Senate

Revised Explanatory Memorandum

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

Chapter 12 - Commencement of the general value shifting regime and consequential amendments

Outline of chapter

12.1 This chapter explains when a value shift is subject to the existing value shifting rules and when the new GVSR rules apply. It also describes amendments to various provisions of the ITAA 1997 and the ITAA 1936 that are required as a consequence of the introduction of the GVSR.

12.2 Other consequential amendments will be included in a later bill.

Context of reform

12.3 The introduction of the GVSR is a key component of the New Business Tax System announced in Treasurer's Press Release No. 58 of 21 September 1999 (refer to Attachment K).

12.4 The introduction of a GVSR to deal comprehensively with value shifting requires amendments to the ITAA 1997 and the ITAA 1936.

Summary of new law

Transition

12.5 In broad terms, the new GVSR measure operates from 1 July 2002. The existing value shifting rules (Division 138 - asset stripping; Division 139 - debt forgiveness; and Division 140 - share value shifting) have a continuing operation in relation to earlier value shifts and, in some cases, to shifts that happen after 30 June 2002.

12.6 Table 12.1 summarises the transitional arrangements.

Table 12.1

Consequential amendments

12.7 There are amendments consequential on the introduction of the new measure that:

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repeal some existing provisions;

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insert new provisions;

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update some existing provisions;

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repeal redundant definitions;

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replace existing definitions; and

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insert additional definitions.

12.8 A new Division 977 is inserted to define what is meant by a 'realisation event' and the circumstances in which a realisation event realises a loss or realises a gain for income tax purposes.

Detailed explanation of new law

Commencement and transitional provisions

12.9 New Division 723 applies to the realisation of an asset on or after 1 July 2002 if a right has been created in relation to the asset on or after that date. Neither the GVSR measure nor the existing DVS rules apply to the creation of rights over CGT assets before 1 July 2002. [Schedule 15, item 2, section 723-1]

12.10 The new measure covers direct value shifting (Division 725 - see Chapter 8) applies to arrangements entered into on or after 1 July 2002. A direct value shift under a scheme entered into on or after 27 June 2002 may also be subject to the new measure, provided that all increases and decreases in the value of interests held by affected owners that result from the scheme happen on or after 1 July 2002 [Schedule 15, item 2, section 725-1] . The existing value shifting rules under Division 140 generally apply to direct value shifting schemes that affect the value of interests before 1 July 2002.

12.11 A transitional provision has been included to extend the operation of Division 140 beyond 30 June 2002, for schemes entered into before 1 July 2002 that are not covered by the new Division 725. [Schedule 15, item 15]

12.12 Division 727, dealing with indirect value shifting (see Chapter 10), also applies to all schemes entered into on or after 1 July 2002. The Division may extend to a scheme entered into before that date, but no earlier than 27 June 2002, if :

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the IVS time for the scheme (see paragraph 10.99) is on or after 1 July 2002; or

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an affected interest is realised on or after 1 July 2002, although an IVS time has not occurred.

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

This could happen, for example, where the parties are committed to a value shifting scheme but some aspect of the scheme (such as the incorporation of the gaining entity) has not been finalised by 1 July 2002.

12.13 For schemes entered into in the period from 27 June 2002 to 30 June 2002, however, the existing value shifting provisions apply, rather than the GVSR measure, if a 'trigger event' referred to in section 138-15 or section 139-10 happened during that period between two companies and was part of the value shifting scheme. A 'trigger event' might be the disposal of an asset or the creation of a right for less than the market value, or the forgiveness of a debt. [Schedule 15, item 2, subsection 727-1(3)]

12.14 Divisions 138 and 139, containing the existing indirect value shifting rules, continue to apply after 30 June 2002 for schemes entered into before 27 June 2002, and for schemes referred to in paragraph 12.13. This continued operation ensures, among other things, that the cost bases and reduced cost bases of interests in companies involved in indirect value shifts before 1 July 2002 are adjusted, where required, when the interests are realised on or after 1 July 2002. [Schedule 15, items 13 and 14]

Repealing redundant provisions

12.15 The GVSR replaces a number of regimes that currently address the issue of value shifting. The following Divisions in the ITAA 1997 are repealed:

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Division 138 (value shifting by asset stripping);

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Division 139 (value shifting through debt forgiveness); and

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Division 140 (share value shifting).

