House of Representatives

Explanatory Memorandum

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

Chapter 3 - Consolidation

Outline of chapter

3.1 Schedule 3 to this Bill amends the consolidation provisions in the income tax law.

3.2 Part 1 amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

•

clarify the operation of the bad debt rules for multiple entry consolidated (MEC) groups

•

ensure that the modifications to the bad debt rules for consolidated groups and MEC groups also apply to determine whether consolidated groups and MEC groups can deduct swap losses.

3.3 Part 2 amends the Income Tax (Transitional Provisions) Act 1997 to extend the time, until 31 December 2005, for head companies of consolidated groups and MEC groups to make or revoke certain choices in relation to setting the tax cost of assets and the utilisation of losses.

Context of amendments

Modification to the bad debt rules for MEC groups

3.4 The bad debt rules specify the circumstances in which an entity (the claimant) can deduct a bad debt. Broadly, the claimant can deduct a bad debt only if it and any entity that has been owed the debt for a period satisfies certain conditions (including the continuity of ownership test or the same business test). The consolidation bad debts rules modify those conditions so that they apply appropriately to a consolidated group.

3.5 As MEC groups are structured differently to ordinary consolidated groups, further modifications are required to clarify the operation of the bad debt rules for MEC groups.

Swap losses

3.6 Swap losses arise if the amount of a debt that is extinguished under a debt/equity swap is greater than the equity value of the shares or units received. The tests to determine whether a taxpayer can deduct bad debts also apply to determine whether a taxpayer can deduct swap losses. Therefore, the modifications to the bad debt rules for consolidated groups and MEC groups also need to apply to determine whether consolidated groups and MEC groups can deduct swap losses.

Making and revoking certain choices

3.7 The consolidation regime provides for a number of irrevocable choices that the head company of a consolidated group or a MEC group can make in respect of setting the tax cost of its assets and for the utilisation of losses. Currently, these choices must be made on or before 31 December 2004.

3.8 Amendments which could affect a head company's decision in relation to these choices were passed earlier this year in the Tax Laws Amendment (2004 Measures No. 6) Act 2005 and the Tax Laws Amendment (2004 Measures No. 7) Act 2005 . Therefore, to give consolidated groups and MEC groups time to consider the implications of these amendments before certain choices they make in relation to setting the tax cost of assets and the utilisation of losses become irrevocable, the time for making and revoking these choices has been extended by 12 months, to 31 December 2005. This will ensure that consolidated groups and MEC groups are not disadvantaged as a consequence of the amendments.

Summary of new law

Modification to the bad debt rules for MEC groups

3.9 Part 1 of Schedule 3 to this Bill modifies the application of the bad debt rules so that, for MEC groups:

•

the continuity of ownership test is applied to the top company of the group

•

if the head company is a listed public company, the same business test is applied to the head company.

Swap losses

3.10 Part 1 of Schedule 3 also ensures that the modifications to the bad debt rules for consolidated groups and MEC groups apply to determine whether consolidated groups and MEC groups can deduct swap losses.

Making and revoking certain choices

3.11 Part 2 of Schedule 3 to this Bill extends the time, until 31 December 2005, within which the head company of a consolidated group or a MEC group can make or revoke each of the following choices:

•

The choice to retain the tax cost of a joining entity's assets.

•

The choice to cancel a loss by the head company of a consolidated group or MEC group.

•

The choice to use the value donor concessions.

•

The choice to waive the capital injection rules.

•

The choice to use certain losses over three years.

Comparison of key features of new law and current law

Detailed explanation of new law

Modification to the bad debt rules for MEC groups

3.12 A company can deduct a bad debt under section 25-35 only if, among other things, there has been no change in ownership or control of the company or the company has carried on the same business.

3.13 Broadly, the consolidation bad debt rules in Subdivision 709-D modify the operation of section 25-35 so that the claimant can deduct the debt, or part of it, only if each entity that was owed the debt for a debt test period could have deducted the debt if it had been written off as bad at the end of the period (section 709-210). For these purposes, the standard continuity of ownership test (section 165-123) and the same business test (section 165-126) principles are modified to make allowance for the different entity types that may be owed a debt within the consolidated group context.

