House of Representatives

Explanatory Memorandum

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

Chapter 4 - Subsidiary members held through interposed non-resident entities

Outline of chapter

4.1 This chapter explains:

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modifications to the consolidation membership rules contained in Division 703 of the ITAA 1997 which relate to when an entity is eligible to be a subsidiary member of a consolidatable or consolidated group, where there are one or more non-resident entities interposed between that entity and the head company of the group; and

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the cost setting rules for the assets of those subsidiary members on joining and on leaving a consolidated group.

Context of reform

4.2 Under the membership rules contained in Division 703 of the ITAA 1997, a consolidated or a consolidatable group consists of a single resident head company and all of the eligible resident wholly-owned subsidiaries of the head company. The rules allow certain resident wholly-owned subsidiaries of the head company to be subsidiary members of a consolidatable or consolidated group despite one or more non-resident entities being interposed between the head company and the resident subsidiaries.

4.3 This measure will make modifications to those rules to allow non-resident entities to be interposed between group members as a transitional measure only. These modifications will maintain the integrity of the consolidation cost setting rules without adding unnecessary complexity to the ongoing rules.

Summary of new law

Membership rules for subsidiary members held through interposed non-resident entities

4.4 This bill amends the membership rules contained in Division 703 of the ITAA 1997 to limit the circumstances within which non-resident entities can be interposed between members of a consolidated or consolidatable group.

4.5 Broadly, only those consolidated groups that consolidate with effect before 1 July 2004 are eligible to have non-resident entities interposed between members of the group. Further, in general, subsidiary members of such consolidated groups may only be held by interposed non-resident entities where those non-resident holdings were in place at the time of formation of those consolidated groups. Such a subsidiary member is referred to as a transitional foreign-held subsidiary.

Cost setting rules for subsidiary members held through interposed non-resident entities

4.6 Modifications are made to the cost setting rules contained in Divisions 701, 705 and 711 to set tax costs of assets of entities that become members of a consolidated group, where there are interposed non-residents between that member and the group.

Detailed explanation of new law

Changes to the consolidation membership rules regarding interposed entities

4.7 Section 703-45 of the ITAA 1997 outlines certain ownership tests that need to be satisfied before an entity that is a wholly-owned subsidiary can qualify as a subsidiary member of a consolidatable or consolidated group where there are one or more entities interposed between it and the head company of the group. Those tests are discussed in Chapter 3 of the explanatory memorandum to the May Consolidation Act.

4.8 The ownership tests in section 703-45 have now been replaced with a test that requires any entities that are interposed between the entity being tested (the 'test entity') and the head company of a consolidatable or consolidated group at a particular time (the 'test time' (see paragraphs 4.13 to 4.14)) to be either:

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a subsidiary member of the group; or

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an entity that holds membership interests in the test entity or a subsidiary member of the group (that is interposed between the head company and the test entity) only as a nominee of one or more entities that are members of the group.

[Schedule 16, item 2, section 703-45]

Circumstances in which non-resident entities can be interposed between members of a consolidatable or consolidated group

4.9 As a transitional measure, the rule in paragraph 4.8 is relaxed in limited circumstances to allow certain resident companies, trusts and partnerships to be subsidiary members of a consolidatable or consolidated group despite one or more (non-member) non-resident entities being interposed between the resident entities and the head company of the group.

4.10 The transitional rules replicate those rules in section 703-45 of the ITAA 1997 which allowed certain non-resident entities to be interposed between members of a consolidatable or consolidated group. However, supplementary rules will now apply so that those rules will now operate in a transitional manner. This limitation is necessary to maintain the integrity of the cost setting rules without adding unnecessary complexity to the ongoing rules.

4.11 Under the transitional rules, the ownership tests to establish whether a resident wholly-owned subsidiary that is held through one or more non-resident entities can be a subsidiary member of a consolidatable or consolidated group will be determined by the nature of the entity being tested. There are slightly different tests that are applied for consolidatable groups and consolidated groups. This is because once a group is consoldiated, the group must meet further tests for foreign held entities to continue to be subsidiary members of the consolidated group. This requirement is not relevant for a consolidatable group. The relevant tests, referred to in this explanatory memorandum as the interposed foreign residency tests, are outlined in paragraphs 4.12 to 4.27.