[Schedule 15, items 9 to 11]

12.16 Section 104-140 of the ITAA 1997, CGT event G2, that happens when there is a share value shift under Division 140 of the ITAA 1997, is also repealed by this bill. [Schedule 15, item 5]

New provisions

12.17 As a result of the introduction of the direct value shifting rules of the GVSR, a new CGT event (CGT event K8) is introduced into the ITAA 1997. Its main features are:

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CGT event K8 happens when there is a taxing event that results in a capital gain under section 725-245 - in some cases, the owner of an equity or loan interest that has lost value in a direct value shift makes a capital gain worked out under section 725-365 (this is discussed in paragraphs 8.155 to 8.165);

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the time of the event is the decrease time for the down interest (i.e. the time when the decrease in market value happens); and

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a capital gain is disregarded if the down interest is a pre-CGT asset.

[Schedule 15, item 6, section 104-240]

12.18 A new subsection is added to section 170-270 of the ITAA 1997. Section 170-270 has the effect that any capital loss a company would have made, or any deduction it would have been entitled to, on disposing of a CGT asset to, or on creating a new asset in, a related entity, is deferred. The new subsection states, to avoid doubt, that the amount deferred is the capital loss or deduction that would have arisen after making any reduction required under Division 723 or under the realisation time method in Division 727. If either of these Divisions would have reduced the capital loss or deduction to nil, no amount remains that could be deferred under section 170-270. [Schedule 15, item 12, subsection 170-270(2)]

12.19 The effect of new subsection 170-270(2) is that, when a subsequent event causes the deferred capital losses or deductions to become available, the capital loss or deduction that arises is the adjusted amount (if any) remaining after applying Division 723 or 727.

Realisation events

12.20 New Division 977 explains a number of terms used in the provisions that implement the GVSR, and are also used in the loss integrity measure amendments discussed in Chapter 13. The terms 'realisation event', 'realises a loss for income tax purposes' and 'realises a gain for income tax purposes' have different operations according to whether the asset concerned is a CGT asset, a revenue asset or an item of trading stock. Division 977 sets out how the terms apply in relation to assets in each of these 3 characters.

12.21 Realisation event has the meaning given by sections 977-5, 977-20 and 977-55. [Schedule 15, item 75, subsection 995-1(1)]

12.22 For a CGT asset, a realisation event is a CGT event, other than CGT event E4 or G1 [Schedule 15, item 19, section 977-5] . A capital loss cannot be made when either of these CGT events happens.

12.23 For an item of trading stock, a realisation event is a disposal of the item or the ending of an income year. [Schedule 15, item 19, section 977-20]

12.24 For a revenue asset, a realisation event is the disposing of, ceasing to own, or otherwise realising the asset [Schedule 15, item 19, paragraph 977-55(a)] . A CGT asset is also a revenue asset if, and only if, a profit or loss on disposing of it, ceasing to own it, or otherwise realising it, would be taken into account, in calculating assessable income as a tax loss, otherwise than as a capital gain or capital loss and the asset is neither trading stock nor a depreciating asset [Schedule 15, item 19, section 977-50] .

Losses realised for income tax purposes

Capital loss

12.25 A realisation event that happens to a CGT asset realises a loss for income tax purposes if the entity makes a capital loss from the event [Schedule 15, item 19, section 977-10] . A realisation event realises a loss for income tax purposes, under this section, even if the capital loss is disregarded (for example, because a roll-over applies under Part 3-3 of the ITAA 1997). This could also be the case if the relevant asset was an item of trading stock, but an item of trading stock normally has a nil or minimal reduced cost base because the cost of the item can be deducted for tax purposes.

12.26 The extent of any capital loss realised from the event may be affected by whether there is also a loss realised for income tax purposes on a CGT asset in its character as a revenue asset. This is because subsection 110-55(9) or 110-60(7) of the ITAA 1997 may have the effect of reducing the reduced cost base of assets by certain deductions obtained on their disposal.

12.27 The capital loss that the event realises is a loss to which Division 723 or 727 may, for example, apply.

Trading stock

12.28 Sections 977-25 and 977-30 deal with the realisation of an item of trading stock at a loss for income tax purposes. Broadly, this happens where the item is sold for an amount less than its cost (if it was acquired and sold in the same income year) or (if it is sold in a later year) is sold for an amount less than its value under Division 70 at the start of the income year. An item of trading stock also realises a loss for income tax purposes if its closing value under Division 70 for an income year is less than its cost or opening value (as applicable) for that year. The difference between the assessable proceeds of sale or the closing value, and the item's cost or value under Division 70, is the loss that may be adjusted under Division 723 or 727. [Schedule 15, item 19, sections 977-25 and 30]

Revenue asset

12.29 A disposal, ceasing to own or other realisation of a revenue asset realises a loss for income tax purposes where a loss results from this realisation event [Schedule 15, item 19, paragraphs 977-55(b) and (d)] . Whether a loss results is determined in accordance with the ordinary accounting principles that apply for calculating a profit or a loss on realisation of an asset. If a loss has been made on this basis, that loss is subject to adjustment - for example, in respect of a value shifting arrangement.