3.14 The amendments in Part 1 of Schedule 3 insert new Subdivision 719-I which makes further modifications to the application of the continuity of ownership test (section 165-123) and the same business test (section 166-40) to ensure that they apply appropriately to MEC groups. [Schedule 3, item 1, section 719-450 ]

3.15 The modifications are required because MEC groups are structured differently to ordinary consolidated groups. Broadly, the modifications ensure that, for MEC groups:

•

the continuity of ownership test is applied to the top company (rather than the head company) of the group

•

if the head company is a listed public company, the same business test is applied to the head company.

When do the MEC group modifications to the bad debt rules apply?

3.16 The MEC group modifications to the bad debt rules apply for the purposes of working out whether the head company of a MEC group can deduct a debt that is incurred by a member of the MEC group (either directly by the head company or by another member of the group) and that is written off as bad. [Schedule 3, item 1, paragraph 719-455(1)(a)]

3.17 The modifications also apply for the purposes of working out whether the head company of a MEC group could have deducted a debt as described in subsection 709-215(2). [Schedule 3, item 1, paragraph 719-455(1)(b)]

3.18 In this regard, the head company of a MEC group could have deducted a debt as described in subsection 709-215(2) because, broadly:

•

a debt is incurred by a subsidiary member of the MEC group prior to it joining the group and is subsequently written off either by the head company of the group or by a subsidiary member that has left the group

or

•

a debt is incurred by a member of the MEC group whilst it is part of the group and is written off after a subsidiary member has left the group.

When the head company is taken to meet the continuity of ownership test

3.19 If the MEC group modifications to the bad debt rules apply, then the head company is taken to meet the continuity of ownership test in section 165-123 only if the top company (the 'test company') for the MEC group at the start of the ownership test period would have met the continuity of ownership test for that period on the assumptions (if applicable) that:

•

nothing happened in relation to certain things that would affect whether the test company would meet the continuity of ownership test

•

the test company would have failed to meet the continuity of ownership test in certain circumstances.

[Schedule 3, item 1, subsection 719-455(2)]

3.20 The continuity of ownership test is applied to the top company for the MEC group to ensure that it is the ultimate owners of the debt that are tested. It would be inappropriate to test the head company of the MEC group as the group's ability to satisfy the continuity of ownership test would change depending on which eligible tier 1 company was chosen as the head company.

3.21 Although the top company is the test company for the purposes of determining whether the head company of a MEC group satisfies the continuity of ownership test, for the purpose of applying the test:

•

the ownership test period referred to in section 165-123 is determined by reference to the head company (rather than the test company)

•

the debt referred to in section 165-123 is a reference to the debt owed to the head company.

Assumption about nothing happening to affect direct and indirect ownership of the test company

3.22 The first assumption that is made for the purpose of applying the continuity of ownership test to the test company is about nothing happening in relation to certain things that would affect whether the test company would meet the continuity of ownership test. [Schedule 3, item 1, paragraph 719-455(2)(a)]

3.23 This assumption must be made whenever there is a change in the identity of the top company for the MEC group during the ownership test period. [Schedule 3, item 1, subsection 719-460(1)]

3.24 The assumption is that, after the change in identity of the top company, for the purpose of applying the continuity of ownership test to the test company, there are no further changes in the membership interests or voting power of:

•

the company that was the top company for the MEC group before the change (the former top company)

or

•

any entity that at the time of the change was interposed between the former top company and the company that became the top company for the MEC group as part of the change (the new top company).

[Schedule 3, item 1, subsection 719-460(2)]

3.25 This assumption ensures that it is the ultimate owners of the MEC group that continue to be tested if the original top company is replaced by a new top company during the ownership test period.