Interposed foreign residency tests

The tests that apply when the test entity is a company

4.12 When the test entity is a company, it will qualify as a subsidiary member of a consolidatable or consolidated group at a particular time (the 'test time') if at the test time:

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there is at least one entity interposed between the test entity and the head company that is either:

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a foreign resident company (referred to as a 'non-resident company'); or

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a trust that does not meet the residency tests set out in the consolidation membership rules (referred to as 'a non-resident trust'. These tests, located in section 703-25 of the ITAA 1997, are discussed in paragraphs 3.60 and 3.61 of the explanatory memorandum to the May Consolidation Act);

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each entity interposed between the test entity and the head company of the group is one of the following:

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an entity that is a subsidiary member of the group;

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a non-resident company;

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a non-resident trust;

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an entity that holds membership interests in an entity interposed between it and the test entity, or in the test entity, only as a nominee of one or more entities each of which is a member of the group, a non-resident trust or a non-resident company; or

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a partnership, where each partner is a non-resident company or a non-resident trust; and

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the test entity would be a subsidiary member of the group if it was assumed that each of the following interposed entities was a subsidiary member of the group:

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each interposed entity that is a non-resident company; and

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each interposed entity that is a non-resident trust.

[Schedule 16, item 5, subsections 701C-10(1) to (5)]

4.13 In addition to the requirements in paragraph 4.12, the requirements in paragraphs 4.15 to 4.20 must be met for an entity, that is a company, to be a subsidiary member of a consolidatable or consolidated group at a particular time. The test in paragraph 4.15 is only applicable if, at the test time, the group is a consolidatable group. The test in paragraph 4.17 is relevant if the test time is the formation time and the group is a consolidated group. The requirements in paragraphs 4.19 and 4.20 will apply if the test time is after the formation time and the group is a consolidated group.

4.14 It is these additional requirements that distinguish the interposed foreign residency tests set out in this explanatory memorandum to the interposed foreign residency tests set out in the explanatory memorandum that accompanied the May Consolidation Act.

Additional requirement for consolidatable groups

4.15 If the group is a consolidatable group, the test time must be before 1 July 2004. [Schedule 16, item 5, subsection 701C-10(6)]

4.16 This test effectively ensures that on or after 1 July 2004 there will be no consolidatable groups in existence that have non-resident entities interposed between members of the group. This effectively prevents consolidated groups that form after 1 July 2004 from being able to form with non-resident entities interposed between members of the group.

Additional requirement for consolidated groups at formation

4.17 If the group is a consolidated group and the test time is at the time at which the group forms a consolidated group, the test time must be before 1 July 2004. [Schedule 16, item 5, subsection 701C-10(7)]

4.18 This test effectively ensures that only those consolidated groups that form before 1 July 2004 are permitted to have non-resident entities interposed between members of the group at the formation time.

Additional requirement for consolidated groups after formation

4.19 This additional requirement applies if:

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the group is a consolidated group; and

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the test time is after the consolidated group comes into existence; and

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one or more membership interests in the test entity are held at the test time by:

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a non-resident company; or

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a non-resident trust; or

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an entity that holds the membership interests only as a nominee of one or more entities each of which is a non-resident company or a non-resident trust; or

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a partnership, each of the partners in which is a non-resident company or a non-resident trust.

[Schedule 16, item 5, paragraphs 701C-10(8)(a) to (c)]

4.20 In this case, the test entity will only be a subsidiary member of the consolidated group where:

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the entity had been a subsidiary member of the consolidated group at all times from the time the consolidated group came into existence until the test time; and

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at the time that the group came into existence as a consolidated group, one or more membership interests in the test entity had been held by a non-resident entity or a nominee of a non-resident entity (of a kind set out in the third dot point of paragraph 4.19).

[Schedule 16, item 5, paragraphs 701C-10(8)(d) and (e)]

4.21 One implication of this rule operating in conjunction with the rule in paragraph 4.17 is that only certain consolidated groups that form before 1 July 2004 will be eligible, after the group forms, to have subsidiary members that are held through interposed non-resident entities.