Where realised loss reduced by another provision

12.30 If a provision of the ITAA 1997 (for example Division 727) reduces the loss that would otherwise be realised for income tax purposes by the event, the loss that is realised is reduced by the same amount [Schedule 15, item 19, subsections 977-10(2), 977-25(2) and (3) and paragraph 977-55(e)] . This may be relevant for the application of another provision of the law (eg. section 165-115ZD of the ITAA 1997) where reference is made to a loss realised for income tax purposes.

Parallel provisions for gains

12.31 Parallel provisions apply to determine whether a realisation event realises a gain for income tax purposes and the amount of the gain.

Gains realised for income tax purposes

Capital gains

12.32 For a CGT asset, a realisation event realises a gain for income tax purposes if the entity makes a capital gain from the event. [Schedule 15, item 19, section 977-15] A realisation event realises a gain for income tax purposes, under this section, even if the capital gain is disregarded. This could be the case if the CGT asset is an item of trading stock. However a capital gain is reduced, not disregarded, if the anti-overlap provisions (e.g. in section 118-20 of the ITAA 1997) apply, so the extent to which a gain for income purposes is realised from the event may be varied where the asset is also a revenue asset.

12.33 The capital gain may be adjusted if, for example, Division 727 applies.

Trading stock

12.34 The realisation of an item of trading stock realises a gain for income tax purposes if the item is sold for an amount more than its cost (if it was acquired and sold in the same income year), or is sold for an amount more than its value under Division 70 at the start of the income year (if the sale happens in a later year). For an item of trading stock that is still on hand at the end of an income year, the realisation event (the ending of the income year) realises a gain for income tax purposes if its closing value under Division 70 at that time is more than its cost or opening value (as applicable). The difference between the assessable proceeds of sale or the closing value, and the item's cost or value under Division 70, is the gain that may be adjusted under Division 727. [Schedule 15, item 19, sections 977-35 and 40]

Revenue asset

12.35 For a revenue asset, a realisation event realises a gain for income tax purposes where a gain results from the event [Schedule 15, item 19, paragraphs 977-55(c) and (d)] . Again, this is determined in accordance with the ordinary accounting principles that apply for calculating a profit or a loss on realisation of an asset. Any gain that results may be subject to adjustment under Division 727.

Adjustments under Division 723 or 727

12.36 Division 723 or 727 may require an adjustment to be made when a realisation event realises a loss for income tax purposes. Under Division 727 an adjustment may also be available when a realisation event realises a gain for income tax purposes. In either case, if the adjustment is to be made in the asset's character as a revenue asset or a CGT asset, it is the loss or gain referred to in Division 977 that is adjusted.

12.37 A slightly different method is used for adjustments in relation to assets held as trading stock. If a loss must be adjusted, the cost or other value of the item of trading stock under Division 70 is reduced by the adjustment amount. If a gain is to be adjusted, the assessable income produced on disposal of the item of trading stock is reduced by the adjustment amount, or (if the item is still held at the end of the income year) its cost or other value as trading stock under Division 70 is increased by the adjustment amount.

12.38 If a provision of the ITAA 1997 (e.g. Division 727) reduces the gain that would otherwise be realised for income tax purposes by the event, the gain that is realised is reduced by the same amount. [Schedule 15, item 19, subsections 977-15(2), 977-35(2) and (3), 977-40(3) and paragraph 977-55(e)]

Updated provisions

12.39 Changes have been made to the summary of CGT events that appears in the table in section 104-5 of the ITAA 1997 to reflect the removal of CGT event G2 and the insertion of CGT event K8. [Schedule 15, items 3 and 4]

12.40 The table in section 112-45 is amended in a similar way. This table indicates which elements of the cost base and reduced cost base of an asset are affected when certain CGT events happen to the asset. A reference to new CGT event K8 replaces the former references to CGT event G2. [Schedule 15, items 7 and 8]

Income Tax Assessment Act 1936

12.41 A value shift may result from the forgiving of a debt. If the debtor and creditor were not dealing at arm's length in connection with the forgiveness, the GVSR measures have a complementary operation to Schedule 2C to the ITAA 1936 (dealing with forgiveness of commercial debts). The GVSR rules apply to the extent that the debt had value at the time it was forgiven, while Schedule 2C applies to any part of the debt's original value that had been lost before the debt was forgiven.