Assumption about the test company failing to meet the continuity of ownership test conditions

3.26 The second assumption that is made for the purpose of applying the continuity of ownership test to the test company is about the test company failing to meet the continuity of ownership test conditions in section 165-123. [Schedule 3, item 1, paragraph 719-455(2)(b)]

3.27 The assumption is that the test company (and therefore the head company of the MEC group) is taken to have failed the continuity of ownership test at the time that certain events happen after the start of the ownership test period in relation to:

•

the MEC group

or

•

the potential MEC group whose membership was the same as the membership of the MEC group.

[Schedule 3, item 1, subsection 719-465(1)]

3.28 One event that could happen after the start of the ownership test period that causes the assumption to apply is that the potential MEC group ceases to exist. [Schedule 3, item 1, subsection 719-465(2)]

3.29 A second event that could happen after the start of the ownership test period that causes the assumption to apply is something that happens in relation to the membership interests of either:

•

a company that, just before the event happens, was an eligible tier 1 company of the top company for the MEC group

or

•

an entity interposed between a company that, just before the event happens, was an eligible tier 1 company of the top company and the company that was the top company for the group just before that time,

where that thing causes a change in the top company for the potential MEC group (but does not cause the potential MEC group to cease to exist). [Schedule 3, item 1, subsection 719-465(3)]

3.30 A third event that could happen after the start of the ownership test period that causes the assumption to apply is the MEC group ceasing to exist because there ceases to be a provisional head company of the group. [Schedule 3, item 1, subsection 719-465(4)]

3.31 If this assumption applies because one of those three events happen, the test company is taken to have failed the continuity of ownership test. However, this does not limit the circumstances in which the test company can fail that test. [Schedule 3, item 1, subsection 719-465(5)]

Head company's failure to meet the continuity of ownership test

3.32 The head company is taken to fail the continuity of ownership test only at the following times (which ever is relevant):

•

The first time the test company failed the continuity of ownership test having regard to the assumptions outlined in sections 719-460 and 719-465.

•

The test time (as described in section 166-40) for the test company if both:

-

Division 166 (which modifies the way in which the continuity of ownership test applies to a listed public company) is relevant in determining whether the test company satisfies the continuity of ownership test having regard to the assumptions outlined in section 719-460

-

the test company is not assumed under section 719-465 to fail the continuity of ownership test before the test time.

[Schedule 3, item 1, subsection 719-455(3)]

Application of the same business test to a head company

3.33 If the head company fails the continuity of ownership test, it will not be able to deduct a bad debt unless it satisfies the same business test (which is contained in Subdivision 165-C).

3.34 Section 166-40 modifies the way in which Subdivision 165-C applies to a company that is a listed public company at all times during the relevant period (the test period) for the purposes of determining whether that company can deduct a bad debt.

3.35 If section 166-40 directly affects whether the head company can deduct a bad debt, then the provisions under that section relating to the same business test are applied to the business of the head company of the MEC group (rather than the test company) just before the time described in subsection 719-455(3). [Schedule 3, item 1, subsection 719-455(4)]

Swap losses

3.36 Section 63E of the Income Tax Assessment Act 1936 (ITAA 1936) specifies the circumstances in which a taxpayer can deduct swap losses. Swap losses arise if the amount of a debt that is extinguished under a debt/equity swap is greater than the equity value of the shares or units received. Section 63E, among other things, specifies that Subdivisions 165-C, 166-C and 175-C of the ITAA 1997 apply to a swap loss deduction in the same way that they apply to a bad debt deduction.

3.37 To ensure that the swap loss rules in section 63E apply appropriately to consolidated groups and MEC groups, the modifications to the bad debt rules for consolidated groups and MEC groups will also apply to determine whether consolidated groups and MEC groups can deduct swap losses. [Schedule 3, items 2, 3 and 19, sections 709-205, 709-215 and 709-220 ]

Making and revoking certain choices

3.38 Part 2 of Schedule 3 to this Bill extends the time within which the head company of a consolidated group or a MEC group can make or revoke each of the following choices:

•

the choice to retain the tax cost of a joining entity's assets

•

the choice to cancel a loss by the head company of a consolidated group or MEC group

•

the choice to use the value donor concessions

•

the choice to waive the capital injection rules

•

the choice to use certain losses over three years.