4.22 This rule effectively prevents an entity from becoming a subsidiary member of any existing consolidated group where membership interests in that entity are held at the test time by a non-resident entity that is interposed between it and the head company of the group. For example, where a non-resident entity that is a wholly-owned subsidiary of the head company (of a consolidated group) acquires all of the membership interests in an Australian resident entity subsequent to that group forming, that resident entity will be ineligible to become a subsidiary member of the group.

4.23 Also, this rule will generally cause an entity whose membership interests are not held by a non-resident entity(s) to cease being a subsidiary member of a consolidated group where some or all of its membership interests are transferred to a non-resident wholly-owned subsidiary of the head company. An exception applies where the entity had been a subsidiary member of the consolidated group at all times since the group came into existence, and at the time that the group formed some or all of the membership interests in that entity were held by an interposed non-resident entity.

4.24 Generally, an entity will continue to qualify as a subsidiary member of a consolidated group where membership interests in that entity were held by an interposed non-resident entity at the time that the group formed and some or all of the membership interests in the entity are subsequently transferred to other subsidiary members of the group, certain non-resident entities or certain nominees.

The test that applies where the test entity is a trust or partnership

4.25 If the test entity is a trust or partnership, it will be a subsidiary member of a consolidatable or consolidated group at a particular time (the 'test time') provided that one or more of the interposed companies are subsidiary members of the group because the relevant requirements in paragraphs 4.12 to 4.20 are met. [Schedule 16, item 5, subsections 701C-15(1) to (3)]

4.26 In addition, it must be the case that, at the test time, the entity would be a subsidiary member of the group had the head company beneficially owned all of the membership interests that are beneficially owned by each company that qualifies as a subsidiary member because the applicable requirements in paragraphs 4.12 to 4.20 are satisfied. [Schedule 16, item 5, subsection 701C-15(4)]

4.27 The interposed foreign residency tests effectively allow the interposed non-resident entities to be disregarded for the purposes of determining who is a subsidiary member of a consolidatable or consolidated group. The non-resident entities will not themselves become subsidiary members of the consolidatable or consolidated group.

Classification of certain subsidiary members that satisfy the interposed foreign residency tests

4.28 Entities that are subsidiary members of a consolidated group in a case where the interposed foreign residency tests (in paragraphs 4.12 to 4.26) are met are classified as either transitional foreign-held subsidiaries or transitional foreign-held indirect subsidiaries.

4.29 The classification of an entity as either a transitional foreign-held subsidiary or a transitional foreign-held indirect subsidiary is dependent on the nature of the entity(s) that holds membership interests in that entity.

What is a transitional foreign-held subsidiary?

4.30 An entity is a transitional foreign-held subsidiary if:

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it is a company that qualifies as a subsidiary member of a consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 are met; and

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one or more membership interests in the entity are held by:

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a non-resident company (this is a foreign resident company); or

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a 'non-resident trust' (this is a trust that does not satisfy the residency tests set out in section 703-25 of the ITAA 1997. See paragraphs 3.60 and 3.61 of the explanatory memorandum to the May Consolidation Act for further details of these tests); or

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an entity that holds the membership interests in that entity only as a nominee of one or more entities each of which is a non-resident company or a non-resident trust; or

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a partnership, each of the partners in which is a non-resident company or a non-resident trust.

[Schedule 16, item 5, paragraphs 701C-20(a) to (c)]

What is a transitional foreign-held indirect subsidiary?

4.31 An entity is a transitional foreign-held indirect subsidiary if:

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the entity, being either a company, trust or partnership, is a subsidiary member of a consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 (applicable where the test entity is a company) or paragraphs 4.25 and 4.26 (applicable where the test entity is a trust or partnership) are satisfied; and

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the entity is not a transitional foreign-held subsidiary; and

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one or more membership interests are held in it by:

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an entity that is a transitional foreign-held subsidiary; or

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an entity that is a transitional foreign-held indirect subsidiary.