12.42 To ensure this complementary operation continues, any adjustments made under the GVSR to the cost base of an asset of the debtor (for example, an interest it holds in the creditor) must be ignored in determining the gross forgiven amount of the debt under Schedule 2C. This is achieved by substituting into subsection 245-85(1) in Schedule 2C a revised paragraph (b), to ensure that the gross forgiven amount is not reduced by the amount of any adjustment made under Division 727. It is also noted, for the purposes of paragraph 245-85(1)(c), that there is no need to exclude a Division 727 adjustment from the operation of that paragraph (which reduces a gross forgiven amount by an amount of a cost base reduction under the CGT provisions) because Division 727 is not part of those provisions. [Schedule 15, items 16 and 17]

12.43 Section 245-250 in Schedule 2C is also amended by omitting the reference to section 138-25. Section 138-25 was included in Division 138 of the ITAA 1997, which will now be repealed (see paragraph 8.12). Section 245-250 now refers to the definition of 'under common ownership' contained in subsection 995-1(1). [Schedule 15, item 18, section 245-250]

Repealing redundant definitions

12.44 Several definitions in the ITAA 1997 that related to the previous value shifting provisions are no longer required and will therefore be repealed. These are:

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associate-inclusive control interest (this definition operated only for the purposes of Division 140 - the definition in Part X of the ITAA 1936 is not being repealed);

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decreased value shares;

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increased value shares;

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indexed common ownership market value;

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material decrease;

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material increase;

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residual value;

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share value shift; and

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total share value increase.

[Schedule 15, items 26, 30, 45, 46, 59, 60, 74, 83 and 85]

Definitions that have been moved

12.45 The definition of 'under common ownership' has been moved from section 138-15 to the Dictionary. The meaning remains unchanged. [Schedule 15, item 88]

Existing definitions with a changed meaning

12.46 A number of terms in the existing law have been redefined as a result of the GVSR. These are:

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adjustable value: redefined to include adjustable value for an equity or loan interest;

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discount: redefined to cover loan interests as well as equity interests that are issued at a discount;

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fixed entitlement: the revised definition refers to an entity, rather than a beneficiary, having a fixed entitlement;

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fixed trust: redefined to incorporate changes in terminology;

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indirectly: redefined to incorporate changes in terminology; and

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provide: redefined to extend its application to a provision of economic benefits.

[Schedule 15, items 22, 36, 39, 40, 51 and 73]

12.47 In addition, the definition of 'market value' has been amended to make it clear that paragraph (a) of the existing definition does not apply in working out the market value of economic benefits or the market value of an equity or loan interest under the value shifting measures. Paragraph (a) of the existing definition requires the market value of an asset, to which it applies, to be reduced by the amount of any GST input tax credit that might arise if the asset were acquired at that time. [Schedule 15, item 58]

New definitions

12.48 A number of new definitions are inserted for terms used in the GVSR. Except where indicated, the meanings of the terms are explained in the previous chapters. The new terms are:

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95% services indirect value shift;

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active participant;

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adjustable value method;

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affected interest;

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affected owner;

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common ownership;

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common ownership nexus;

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control (for value shifting purposes);

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decrease time;

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direct value shift;

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direct roll-over replacement;

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disaggregated attributable decrease;

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disaggregated attributable increase;

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down interest;

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equity or loan interest;

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gaining entity;

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greater benefits;

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in connection with;

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increase time;

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indirect equity or loan interest;

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indirect primary equity interest;

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indirect roll-over replacement;

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indirect value shift;

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intermediate controller;

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IVS period;

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IVS time;

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lesser benefits;

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losing entity;

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loss-focused basis;

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non-complying approved deposit fund (this term refers to an approved deposit fund that is not a complying approved deposit fund under the Superannuation Industry (Supervision) Act 1993 );

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non-fixed trust (a trust is a non-fixed trust unless entities have fixed entitlements to all of the income and capital of the trust);

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post-CGT asset (a CGT asset is a post-CGT asset unless it was last acquired before 20 September 1985 and has not stopped being a pre-CGT asset through the operation of a provision in the ITAA 1936 or the ITAA 1997);

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predominantly-services indirect value shift;

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pre-shift gain;

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pre-shift loss;

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presumed indirect value shift;

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primary equity interest;

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primary interest;

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primary loan interest;

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prospective gaining entity;

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prospective losing entity;

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realisation event;

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realisation-time method;

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realised for income tax purposes;

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revenue asset;

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secondary equity interest;

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scheme period;

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secondary interest;

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secondary loan interest;

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taxing event generating a gain;

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ultimate controller;

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ultimate stake; and

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up interest.

[Schedule 15, items 20, 21, 23 to 25, 27 to 29, 31 to 35, 37, 38, 41 to 44, 47 to 50, 52 to 57, 61 to 72, 75 to 82, 84, 86, 87 and 89]