3.39 The amendments do not extend the consolidation transitional period (which is from 1 July 2002 to 30 June 2004) and do not override any existing requirement that a loss be transferred to the head company of a consolidated group or a MEC group before 1 July 2004.

The choice to retain the tax cost of assets ('stick' or 'spread')

3.40 The head company of a consolidated group that is a transitional group can, in certain circumstances, make a choice, or revoke an earlier choice, for a joining entity to be a chosen transitional entity (section 701-5 of the Income Tax (Transitional Provisions) Act 1997 ). Currently, this choice, or the revocation of the choice, must have been made by the end of 31 December 2004. If a joining entity is a chosen transitional entity, the tax cost of the joining entity's assets are not reset. This choice is commonly referred to as a choice to 'stick' or 'spread'.

3.41 The time within which the head company must make, or can revoke, this choice will be extended until the end of 31 December 2005. [Schedule 3, items 21 and 22, paragraphs 701-5(2)(b) and 701-5(4)(a) of the Income Tax (Transitional Provisions) Act 1997]

The choice to cancel the transfer of a loss by the head company of a consolidated group

3.42 Losses made by the joining entity of a consolidated group prior to joining the group are, provided certain tests are satisfied, generally transferred to the head company of the group (section 707-120 of the ITAA 1997). The head company can make a choice to cancel the transfer of the loss (section 707-145). A head company may make this choice to, for example, avoid having to recalculate available fractions for its existing bundle of losses when a new loss entity joins the group. Broadly, the available fraction specifies the rate at which losses made by the joining entity of a consolidated group prior to joining the group can be utilised by the head company.

3.43 If an affected entity leaves the consolidated group, the head company can revoke the choice to cancel the transfer of the loss, provided that all affected entities agree (section 707-145 of the Income Tax (Transitional Provisions) Act 1997 ). Currently, the revocation of the choice must have taken place before 1 January 2005.

3.44 The time within which the head company can revoke a choice made under section 707-120 of the ITAA 1997 will be extended so that the revocation of the choice must take place before 1 January 2006. [Schedule 3, item 23, paragraph 707-145(a) of the Income Tax (Transitional Provisions) Act 1997]

The choice to cancel the transfer of a loss by the head company of a MEC group

3.45 When a company joins an existing MEC group and becomes an eligible tier 1 company of the group or an ordinary consolidated group converts to a MEC group, sections 719-305, 719-310 and 719-315 of the ITAA 1997 may require the head company of the group to:

•

establish an available fraction for any prior year losses of the new eligible tier 1 company

•

adjust the available fractions for bundles of losses of the existing MEC group.

3.46 The head company of a MEC group can choose to cancel all the losses in certain bundles of losses (section 719-325). This choice can be revoked by the head company. However, currently, the revocation of the choice must have taken place before 1 January 2005 (section 719-310 of the Income Tax (Transitional Provisions) Act 1997 ).

3.47 The time within which the head company can revoke a choice made under section 719-325 of the ITAA 1997 will be extended so that the revocation of the choice must take place before 1 January 2006. [Schedule 3, item 32, section 719-310 of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to use the value donor concessions

3.48 The available fraction for a bundle of losses transferred to the head company of a consolidated group is worked out by, broadly, dividing the modified market value of the real loss maker at the time of the transfer by the transferee's adjusted market value at that time (section 707-320 of the ITAA 1997).

3.49 As a transitional rule, the value donor concessions allow, in certain circumstances, the transferee to increase the available fraction for a bundle of losses by, broadly, choosing to work out the available fraction using some or all of the modified market value of a company other than the real loss maker (section 707-325 of the Income Tax (Transitional Provisions) Act 1997 ).