[Schedule 16, item 5, paragraph 701C-20(d)]

4.32 One implication of the requirement in the third dot point in paragraph 4.31, as illustrated by Example 4.2, is that an entity will be classified as a transitional foreign-held subsidiary (rather than a transitional foreign-held indirect subsidiary) where membership interests in that entity are held by entities that include the following:

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an entity that is a non-resident entity or a nominee of a non-resident entity (of a kind set out in the second dot point of paragraph 4.30); and

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an entity that is a transitional foreign-held subsidiary.

4.33 Examples 4.1 and 4.2 illustrate the differences between transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries.

Example 4.1

Assume that all of the entities in this example are companies.

In this example, a consolidated group exists consisting of a head company, Head Co, and subsidiary members Y Co, X Co, A Co and Z Co.

Head Co holds all of the membership interests in a non-resident entity, which in turn holds all of the membership interests in A Co. A Co holds all of the membership interests in Z Co.

Assume that A Co and Z Co qualify as subsidiary members of the consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 are satisfied.

Which entities are transitional foreign-held subsidiaries?

A Co is a transitional foreign-held subsidiary. This is because:

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it is a company that qualifies as a subsidiary member of a consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 are satisfied; and

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its membership interests are held by a non-resident company.

Z Co is not a transitional foreign-held subsidiary as its membership interests are not directly held by a non-resident entity (or a nominee of a non-resident entity).

Which entities are transitional foreign-held indirect subsidiaries?

Z Co is a transitional foreign-held indirect subsidiary. This is because:

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it is a company that qualifies as a subsidiary member of a consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 are satisfied; and

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it is not a transitional foreign-held subsidiary; and

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its membership interests are held by A Co, a transitional foreign-held subsidiary.

Example 4.2

This example modifies Example 4.1, the differences being:

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A Co holds 50% of the membership interests in Z Co, with the non-resident entity holding the remaining 50% of the membership interests in Z Co.

In this example, a consolidated group consists of the head company, Head Co and subsidiary members Y Co, X Co, A Co and Z Co.

Assume that A Co and Z Co qualify as subsidiary members of the consolidated group in a case where the relevant interposed foreign residency tests in paragraph 4.12 to 4.20 are met.

Which entities are transitional foreign-held subsidiaries?

A Co is a transitional foreign-held subsidiary, for the reasons stated in Example 4.1.

Z Co is also a transitional foreign-held subsidiary. This is because:

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it is company that is a subsidiary member of a consolidated group in a case where the relevant interposed foreign residency tests in paragraphs 4.12 to 4.20 are satisfied; and

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some of its membership interests are directly held by a non-resident company (unlike in Example 4.1).

An entity that is a transitional foreign-held subsidiary cannot be a transitional foreign-held indirect subsidiary (see paragraph 4.31). Therefore, Z Co (and A Co) is not a transitional foreign-held indirect subsidiary.

Why can't certain entities that are owned through interposed non-resident entities become subsidiary members in other circumstances?

4.34 The key policy principle in relation to cost setting is to align the cost of acquiring an entity with the tax cost of the assets within that entity. An exception to this rule is where a consolidated or MEC group forms during the transition period and the choice is made to retain the costs of the assets of the group.

4.35 It is not possible to reset the cost bases of assets of a transitional foreign-held subsidiary. This is because the cost setting rules cannot be applied to that subsidiary through an interposed non-resident entity. Any modifications that are made to apply the cost setting rules to a non-resident entity would be both complex and affect the integrity of the cost setting rules.

4.36 This means that the tax cost of assets in a foreign-held entity cannot be reset. If foreign-entities were to be accommodated on an on-going basis further complexity will be added to the cost setting rules. Without further rules that take into account the fact that foreign-held entities do not have their tax cost reset there would be an unintended harsh result where the majority of the cost bases of the assets in the transitional foreign-held entities are less than their market values. In the reverse situation, where the cost bases of the assets of the transitional foreign-held entities are more than their market values, there may be a duplication of losses.

