedule 15, item 1, subsection 727-865(2)]

10.306 In order to apply the provisions detailing these exclusions, the presumed indirect value shift is treated as if it were an actual indirect value shift, the time of realising the interest in the losing entity is treated as the IVS time for the scheme, and the IVS period ends at that realisation time. The provisions apply as if the prospective losing entity for the scheme were the 'losing entity' and each prospective gaining entity a 'gaining entity'. There are further modifications to facilitate the application of the exclusion for 95% services indirect value shifts. [Schedule 15, item 1, subsection 727-865(3)]

10.307 If the conditions described in paragraphs 10.260 to 10.265 are satisfied, the loss that would have resulted from realising the equity or loan interest is reduced in a similar way to reductions made under the realisation time method. A loss that is attributable wholly to the presumed indirect value shift under the scheme is reduced to nil. For a loss partly due to other factors, an estimate should be made of the extent to which the scheme reduced the market value of the interest: the loss is reduced by this amount. If an equity or loan interest is realised more than once before an IVS time occurs, the amount of the adjustment at the second or subsequent time does not take into account any effect the presumed indirect value shift may have had on its value before the previous realisation [Schedule 15, item 1, paragraphs 727-850(1)(i) and (j)] . There are rules for presumed indirect value shifts equivalent to those for indirect value shifts in the case of interests that are split or merged between the time of entering into the scheme and realisation of the interest and for realisation events at which a CGT rollover applies or that are held as revenue assets or trading stock. [Schedule 15, item 1, subsection 727-865(4) and sections 727-870 and 727-875]

10.308 These adjustments relate to direct and indirect interests in the prospective losing entity. No reductions are available for gains that might arise when interests in a gaining entity are realised before the IVS time. However, adjustments that are made to losses following a presumed indirect value shift are later taken into account in determining the maximum adjustments that may be made when interests in a gaining entity are realised after the IVS time for the scheme. The particular operation of the IVS provisions provided for in Subdivision 727-K does not prevent Division 727 applying in the normal way if it would have had any additional application to the indirect value shift.

Subdivision 727-L: Indirect value shift resulting from a direct value shift

10.309 An indirect value shift may arise as a consequence of a direct value shift. For example, if a company and trust (which are associates) hold all of the shares in another company and the value of the shares held by the company falls because some of the rights attached to them are changed and the values of shares of the trust increase as a result, a direct value shift has occurred. The shares held by the company are down interests to which Division 725 may apply. The reduction in value of the shares may then be reflected in the value of interests that a controlling entity has in the company. In the same way, shares of the trust are up interests to which Division 725 may apply. The increase in value of the shares may be reflected in the value of interests the same controlling entity has in the trust. An indirect value shift has occurred affecting the interests of the controlling entity in the company and trust.

10.310 Subdivision 727-L applies to an indirect value shift (including a presumed indirect shift) that results from a direct value shift. The losing entity (the company or trust in the above example) is treated as having provided economic benefits to the entity that owned the up interests under the direct value shift. The value of the economic benefits taken to have been provided is equal to the total amount of value shifted from the down interests to the up interests. [Schedule 15, item 1, subsections 727-910(1) and (2)]

10.311 The 2 entities are also taken not to have been dealing with each other at arm's length in providing these economic benefits; and the benefits are assumed not to consist of or include the provision of services or a right to have services provided (so that the exclusions for services-related value shifts cannot apply). [Schedule 15, item 1, subsections 727-910(3) and (4)]

10.312 The effect of these provisions is that, if the ultimate controller test or the common ownership nexus test is satisfied for the losing and gaining entities, the conditions may be met for Division 727 to apply to affected interests in relation to the indirect value shift. Unless one of the exceptions in Subdivision 727-C applies, or the exception under the realisation time method for value shifts of less than $500,000 that happen more than 4 years before an interest is realised, adjustments may be required in respect of the indirect value shift.

10.313 Subdivision 727-L may apply even if the direct value shift does not have consequences under Division 725. For example, a direct value shift may have no consequences under Division 725 if the state of affairs that produced the value shift is likely to be of limited duration (section 725-90). Despite this exclusion, adjustments may be required in respect of the resulting indirect value shift under Division 727. [Schedule 15, item 1, subsections 727-905(1) and (2)]

10.314 An entity may cause a direct value shift to happen in various ways, including by issuing new interests at a discount, buying back existing interests or changing the voting rights attached to existing interests. In the case of an issue of new interests at a discount, the potential exists for both the DVS and IVS measures to make adjustments in respect of the same interests. This potential duplication is avoided by preventing Division 727 from applying, in these particular cases, except as specified in Subdivision 727-L. [Schedule 15, item 1, subsection 727-905(3)]

Example 10.33

H Co wholly owns X Co. X Cohas a controlling shareholder interest in Y Co and also such an interest in Z Co. Z Co issues shares at an undervalue to Y Co. There is the possibility of the DVS rules being attracted in respect of X Co's shares in Z Co (they are down interests) and the IVS rules also applying at that level (because there was an unequal exchange of economic benefits between Z Co and Y Co). The priority rule will mean that the DVS rules will take precedence.

Application and transitional provisions

10.315 The Division will apply to schemes entered into on or after 1 July 2002 from which indirect value shifts result. Divisions 138 and 139 will be repealed as from 1 July 2002.

10.316 There are transitional provisions ensuring that reductions required to be made under the repealed Divisions are still made (see Chapter 12).

10.317 Further consideration is to be given to the application of Division 727 to non-resident entities (including CFCs).

Consequential amendments

10.318 Consequential amendments are discussed in Chapter 12.