3.50 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 24, paragraph 707-325(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.51 In addition, the time within which this choice can be amended or revoked will be extended until 31 December 2005. [Schedule 3, item 25, subsection 707-325(6 ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.52 Where the transferee has chosen to apply section 707-325 of the Income Tax (Transitional Provisions) Act 1997 and uses some or all of the modified market value of a company other than the real loss maker to work out the available fraction for a bundle of losses, the transferee can also choose to treat certain losses made by the value donor as being included in the real loss maker's loss bundle (section 707-327 of the Income Tax (Transitional Provisions) Act 1997 ).

3.53 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 26, subparagraph 707-327(5)(a)(ii ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.54 In addition, the time within which this choice can be revoked will be extended until 31 December 2005. [Schedule 3, item 27, paragraph 707-327(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to waive the capital injection rules

3.55 The capital injection rules prevent a consolidated group from being able to inflate a joining entity's available fraction by a capital injection or by undertaking a non-arm's length transaction prior to the joining entity becoming a member of the group (section 707-325 of the ITAA 1997).

3.56 As a transitional rule, in certain circumstances where the transferee chooses to apply the value donor concessions, the transferee can also make a choice so that the capital injection rules do not apply to work out the joining entity's available fraction (section 707-328A of the Income Tax (Transitional Provisions) Act 1997 ).

3.57 The time within which the transferee can make this choice will be extended until the later of:

•

broadly, the day on which the transferee entity lodges its income tax return for the first income year for which it utilises the transferred losses

•

31 December 2005.

[Schedule 3, item 28, subparagraph 707-328A(4)(a)(ii ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.58 In addition, the time within which this choice can be amended or revoked will be extended until 31 December 2005. [Schedule 3, item 29, paragraph 707-328A(4)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

The choice to use certain losses over three years

3.59 As a transitional rule, certain losses transferred to a head company can be utilised over three years rather than being limited to an available fraction (section 707-350 of the ITAA 1997). Broadly, this transitional rule applies to losses that were made during an income year ending on or before 21 September 1999 and that were transferred to the head company because they satisfied the continuity of ownership test. The transferee must make a choice to apply this transitional rule.

3.60 The time within which the transferee can make this choice will be extended until the later of:

•

the day on which the transferee entity lodges its income tax return for the first income year for which it utilises any losses transferred

•

31 December 2005.

[Schedule 3, item 30, paragraph 707-350(5)(b ) of the Income Tax (Transitional Provisions) Act 1997 ]

3.61 In addition, the time within which this choice can be revoked will be extended until 31 December 2005. [Schedule 3, item 31, subsection 707-350(6 ) of the Income Tax (Transitional Provisions) Act 1997 ]

Application and transitional provisions

3.62 The amendments in Schedule 3 will apply from 1 July 2002 (being the commencement date of the consolidation regime). [Schedule 3, items 20 and 33, section 719-450 of the Income Tax (Transitional Provisions) Act 1997 ]

3.63 These amendments clarify the application of the bad debt rules in the income tax law to MEC groups and give all consolidated groups (including MEC groups) more time to make certain irrevocable elections. Having the amendments apply from 1 July 2002 will provide maximum certainty and minimise the risk of arbitrary outcomes arising from a later commencement date.

Consequential amendments

Modification to the bad debt rules for MEC groups

3.64 Consequential amendments are made to include a reference to new Subdivision 719-I (which contains the modifications to the bad debt rules for MEC groups) in:

•

various provisions and notes to provisions in the Financial Corporations (Transfer of Assets and Liabilities) Act 1993

•

various provisions and notes to provisions in the ITAA 1936

•

various reference tables and notes to provisions in the ITAA 1997.

[Schedule 3, items 4 to 18, section 22 of the Financial Corporations ( Transfer of Assets and Liabilities ) Act 1993, section 427 of the ITAA 1936, sections 266-35, 266-85, 266-120, 266-160, 267-25, 267-65 and 271-60 in Schedule 2F to the ITAA 1936 and sections 12-5, 25-35 and 165-120 of the ITAA 1997 ]