4.37 Additionally, such an ongoing rule would present tax arbitrage opportunities. More specifically, such a rule would effectively extend the transitional option to retain the costs of assets on an ongoing basis, which would weaken the integrity of the cost setting rules. For example, in situations where a head company wishes to acquire a resident entity, the head company could avoid the requirement to reset the costs of the assets held by the resident entity by interposing a wholly-owned non-resident between itself and the acquired entity. This would have the effect of turning the acquired entity into a transitional foreign-held subsidiary, which would then not have its costs reset. Such a feature would be in direct conflict with the original policy principle of aligning the costs of acquiring the membership interests in an entity with the cost of the assets of that entity.

Cost setting rules for transitional foreign-held entities

4.38 Where a group first comes into existence, the general tax cost setting rules are modified so that each entity that becomes a subsidiary member of the group is treated in the same way as an entity joining an existing consolidated group (see Subdivision 705-B of the ITAA 1997).

4.39 These amendments will further modify the cost setting rules contained in Subdivision 705-B to accommodate transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries that become members of a consolidated group when the group forms [Schedule 16, item 5, subsection 701C-25(2)] . Some or all of the membership interest in the transitional foreign-held subsidiary are owned by non-resident entities. Membership interests in transitional foreign-held indirect subsidiary are owned entirely by members of the consolidated group. It is due to this difference in circumstance that the cost setting rules differ for transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries. There are modifications in relation to the transitional foreign-held subsidiary (see paragraphs 4.40 to 4.42 and 4.51 and 4.52) for when that subsidiary becomes a member and leaves a consolidated group. The cost setting rules for transitional foreign-held indirect subsidiaries do not need to be modified (see paragraphs 4.43 to 4.44 and 4.50).

Cost setting modifications when a consolidated group comes into existence

4.40 A general modifying rule is required to set the tax costs of assets of a transitional foreign-held subsidiary because the cost setting rules cannot be applied through an interposed non-resident entity. Setting the tax costs of assets of a transitional foreign-held subsidiary through the interposed non-resident would add complexity to the law and impinges on the integrity of the cost setting rules (see paragraphs 4.34 to 4.37).

4.41 Under the general modifying rule the transitional foreign-held subsidiary is treated as if it were a part of the head company of the group, rather than a separate entity [Schedule 16, item 5, section 701C-30] . This has the effect of retaining the existing tax costs of the assets of that subsidiary. This is because the rules that set the tax costs of assets only applies to subsidiary members of a group. The head company of a group does not have its costs reset.

4.42 Other important effects of the general modifying rule are:

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the cost setting provisions that operate if the head company of the group holds membership interests in another entity operate if the transitional foreign-held subsidiary holds membership interests in another entity [Schedule 16, item 5, section 701C-30, note 1(a)] ;

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the cost setting provisions that operate if the head company owns or controls another entity operate if the transitional foreign-held subsidiary own or control another entity [Schedule 16, item 5, section 701-C-30, note 1(b)] ; and

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references within the cost setting provisions to an entity interposed between the head company and another entity will apply to an entity interposed between a transitional foreign-held subsidiary and another entity [Schedule 16, item 5, section 701C-30, note 1(c)] .

4.43 The cost of assets of transitional foreign-held indirect subsidiaries are reset using the cost setting rules contained in Subdivision 705-B. The retained cost base of the direct membership interests that the transitional foreign-held subsidiary holds in the transitional foreign-held indirect subsidiary is used when determining the joined group's ACA in relation to the transitional foreign-held indirect subsidiary.

4.44 Where the consolidated group that has transitional foreign-held members satisfies the conditions for transitional groups, the head company will be able to choose to apply the transitional cost setting rules to retain the tax costs of assets held by transitional foreign-held indirect subsidiaries.

Trading stock of a transitional foreign-held subsidiary

4.45 As the cost assets (including trading stock) of a transitional foreign-held subsidiary are not reset when the consolidated group comes into existence, there is no need to set a tax neutral amount for its trading stock. [Schedule 16, item 5, section 701C-35]

Application of other cost setting rules

4.46 The membership rules dictate which set of cost setting rules contained in Division 705 that will apply. Transitional foreign-held entities can only become members of a consolidated group when the group comes into existence in the transitional period (see paragraphs 4.9 to 4.18).

4.47 As a result, if a transitional foreign-held subsidiary is a member of a consolidated group (the acquired group), and that group is acquired by another consolidated group (the acquiring group), the cost setting rules in Subdivision 705-C cannot apply. This is because the membership rules require the transitional foreign-held subsidiary to be a member of the acquiring group at the formation time of the acquiring group. In this case, the acquired group would be broken up at the joining time, with those resident subsidiaries that are still eligible to join the acquiring group having their costs reset under the 'linked entities' provisions in Subdivision 705-D.

4.48 An entity is precluded from joining a consolidated group when it is acquired after a consolidated group is formed, and there is a non-resident interposed between the entity and the head company of the group. In these circumstances, the group will only be able to bring the entity into the group by transferring the interposed non-resident's interests to members of the group. Existing roll-over relief can be used to effect the restructure. The rolled over cost base, calculated using existing provisions, of the non-resident's membership interests in the transitional foreign-held subsidiary is used in working out the group's ACA for that subsidiary.

Cost setting rules for when a transitional foreign-held subsidiary or transitional foreign-held indirect subsidiary leaves a consolidated group

4.49 Where a subsidiary leaves a consolidated group, just before the time the entity leaves, the head company recognises the membership interests in the leaving entity. The cost for membership interests is set at a cost equal to the head company's cost for the net assets that the leaving entity takes with it. The rules for setting the cost of membership interests held by a head company in a leaving entity are contained in Division 711 of the ITAA 1997. These cost setting rules preserves the alignment between the cost for membership interests in the leaving entity and its assets.

4.50 Where a transitional foreign-held indirect subsidiary leaves a consolidated group, Division 711 will apply. No modification is required to the Division 711 rules because the transitional foreign-held indirect subsidiary has all of its membership interests held, directly or indirectly, by the head company.

4.51 A modification is made to the operation of Division 711 in relation to a transitional foreign-held subsidiary that leaves the group. This is because, in contrast to transitional foreign-held indirect subsidiaries, some or all of the membership interests in a transitional foreign-held subsidiary are held by entities that are not members of the group. Without the modification, Division 711 would only recognise membership interests in the leaving transitional foreign-held subsidiary held by members of the group.

4.52 Division 711 is applied to the non-resident's membership interests in the transitional foreign-held subsidiary as if those membership interests were held by the head company [Schedule 16, item 5, section 701C-40] . As there is an ability to transfer assets and businesses within a consolidated group, a transitional foreign-held subsidiary may leave the group with different assets from those that it bought into the group. Without the modification that applies Division 711 to transitional foreign-held subsidiaries, value shifting opportunities would arise in relation to membership interest held in those subsidiaries.

Application and transitional provisions

4.53 The interposed foreign residency tests will be relevant to certain consolidatable groups before 1 July 2004 and to certain consolidated groups that come into existence before 1 July 2004.

4.54 The joining cost setting rules apply to transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries that become members on formation of consolidated groups, where those groups come into existence before 1 July 2004.

4.55 The leaving cost setting rules apply to transitional foreign-held subsidiaries and transitional foreign-held indirect subsidiaries when those members leave a consolidated group.

Consequential amendments

4.56 Minor consequential amendments have been made to Division 703 of the ITAA 1997 as a result of the changes to that Division discussed in this chapter.

4.57 Amendments to section 703-45 and subsection 703-15(2), item 2, column 4 in the table reflect the fact that the consolidation membership rules now only allow non-resident entities to be interposed between members of a consolidatable or consolidated group as a transitional measure. [Schedule 16, item 1, item 2, column 4 in the table in subsection 703-15(2); item 2, section 703-45]

4.58 Section 705-15 of the ITAA 1997 and the title to Division 701B of the IT (TP) Act 1997 are amended as a result of the insertion of the transitional foreign-held entity rules. [Schedule 16, items 3 and 4]

4.59 A note is added to section 711-5 (tax cost setting amount for membership interests where entities leave a consolidated group) to provide a cross-reference to the modifications made to Division 711. [Schedule 16, item 5, section 701C-50]